Temporary stabilization: a stochastic analysis

Abstract

Although much knowledge has been gained about temporary inflation stabilization from the experience of South America and the Middle East in the 1970s and 1980s, much remains to be learned. The Mexican episode of 1989-1994 brings the issue to our attention once again. The purpose of this paper is to extend Calvo's (1986) work on temporary stabilization into a richer stochastic environment. After all, what produces expected temporariness is uncertainty. It is assumed that, inside an adjustable band, the expected rate of devaluation is driven by a mixed diffusion-jump process. The paper provides au explanation of the response of consumption to stabilization plans under political uncertainty, as occurred in Mexico during 1989-1994. An important aspect of this paper is that Calvo's (1986) deterministic result on booms in consumption under temporary stabilization, in a cash-in-advance economy, is locally preserved despite stochastic considerations. However, in a Sidrauski-type stochastic model, we show that Pareto-Edgeworth independence does not lead to exchange-rate policy neutrality, contrary to Calvo's deterministic conclusion, We also assess welfare consequences, carry out simulation experiments, and examine the effects of stochastic stabilization horizons.