Inflation Policy
Fiscal reform comes first

Recent inflationary experience in countries like Israel, Argentina and Brazil cannot be explained using conventional arguments concerning the relation between macroeconomic policy and inflation. Keynesian theory cannot explain the peculiar 'plateau' path taken by inflation in those countries: inflation is often stable for several years, suddenly jumps to a new plateau, stays there for some years, and then jumps again. Simple monetarist explanations are unsatisfactory as well, with no apparent link between increases in inflation and prior or simultaneous increases in the money supply. A final puzzle concerns the unhappy experiences of some Latin American countries in the late 1970s and of Israel in 1982-83. They attempted to stabilize inflation by freezing or restraining exchange-rate movements. Not only did experiments along these lines end in failure, but after the collapse of the experiment all these countries saw inflation accelerate to levels well above those observed before the stabilization programme started.

In Discussion Paper No. 87, Research Fellow Sweder van Wijnbergen suggests an explanation for these phenomena which draws upon the 'public finance approach' to inflation first introduced by Phelps. This approach does not rely on assumptions of irrational behaviour, arbitrary expectation mechanisms, or unexplained 'inertia' in the system. Van Wijnbergen uses a simple open- economy model in which consumers base intertemporal expenditure plans and asset-market demands on rational optimizing behaviour. They have perfect foresight and take full account of their own budget constraint as well as that faced by the public sector.

Van Wijnbergen uses this model to investigate the response of the economy to various policy-induced and external shocks under a floating exchange rate regime. He analyses the transition to a fixed exchange rate regime and discusses its sustainability. In particular, he explores the behaviour of the economy when inconsistent policy measures are adopted and the fixed regime is therefore unsustainable.

Under a floating exchange rate regime, higher world real interest rates will bring about an increase in inflation in the presence of externally held government debt. Van Wijnbergen notes that this may illuminate the experience of Brazil between 1981 and 1985. In addition, van Wijnbergen shows how restrictive monetary policies, if they are inconsistent with the government's intertemporal budget constraint, will actually lead to a depreciation and permanently higher inflation. This result is similar to the earlier analysis of a closed economy by Sargent and Wallace.

Van Wijnbergen's main results, however, concern the policy of freezing the exchange rate. He studies the conditions under which a fixed exchange rate regime will collapse and shows that inflation after the collapse will exceed the rate just before the start of the stabilization experiment: a botched stabilization is worse than none at all.

He also shows that during a freeze, restricting domestic credit growth to a rate that will prevent reserve outflows is insufficient to prevent speculative attacks on the fixed exchange rate. If the public sector follows such a credit policy, financing the remainder of its deficit by issuing public debt, the post-collapse rate of inflation will be even higher than that which would result from financing the deficit through credit creation alone.

Van Wijnbergen's analysis assumes that the government does not undertake the reforms in government expenditure and taxation necessary to make the fixed exchange rate regime feasible. He stresses that even if the government intends to undertake such reforms in the future, speculative disruption of its policies will occur if the private sector doubts that these reforms will in fact be implemented. The policy conclusion is clear, according to van Wijnbergen: credible fiscal reform is not only necessary for the success of anti-inflation programmes, but should take precedence.


Fiscal Deficits, Exchange Rate Crises and Inflation
Sweder van Wijnbergen

Discussion Paper No. 87, December 1985 (IT)