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We offer an explanation of why optimal policy under commitment requires weaker reaction to supply shock, reflected in the failure of the Taylor principle. This lesson seems to be prevalent among central banks and yet has been analyzed incomprehensively in the economic literature.

This paper challenges the dominant model which was used to explain the chronic inflation process, as in Latin America in the seventies and eighties. Unlike the usual long term view we present a variant of the Barro and Gordon policy game model which is based on short term considerations in the inflationary period. In the latter period the model implies a random walk and after stabilization the model implies stationarity. Thestatistical tests, using data from Brazil and Israel, do not reject the implications of the model.

The payment of interest on reserves has been a common practice in inflationary economies. This policy may seem paradoxical since it involves returning part of the seigniorage, generated by the inflation process, with the intention to finance the fiscal deficit. This paper argues that the motivation for this policy can be captured by the discretionary regime, where the policymaker pays interest on reserves because he is concerned with the erosion of real liquidity by inflation, which is in part beyond his control. However, this policy is an unlikely outcome in the commitment regime, where the policymaker is in full control of inflation.

The paradox is that inflationary finance is supposed to repress money substitutes, while in practice chronic inflation economies introduced indexed money substitutes on a large scale. My explanation is that the regime in the latter economies was probably closer to discretion than to rules. It is shown that under discretion it is optimal to introduce indexed money to protect the liquidity position, in the face of adverse expectations.

In the mid-1980’s Mexico successfully brought down its high rate of inflation by using the exchange rate as nominal anchor in combination with strict fiscal discipline, tight monetary policy, and incomes policy. This paper discusses the role of exchange rate policy as nominal anchor in Mexico and develops the inflation target as the monetary framework for anchoring prices. It also describes how Mexico is applying this frame work while shifting to a more flexible exchange regime and discusses the role of the newly independent central bank and monetary policy in keeping inflation under control while shifting nominal anchors. This paper describes the situations as seen in early 1994, and makes no attempt to describe the events that led to the 1994 crisis and its aftermath.

The high inflation equilibrium (HIE) refers to a steady state solution where inflation is higher than the one which maximizes seigniorage (i.e. inflation is on the falling segment of the Laffer curve). It has been claimed that the HIE can be stable when the adjustment of expectation is fast. However, adjustment is fast because inflation is high; so the argument is circular. In this paper we rationalize the HIE using the policy game approach which distinguishes between discretionary and precommitment regimes. We expand, and demonstrate rigorously (using a technique developed by Obstfeld), Barro's suggestion that a HIE may result from a discretionary regime. We show that this is not possible under precommitment. In addition, we demonstrate that a HIE may result from non-fiscal factors (such as the motivation to reduce unemployment) in a discretionary regime. We conclude with a simple diagrammatic exposition of the difference between our approach and the previous one.

Inflation inertia may be quite tenacious because of the simultaneous interaction between policy actions and inflationary expectations under imperfect credibility. This result is particularly relevant for understanding some of the failed efforts to stabilize inflation in South America. This article deals with the issue of inertia in the framework of imperfect information about the type of the policymaker and extends the existing models to an infinite horizon. Because policymakers do not have perfect control of inflation, a frivolous stabilizer may deviate from the policies of a serious stabilizer without necessarily being unmasked immediately. When the difference in the ability of strong and weak policymakers to control inflation is large, unexpected inflation may be persistently negative for quite a while, thus causing reduced economic activity and giving the indication that credibility is low. If the policymaker persists with the stabilization, this pattern gradually disappears as his reputation rises. But before this final stage the serious policymaker has to compromise his inflation objective in view of adverse expectation about this type and pay the cost of imperfect credibility.

What advantages and disadvantages does the heterodox strategy offer to stabilization programs in countries with chronic high inflation? heterodox stabilization programs, in our definition, are those that support orthodox policies that is, tight fiscal policy and a fixed exchange rate-with the initial, temporary use of incomes policies-that is, price and wage controls. This evaluation, based on several heterodox programs, successful and unsuccessful, from the 1960s and 1980s in Latin American countries and Israel.

This paper examines the optimal behavior of a policymaker who is able to precommit (labelled ‘strong’) when the public entertains the possibility that he is either strong or weak (unable to precommit). The main result is that, in the presence of doubts about their type, it is optimal, even for strong policymakers, to partially accommodate inflationary expectations. This contrasts with Vickers (1986) who finds that when strength is conceived in terms of the relative concern for employment the strong policymaker inflates less under incomplete than under full information. The paper also provides a theory of endogenous announcements.

It is well known that flexible exchange rates are mostly connected with discretionary monetary regimes. Commodity standards using the same commodity, for instance gold or silver, or a commodity basket as a base necessarily imply fixed exchange rates. Under such conditions these rates can only move in a very narrow range determined by transportation and insurance costs. In gold or silver standards the limits of this range are given by the upper or lower gold or silver points. If free markets in these commodities exist, the exchange rates will be maintained within this range by the arbitrage activities of private individuals.

Central and East European countries experienced severe output declines during stabilization. To many this is not surprising, as reductions in the budget deficit and tight monetary and credit policies are usually recessionary. But the importance of stabilization in the output decline is still under debate because these programs were accompanied by major structural reforms to switch from centrally planned systems to market economies (see Blejer et al., 1993; Bruno, 1993; Calvo and Coricelli, 1992; Lipton and Sachs, 1990). Curiously, the output declines were as severe in countries that made major strives to stabilize (for example, Poland and the CSFR) as in those where inflation was rampant and fiscal stabilization is still lagging (Russia and Romania).

The purpose of this paper is to identify the factors which determine the strength of commitment that policymakers choose to back up a fixed exchange rate system. In practice the commitment level is achieved by choosing a particular set of monetary and exchange rate arrangements. The authors develop a Barro-Gordon type model in which the policymaker has to decide how much to commit under uncertainty. An important assumption is that the stronger the commitment to the fixed exchange rate the greater the political cost of reneging on it. Thus, prior to deciding on the choice of exchange rate arrangements the policymaker has to weigh the benefits, to the disinflation program, from making a strong commitment against the potential costs of being forced to renege on it. Some of the more technical details are presented in appendices. The paper illustrates the results of the model with examples from Latin American countries and concludes with a comparison of the results of the authors approach with related work.

Part 1 The transition from stabilization to sustained growth in Bolivia, Juan Antonio Morales: comments by Peter Bernholz comments by Juan L. Cariaga general discussion. Part 2 Chile's experience with stabilization revisited, Vittorio Corbo and Andres Solimano: comments by Sebastian Edwards comments by Leonardo Leiderman general discussion. Part 3 From sharp disinflation to hyperinflation, twice - the Argentine experience, 1985-1989, Daniel Heymann: comments by Jose Juis Machinea comments by Simon Teitel general discussion. Part 4 From inertia to megainflation - Brazil in the 1980s, Eliana Cardoso: comments by Persio Arida comments by Juan Carlos de Pablo general discussion. Part 5 The inflation-stabilization cycles in Argentina and Brazil, Miguel A. Kiguel and Nissan Liviatan: comments by Mario I. Blejer comments by Assaf Razin general discusion. Part 6 The costly transition from stabilization to sustainable growth - Israel's case, Michael Bruno and Leora (Rubin) Meridor: comments by Stanley Fischer general discussion. Part 7 Mexico beyond the debt crisis - toward sustainable growth with price stability, Guillermo Ortiz: comments by Fernando Clavijo comments by Sylvia Piterman general discussion. Part 8 Premature liberalization, incomplete stabilization - the Ozal decade in Turkey, Dani Rodrik: comments by Sweder van Wijnbergen general discussion. Part 9 The Yugoslav path to high inflation, Velimir Bole and Mitja Gaspari: comments by Neven Mates comments by Domenico Mario Nuti general discussion. Part 10 Panel discussion - what's new since Toledo?

In a recent paper Sargent and Wallace present an example where tightening of monetary policy over a specified time interval, in conjunction with a constant deficit, leads to an increase in the rate of inflation not only beyond this interval but even from the outset. In the present paper I show how the latter result can be derived from a standard monetary-growth model of the Sidrauski-Brock type. This enables a relatively simple interpretation of the apparent paradox.

This paper examines the thesis of neutrality of government bonds in the framework of a monetary growth model with an infinitely lived representative consumer. It is shown that, unlike the case of a non-monetary economy, the additional interest on an increased national debt can be offset partly by the ‘inflation tax’ rather then by ordinary taxes. If the former option is adopted by the government, then its bonds will no longer be neutral. Various forms of non-neutrality are derived and interpreted.

The Tight Money Paradox refers to a result obtained by Sargent and Wallace stating that a reduction in the constant rate of monetary expansion may lead to higher inflation both in the short and long runs. This result was obtained for a system which is dynamically unstable. In the present paper I show that the foregoing result can be obtained within the framework of a stable system if we redefine “tight money” to mean a reduction in the share of money financing of the budget deficit.

In recent literature the monetary model of trade is presented diagrammatically in terms of hoarding and of the relative price of non-traded goods. In this paper we go back to the original diagrammatic approach of Mundell where he uses the stock of domestic money instead of hoarding. We adapt Mundells approach to the more recent developments of the monetary model and point out its expository advantages. We conclude the paper with a comparison of the two approaches.

Orthodox stabilization programs in Latin American countries have been notoriously unsuccessful in combating inflation, despite the imposition of stringent cuts in government deficits. In most cases inflation came down only slowly and temporarily, with concomitant declines in growth and employment. The Bolivian program, one of the only Latin American successes, is contrasted with those of Argentina, Brazil, Chile, and Mexico. The problems of dealing with chronic inflation are compared with those of hyperinflationary countries, and the influence of price and wage rigidities, expectations, and credibility is explored. The study shows that fiscal restraint is a necessary but not sufficient condition for success, and that sound management of nominal variables (the exchange rate and money supply) are also necessary. The critical role of credibility is linked with price and wage rigidities in the chronic inflation countries, whereas the unsuitability of hyperinflation is seen to increase the credibility of and thus the potential for successful stabilization programs.

This paper examines the effect of a change in the rate of monetary expansion on the dynamics of the real exchange rate under fully flexible domestic prices and a floating exchange rate. The model is similar in structure to an ealier paper by Calvo and Rodriguez, the main difference being that in our model consumers have an infinite planning horizon and long-run perfect foresight. One of the main findings is that an increase in the rate of monetary expansion has the impact effect of creating a real appreciation of the exchange rate and a deterioration of the balance of payments, contrary to the results of Calvo and Rodriguez.

We consider government intervention in the capital market by selling indexed bonds and buying non-indexed bonds of equal value. If the profits or losses of this operation are transmitted to the public which takes this into consideration then the government's intervention may have no effect on the economy. Insofar as the assumptions of the model permit real effects of the foregoing policy the impact on the economy tends to be deflationary. In analyzing this tendency a distinction is made between the case where the government intervenes in an existing market and the case where it creates a new market for indexed bonds.

This paper examines the monetary approach to the balance of payments under fixed exchange rates when domestic prices and wage rates are not fully flexible. This leads to a formulation in the spirit of a ‘disequilibrium analysis’. We analyze alternatively the cases where the prices of nontraded goods or the nominal wage rate are treated as state variables along with the stock of money. The properties of these systems are analyzed from the point of view of the momentary equilibrium and of the dynamic adjustment process.