Sticky inflation and the real effects of exchange rate-based stabilization

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jinteco.2005.05.014 Byline: Oya Celasun Keywords: Inflation; Disinflation; Inflation persistence; Exchange rate pegs; Consumption Abstract: This paper tests the empirical validity of the forward-looking pricing hypothesis using data from four exchange rate based stabilization (ERBS) episodes. It finds that backward-looking components of inflation play an important role in inflation dynamics, in some cases exceeding the importance of forward-looking components. The paper then shows that the presence of empirically relevant degrees of inflation stickiness increases the size of the real exchange rate appreciation predicted by an imperfect credibility model of ERBS. The 12% real appreciation predicted by the sticky inflation model is a 70% improvement over the predictions of the fully forward looking pricing setup, but as in other ERBS models, still falls short of matching the real appreciations observed in practice. Author Affiliation: Research Department, International Monetary Fund, 700 19th Street NW, Washington DC 20431, United States Article History: Received 4 May 2004; Revised 11 February 2005; Accepted 17 May 2005