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					Part II


The use of the exchange rate to achieve economic goals has, historically
speaking, not always been met with success. An infamous precedent was the
final collapse of the Bretton Woods agreement, in which industrial nations
finally abandoned their efforts to sustain a fixed exchange rate system. In the
aftermath of Bretton Woods and in congruence with the prevailing economic
ideology of the times, many developing countries that adopted more flexible
exchange rate regimes during the 1980’s found their efforts to attain macro-
economic stability thwarted by the debt crisis of 1982. For many, exchange
rate flexibility became another name for chronic inflation. Even for members
of the IMF Executive board, enthusiasm for an active exchange rate policy
”went too far”; according to their view exchange rates should move towards
more rigidity as a way to introduce financial discipline and provide a nominal
anchor.23 It is no wonder then that the tides again have turned in favor of us-
ing the exchange rate as an instrument to attain macroeconomic stability.24 .
Responding in part to the failure of monetary (orthodox) stabilization, dis-
inflation policies that include an exchange-rate-based stabilization have been
widely used in the developing economies (especially in Latin America) to
combat chronic inflation.
    The main component of an ERBS is the announcement of a reduction
or freeze in the rate of devaluation aimed at curbing inflationary pressures,
whether these originate in excessive budget deficits or in the wage and price-
setting behavior of the private sector. Specifically, an ERBS tackles the
     See Sebastian Edwards, 1995, p. 2.
     The rather nostalgic appeal for using a fixed exchange rate as a way to maintain price
stability originates in the pre-World War II period from its undeniably decisive role in
bringing hyperinflation under control (by restoring convertibility of the domestic currency
to the dollar or equivalently to gold). Historical examples in Austria (1924), Germany
(1924), Poland (1924), Greece (1946) and others make a case for fixing the exchange rate
to a nominal anchor. Thomas Sargent (1986), third chapter, offers an extensive and
insightful discussion of the role of the gold standard in hyperinflation of the 20’s.

problem of inflation by using the exchange rate as the main nominal anchor,
where an inflation-prone country (unilaterally) pegs the exchange rate of its
currency to the currency of another country that has a tradition of low infla-
tion.25 The basic argument is that by importing the anti-inflationary regime
of stable countries through an exchange rate peg, price-setters in the goods,
labor and foreign exchange market adjust their inflationary expectations to
the rate of inflation prevailing in that of the anchor country.
    Governments that use the exchange rate in discretionary fashion to ease
their external position tend to abuse this instrument, thus introducing an
inflationary bias into the economy. One major rationale for resorting to a
fixed exchange rate regime is the belief that the mere announcement of an
ERBS program will help to reduce inflationary expectations, thus raising
the probability of the program’s success. The adoption of a predetermined
exchange rate anchor thus serves as a commitment technology and, given a
disreputable history of failed stabilization attempts, represents a fundamen-
tal change in the exchange rate regime of the government. Given a suitable
institutional framework the introduction of a fixed exchange rate acts as a
constraint in the government’s ability to surprise the private sector through
an unanticipated devaluation. The caveat is that a fixed exchange rate rule
is basically a commitment to carry out a given monetary policy and subse-
quently domestic policymakers completely forgo the use of monetary policy
for stabilization purposes.26
    An historical example of an ERBS are the orthodox stabilization27 efforts
of Argentina and Chile in the late 70s. The cornerstone of stabilization was
a preannounced exchange rate against the US-dollar, the so-called tablita,
with a decreasing rate of devaluation that was below the ongoing rate of
inflation. If everything had gone according to plan, the inflation rate should
     Some ERBS programs have alternatively relied on less stringent exchange rate schemes
than a fixed parity. For example some countries implemented a rule-based crawling peg
system with a low rate of depreciation (e.g. Mexico 1987), or a preannounced gradual
reduction in the rate of devaluation.
     This assumes, of course, the existence of an open capital market. Then it holds
that “a country cannot simultaneously maintain fixed exchange rates and an open capital
market while pursuing a monetary policy oriented toward domestic goals.” (Obstfeld,
M. (1998), p. 14-15.).
     Labeled as “orthodox” to distinguish stabilization programs from “heterodox” pro-
grams that additionally rely on price or wage controls to cushion the effects on the econ-

have converged quite rapidly to the world inflation rate plus the preset rate of
devaluation. In fact, Argentina’s program succeeded in dampening inflation,
but contrary to what the architects had expected, the speed of convergence
of the inflation rate to the preannounced rate of devaluation proved to be
very slow. The ensuing real appreciation of the currency had the less desir-
able effect of deteriorating the current account balance, “reaching a deficit
of around 3% of GDP in 1979 and 1980.”28 The severe imbalance in the
external account fueled expectations of a devaluation and the program was
eventually abandoned in 1981. The same pattern of asynchronous inflation
and devaluation rate, deteriorating current account and subsequent default
were to be observed in the Chile. The real appreciation of the Chilean peso
(over 30% with respect to 197529 ) led to a dramatic deterioration in the exter-
nal position, with the current account deficit increasing to 14.5% of GDP in
1981.30 The record on inflation front shows that during the initial phase the
Chilean experience was no better than Argentina was in reducing inflation
to tolerable levels.31 As the external environment became hostile (due to the
debt crisis, the fall in copper prices, capital flight and a gaping balance of
payments deficit) the government was forced to renege on its exchange rate
commitment and devalued the currency in 1982.
    A similar pattern emerges when observing the more recent historical
record on the use of managed exchange rate policies in Table 5.6. In most
cases the trade balance deteriorated to a considerable degree in the year fol-
lowing the announcement of the exchange rate regime, the sole exception
being Israel’s program of 1985, which also had the unique property among
the selected programs of being quite effective in bringing down inflation. Nei-
ther the Argentine Austral Plan of 1985, nor the Brazilian Cruzado Plan of
1986 succeeded in achieving a lasting stabilization. In Brazil, a deteriorating
external position and large fiscal deficits led to unsustainable imbalances that
finally undermined the stabilization attempt.32 .
     Kiguel and Liviatan (1994), p. 10.
     Ibid., p. 12.
     Carlos A. Vegh (1992), p. 649. According to this source, the huge current account
deficits were largely financed by large capital inflows.
     To be fair, the Chilean program did eventually bring inflation down to international
levels, but “this took five years, with the decisive period (of pegging the exchange rate)
lasting two years” (Kiguel and Liviatan (1994), p. 12).
     As Agenor and Taylor (1992) note, ”The balance of payments deteriorated sharply
as a result of the trade deficit and also because of widespread speculation that corrective

    Argentina’s more recent ERBS program, initiated in 1990 is still up and
running, even despite the aftershocks of the so-called ‘tequila effect’ and
the Asian crisis that followed. It qualifies as a prime example of successful
disinflation using a fixed parity (fixed to the US-dollar in a currency board),
bringing an end to almost four decades of high inflation. The achievement
was markedly more successful than previous attempts with an ERBS. Mexico
used a crawling target zone, where the (preannounced) rate of devaluation
was deliberately set below the rate of ongoing inflation. Until the collapse of
the peg in 1994, the program did quite well in reducing inflation to tolerable
levels, albeit with the familiar side-effect of external imbalance.

                   Tab. 5.6: ERBS programs in practice

        Selected Exchange-rate-based stabilization         programs 1985-1990
        Country     Date          Inflation                    Trade Balance
                             (-1)    (0) (+1)               (-1)   (0) (+1)
        Argentina 6/85 1,189 50              110           1,462 1712 888
        Argentina 3/90 20,274 287            18             1038 1935 1151
         Brazil     2/86     289     52      481           2,021 2460 585
          Israel    1/85     446     24      20             -603 -639 -355
         Mexico     12/87    159     52      20             1879 1770 -456

        Source: Kamien, S. (1991) and International Financial Statistics, various
        issues. Inflation rates measure consumer inflation, month over year-earlier
        month. Trade balance is given in millions of US$ for the quarter in which
        the program was initiated. (-1) refers to the 12 months prior to the program
        announcement, (0) refers to the year in which the announcement was made,
        and (+1) refers to the following 12 months.

    To summarize then, the empirical evidence suggests that the ERBS were
generally more effective than previous “experiments” with money-based pro-
grams in combatting chronic inflation. But on closer inspection the stylized
facts emerge that reductions in inflation were usually only gradual, with the
inflation rate converging only sluggishly to the new parity, resp. rate of deval-
uation, resulting in a deterioration of the trade balance and current account.
Also, once macroeconomic imbalances went out of control the authorities
action would include a major devaluation of the domestic currency.” (p. 560).

were more than willing to renege on their previous commitment to the fixed
exchange rate.
    What went wrong? With modern macroeconomic views emphasizing ex-
pectations and institutional constraints, the ERBS approach has become
closely linked with the issue of credibility. In this line of reasoning, one com-
pelling explanation representative of many is that “the persistence of inflation
was driven by lack of credibility about the ability or willingness of the au-
thorities to adhere to the exchange rate rule in the event of adverse shocks”33
A central feature of general idea that motivated these ERBS was that the
mere proclamation of a realignment (such as with the tablitas) of exchange
rates could suffice to deaccelerate inflation. As commentator observed, the
program would be able to

        . . . break inflationary expectations by announcing in advance an ex-
        change rate path . . . It was hoped that confidence in the reform would
        be built up month by month as the announced exchange rates we[re]
        (sic) successfully maintained, and that the increased confidence in the
        reform would provide an ‘expectation bonus’ in terms of reduced infla-
        tionary expectations and a consequent reduction in current inflation.34

The “announcement effect” (i.e. the immediate effects occurring when a
change in policy is announced) can be as powerful as the implementation of
policy itself. At the time that an ERBS is announced, however, the public
has only the previous track record of the government on which to formulate
its expectations of future policy. If the public is not persuaded by the procla-
mation to believe in the sustainability of an ERBS then the economy will
not move quickly to a new equilibrium with lower price expectations. Con-
sequently, the reduction in inflation will be lower than the reduction in the
rate of devaluation so that there will be a real appreciation of the currency
which undermines the competitiveness of the economy. If the parity is to be
retained in such a situation there is no automatic mechanism to generate the
real depreciation necessary to reduce the increasing current account deficit.
The consequence will be to default on the ERBS. As the evidence quite strik-
ingly illustrates, “The major flaw with fixed exchange rates is that credibility
usually comes before — not after — policy making has been carried out.”35

      See Kiguel and Liviatan (1994), p. 16.
      See Baxter, M. (1985), p. 344.
      See Colombatto and Macey (1996), p. 197.

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