Chapter 5 Fiscal and monetary policy interaction II: The role of expectations, inflationary and fiscal regimes

Transcription

1 Chapr 5 Fiscal and monary policy inracion II: Th rol of xpcaions inflaionary and fiscal rgims 5. Inroducion In Chapr w considrd on of h basic approachs o h macroconomic policy namly h principl of a susainabl fiscal policy. This principl sas ha a vry poin in im h public db mus b backd by h prsn discound valu of h n govrnmn rvnu which is gnrally drmind as h sum of h primary budg surplus and signiorag. In his chapr w will invsiga unilaral and join acions of h govrnmn and cnral bank ha will kp h public db on a susainabl pah. Th abiliy of h cnral bank o conrol h flow of signiorag givn h primary budg dfici or surplus is obviously of gra pracical imporanc for counris in which signiorag is a significan sourc of financing h budg dfici. Th modl suggsd blow allows us o widn h principl of unplasan monaris arihmic considrd in cion.4 in crain aspcs. Firs a dcras in h growh ra of bas mony may bring abou ihr a dcras or an incras in h sady lvl of signiorag dpnding on h inflaion rgim posiion h inflaion ax Laffr curv. Th logic and rsuls of h argn and Wallac modl ar ru only for h incrasing branch of h inflaion ax Laffr curv ha is for low inflaion whn h dmand for ral mony balancs ha is inlasic wih rspc o inflaion xpcaions. cond. Th dircion of h ransiional dynamics of signiorag may diffr from h dircion of chang in is sady lvl. n imporan rol is playd hr by h xpcaions of conomic agns. W assum ha xpcaions ar forward-looking and w addiionally allow for h possibiliy ha informaion abou changs in macroconomic policy bcoms availabl bfor hy ar acually implmnd. s can b sn from h analysis givn in cion.3 in his cas h xpcd dcras incras in h growh ra of bas mony will bring abou an incras dcras in h dmand for ral mony balancs vn bfor h acual changs in monary policy. Hr w should rmmbr ha signiorag is h produc of h acual growh ra of bas mony and h quaniy of ral mony balancs h dmand for which dcrass wih an incras in h xpcd fuur acual growh ra of bas mony. Thrfor boh h currn signiorag and h prsn discound valu of fuur signiorag flow may chang vn bfor swichs in macroconomic This fac was firs nod in conncion wih h principl of unplasan monaris arihmic by Liviaan 984 and Drazn 985. also Liviaan Th analysis in h Chaprs 3 and 4 also usd his vry imporan considraion. 4

2 policy ar implmnd. This facor byond any doub plays a vry imporan rol and as w will show lar may viola h principl of unplasan monaris arihmic vn in a low-inflaion conomy. Third. Th inrs ra on h public db play an imporan rol in h fiscal and monary policy inracion; i drmins in ssnc h discoun facor whn calculaing h prsn valu of fuur budg surpluss and of signiorag. Cris paribus a high inrs ra maks disan changs in macroconomic policis lss imporan and forcs h govrnmn and cnral bank o concnra mor on hir shor-run policis. By conras a low inrs ra will giv grar wigh o long-run policis. If i is h fuur valus of budg surpluss and signiorag ha is considrd by h principl of susainabl macroconomic policy hn h valu of h inrs ra will significanly influnc h choic of how fiscal and monary policis will inrac. 3 This chapr has h following srucur. In h scond scion w drmin join forwardlooking dynamics for ral mony balancs ra of inflaion and public db. In cions w sudy svral possibl ways in which fiscal and monary policis may inrac. In paricular cions and 5. provid hisorical xprinc of h Unid as Lain mrican and sian counris ha srv as counrpars o horical scnarios. W show ha undr crain assumpions monary policy may b prmannly ighnd givn xognous fiscal policis hus avoiding h unplasan monaris arihmic of argn and Wallac. Th xampls w discuss do no com clos o xhausing all possibl yps of macroconomic policy; hy do howvr allow us o drmin hr facors ha w considr o b of major imporanc in choosing how fiscal and monary policis should inrac namly: i fuur xpcaions of changs in policis ii inflaionary rgim lasiciy of h dmand for ral mony balancs and iii h inrs ra on public db. In cions w considr h consquncs of uncrainy abou h iming and yp of changs in macroconomic policis. In cion 5.4 w rurn y again o h problm of h Th rol of xpcaions of fuur changs in macroconomic policy h xpcaion of fuur sabilizaion was considrd xnsivly. for xampl Calvo 988 Drazn and Hlpman 988 Bnal and Ecksin 99 Millr kidlsky and Wllr 99 Brola and Drazn 993 argn 993 Millr and Zhang 997 uhrland 997 Rankin 998 Eldr 999 Rug and Murcia 999. Our rsarch concrns problms ha ar closs o hos considrd by Drazn and Hlpman s a rul spcial anion is paid o h inrs ra on h public db as i drmins h burdn of db srvic. a gnral ovrviw of his problm by Missal 999. In considring in ssnc h sam problm w ransfr h analysis o h conx of h inracion bwn fiscal and monary policy. I should also b nod ha w considr h inracion of fiscal and monary policy undr h assumpion ha h lar drmins h growh ra of bas mony. Howvr in raliy h cnral bank ofn pays mos anion no o h bas mony bu rahr o h inrs ra. In many counris afr World War II monary policis kp h inrs ra a a rahr low lvl hus dcrasing h burdn of public db srvic. This is an imporan xampl of h logic of h inracion of fiscal and monary policis; howvr in his rsarch w considr a monary policy ha conrols h mony bas no h inrs ra. 5

3 susainabiliy and fasibiliy consrains for macroconomic policy. In h final scion 5.5 w summariz our rsuls. Th nonlinar characr of h inflaion and of public db dynamics dos no allow us o invsiga h conomic sysm by purly analyical mans. Th ppndix a h nd of h chapr conains som numrical valus of h paramrs in h modl and h rsuls of horical xprimns ha confirm h mos imporan rsuls ha w arrivd a in h chapr. 5. usainabl macroconomic policy s in h prvious chapr w will considr hr h sandard pair of quaions ha dscrib h dynamics of h public db and of ral mony balancs: b& = d + rb m 5. m& = π m m. Howvr unlik our prvious analysis in his chapr w will considr h forward-looking dynamics of h variabls: τ x = E τ d τ 5. τ π = E τ dτ 5.3 τ E τ = dτ 5.4 b = E τ d τ rτ dτ. 5.5 In ordr o simplify our analysis and in ordr o b abl o arriv a analyical soluions w will bas our approach on h Cagan funcion for h dmand for ral mony balancs.. s in h cas of h backward-looking soluion 4.3 h scond quaion s indpndnc of h public db and of h paramrs of fiscal policy allows us by using h rsuls of our analysis in cion.3 o find h forward-looking soluion 5. for h logarihm of ral mony balancs. Th Cagan funcion. givs us x = ln m = π and his allows us o auomaically arriv a h quaion for h dynamics of inflaion 5.3. Thus using h dfiniion of signiorag ha = m and h fac x m = w find h volum of h monizaion of h opraional budg dfici 5.4. Finally 6

4 quaion 5.5 dscribs h dynamics of h public db in h cas of conducing susainabl fiscal policy. s w discussd in cion. quaion 5.5 characrizs h inrmporal budg consrain of h govrnmn givn h no-ponzi gam condiion.7: r lim b =. In h gnral cas fiscal and monary policis in h fuur may b unknown o h priva scor. Thus quaions includ an opraor for raional xpcaions E. Expcaions ar basd on h informaion s ha is availabl a im. In all xampls ha w considr blow h apparanc of informaion and changs in h xpcaions of conomic agns ar of principl imporanc. In ordr o simplify h analysis w will assum ha h insrumns of fiscal and monary policy and ar picwis-consan funcions of im. Changs in h lvls of d and d may b unknown a h iniial poin of im. In his rahr simpl framwork of prfc forsigh h us of raional xpcaion opraor may sm rdundan whil i would b ncssary if w modl h dynamics of h growh ra of bas mony and govrnmn dficis as a sochasic procsss for xampl Io procsss. Bu w prfr o kp his gnral approach for convninc s for xampl h sam noion in h xbook by Turnovsky ch prmann incras in h growh ra of bas mony I is clar from quaions 5. and 5.3 ha h xpcd prmann incras in h growh ra of bas mony rsuls in an incras in inflaion and a dcras in ral mony balancs now and in h fuur. Inrsingly from 5.4 and 5.5 h ffc on signiorag and fiscal sphr is ambiguous. L us considr h following simpl xampl. aring wih a consan growh ra of bas mony = a im h cnral bank announcs ha in h fuur saring from > h growh ra of bas mony will b incrasd o = >. I should b srssd ha h xisnc of h im inrval [ ] bwn his announcmn and h acual policy swich is crucial o h principal rsuls w arriv a. Using w can dscrib h dynamics of h log of ral mony balancs inflaion and signiorag: τ dτ + x = =. τ dτ = 5.6 7

5 π = =. 5.8 = Prior o h announcmn h mony mark is in a sady sa. Th announcmn a im lads o discr jumps in h log of ral mony balancs Δx = > = and in inflaion Δπ = =. Fig. 5. shows h im pahs of hs variabls. No mar wha sid of h inflaion ax Laffr curv h conomy is on h incras in h growh ra of bas mony iniially rsuls in a discr fall in signiorag: Δ = =. Up o im whn monary policy swichs h log of ral mony balancs and inflaion gradually adjus o hir nw sady lvls. In conras a his im signiorag undrgos anohr discr jump Δ = =. Dpnding on which sid of h inflaion ax Laffr > curv h conomy was on and h magniud of h chang in h growh ra of bas mony h nw sady sa valu of signiorag may b ihr highr or lowr han i was iniially. Wih rgard o h fiscal sphr wha is imporan is h consquncs for h prsn valu valuad a im of fuur signiorag rvnus. ssum for simpliciy ha h public db is iniially a h sady sa for som consan lvl of primary budg dfici. If h nw sady sa lvl of signiorag for > is lowr han i was iniially for hn h prsn valu of signiorag will fall. This mans ha h currn prdrmind lvl of public db is highr han i should b assuming a susainabl fiscal policy. Th boom diagram in Fig. 5. dpics h pah of h susainabl lvl of public db b drmind by 5.5. Is downward jump h dod lin is a rsul of a dcras in h prsn valu of signiorag. 4 primary budg dfici ha dos no chang lads o h xplosiv growh of h acual lvl of public db. To avoid his scnario o 4 Hr and blow w implicily assum ha h govrnmn cnral bank rcivs h sam informaion abou fuur monary fiscal policy changs and a h sam im no in fac a crucial assumpion. 8 as h priva scor. Howvr his is

6 avr a confidnc crisis h govrnmn mus adjus h fuur pah of h budg dfici d so ha h rducion in is prsn valu compnsas h fall in h prsn valu of signiorag rvnus. In h simpls cas of a picwis-consan primary dfici h govrnmn should dcras d a im by an amoun qual o h produc of h inrs ra and h chang in sady sa lvl of signiorag. h sam im h pah of b will shif upward for > bridging h gap wih h acual prdrmind lvl. 5 Rmaining on a sabl susainabl pah h public db will iniially dcras and hn incras and rach is nw sady sa lvl a im which will in fac b lowr han h iniial sady sa lvl. n incras in h sady sa lvl of signiorag for > dos no auomaically lad o an incras in is prsn valu a im. Thus h ffc of his incras is ambiguous and criically dpnds on h inrs ra on public db. If h im inrval [ ] b is long nough if h fall in ral mony balancs is larg and mos imporanly if h inrs ra is high hn h prsn valu of fuur signiorag rvnus may dcras. Th consquncs of his scnario ar similar o hos dscribd abov s h solid lin on h im diagram for. Th govrnmn will b forcd o dcras h primary dfici liminaing h jump in b. long h susainabl pah public db will incras up o is nw sady sa. Tabl 5.. in ppndix provids a numrical spcificaion of paramrs ha shows his scnario o b qui possibl. n incras in h prsn valu of signiorag is possibl cris paribus if h inrs ra is rlaivly low. In his cas h accumulad lvl of db bcoms lowr han s h chain lin in Fig. 5. and also h numrical xampl in Tabl 5.. in h ppndix. If h govrnmn dos no rac public db will dcras. Howvr in his siuaion h govrnmn can incras h primary dfici is prsn valu in gnral which in many circumsancs may indd b dsirabl for ihr conomic or poliical rasons. uch acion will kp h db on a sabl pah. Th nw sady sa lvl will b highr han i was iniially jus as in h cas considrd abov. Th las possibl oucom is ha of a prmann incras in h growh ra of bas mony ha will no chang prsn valu of signiorag a all. 6 Th principl of susainabl fiscal policy is no violad. Public db riss along h susainabl pah up o is nw sady-sa lvl h doubl do-chain lin in Fig b 5 Fig. 5. and ohrs do no illusra his possibl chang. 6 W do no illusra numrically his cas in h ppndix du o h obvious complxiy of h ncssary calculaions. Howvr his rsul is possibl. 7 ll h lins on h im diagram for b in Fig. 5. should no in fac convrg o h sam sady sa lvl. W show h sam sady sa lvls in ordr o simplify visual prcpion. Th sam applis o h ohr diagrams blow. 9

7 π x b Fig. 5.. Dynamics of inflaion h log of ral mony balancs signiorag and h susainabl lvl of public db for a prmann incras in h growh ra of bas mony 5.4 prmann incras in h primary budg dfici Th mos imporan conclusion w larn from h xampl abov is ha hr is no simpl or unambiguous corrspondnc bwn changs in h growh ra of bas mony and inflaion and h dircion in which fiscal policy mus b adjusd in ordr o kp h public db on a susainabl pah. Th rvrs is also ru. To prov his l us considr h following simpl scnario. ssum ha iniially h mony mark and h public db ar in sady sas for crain valus of h

8 growh ra of bas mony and of h primary dfici. Thn for som rason h govrnmn nds o incras prmannly h primary budg dfici by incrasing spnding or by dcrasing axs. To kp h public db on a susainabl pah i is ncssary o incras h prsn valu of signiorag by an amoun qual o h incras in h prsn valu of fuur budg dficis. ssum for concrnss ha h conomy is on h incrasing branch of h inflaion ax Laffr curv. 8 possibl approach would b o incras h growh ra of bas mony as was dscribd abov. This mus b don a im whil an announcmn o ha ffc could b mad a im. This acion rsuls in a highr sady sa lvl of signiorag afr a priod of mporary dcras bu a h cos of an incras in h sady sa ra of inflaion and of a dcras in ral mony balancs. Howvr his is no h only way o incras h prsn valu of signiorag. In som circumsancs his objciv can also b achivd by dcrasing h growh ra of bas mony. 9 Th following scnario is illusrad in Fig. 5.. Indd if is h momn a which hr is a swich in fiscal policy and h cnral bank announcs a prmann drop in h growh ra of bas mony afr hn inflaion will undrgo a discr fall whil ral mony balancs jump up. Up o h im of acual changs in h growh ra of bas mony inflaion ral mony balancs will gradually dcras incras o is nw sady sa lvl. This rsuls in a mporary incras in signiorag. Dspi h fac ha i vnually falls o a nw sady sa a im is prsn valu for im may incras. This scnario is mor likly for high inrs ras. In gnral jus as in h prvious xampl whhr h prsn valu of signiorag will incras or dcras dpnds on h inrs ra ha is usd in discouning fuur valus on h lngh of h im inrval bwn h announcmn of an impnding policy swich and is acual implmnaion on h magniud of h chang in h growh ra of bas mony and on h smilasiciy of h mony dmand funcion. Fig. 5. dpics possibl rajcoris for h susainabl lvl of public db. 8 If h conomy is funcioning wih high inflaion i.. i is on h wrong sid of h inflaion ax Laffr curv hn a dcras in h growh ra of mony will unambiguously lad o an incras in h prsn valu of signiorag. h sam im an incras in h growh ra of bas mony will rsul in a dcras in h prsn valu of signiorag. For obvious rasons h dircion of h ransiory dynamics of signiorag and h dircion of h chang in is sady sa ar h sam upward or downward along h wrong sid of inflaion ax Laffr curv. 9 In ordr o no b misundrsood w should srss ha hr is no radoff bwn conracionary and xpansionary monary policy aimd a incrasing h prsn valu of signiorag. W dmonsra blow ha dpnding on h paramric spcificaion mos imporanly on h inrs ra monary policy could produc a highr prsn valu of signiorag only for on dircion of chang whil h ohr dircion will produc qui h opposi rsul.

9 π x b Fig 5.. Dynamics of inflaion h log of ral mony balancs signiorag and h susainabl lvl of public db for a prmann dcras in h growh ra of bas mony For crain paramrizaions of h xprimn s h corrsponding xampls in Tabl 5.. in h ppndix and in paricular for high inrs ras for public db a prmann incras in h growh ra of bas mony lads o a discr upward jump in. In our xampl h siz of h jump is qual o h raio of h chang in h primary dfici o h inrs ra. W will dmonsra in cion 5. ha dpnding on h magniud of h chang in h growh ra of bas mony and on h lngh of h im inrval h cnral bank s abiliy o incras h b

10 prsn valu of signiorag is boundd from abov if i xiss a all. Wihou changs in h primary budg dfici if his kind of monary policy is abl o produc an incras in h prsn valu of signiorag by im hn afr a discr incras b will gradually dcras o is nw sady sa lvl h solid lin in Fig. 5.. s long as h nw sady sa lvl of signiorag is lowr han i was iniially h nw sady sa lvl of public db mus also b lowr. inc h incras in h primary budg dfici should b balancd by h incras in h prsn valu of b signiorag will no undrgo a jump a im ; insad i will gradually dcras along h susainabl pah o is nw sady sa lvl. Cris paribus in h cas of a low inrs ra a dcras in h sady sa lvl of signiorag in h fuur plays an imporan rol and hus h prsn valu of signiorag may dcras or rmain a las h sam s h dod and chain lins in Fig. 5.. Qualiaivly h nsuing dynamics of b ar h sam as in h xampl givn abov a dcras o a nw consan lvl. Howvr along wih h incras in primary dfici i is possibl h prdrmind public db a im is highr han i should b in accordanc wih 5.5 i.. i bcoms unsusainabl. 5.5 Crdibl sabilizaion programs: Isral Chil and Mxico Discussion in cions 5.3 and 5.4 srssd on imporan poin: as long as h susainabiliy of public db dpnds no only on fuur fiscal policy bu on fuur signiorag as wll monary policy may no b abl o sabiliz inflaion wihou corrsponding fiscal adjusmns. Th ncssiy of join fiscal and monary masurs o figh high inflaion is h ssnc of h so-calld orhodox sabilizaion. Hr w provid xampls of succssful high inflaion sabilizaion programs in Isral Chil and Mxico. In all hs cass h inroducion of a igh monary policy was accompanid by budg cus ha wr prcivd as a crdibl amp o sop high inflaion immdialy a h bginning of h program or afr a shor dlay. W do no considr hs xampls in a chronological ordr howvr and w sar wih Isral s sabilizaion program sinc i was h mos succssful of h hr. In all cass w no h prsnc of addiional sabilizaion policy lmns ha wr mosly par of h alrnaiv packag h so-calld hrodox sabilizaion program. Our analysis dos no ak ino accoun inflaion inria ha is considrd o b a vry imporan characr of chronic high inflaion. Th lmns of h hrodox sabilizaion policy ar dsignd o brak inflaion inria. Whil in all cass h orhodox program was a h cor of h inflaion sabilizaion ffors h absnc of an adqua hrodox program may b viwd as h main rason for h low ra of dcras in inflaion in Chil. 3

11 Isral Isral s xprinc in h mid 98 s provids a good xampl of inflaion and public db sabilizaion undr a policy packag consising of monary anchoring and fiscal adjusmn among ohr ffors. Morovr as hisory shows a igh monary policy and cus in h budg dfici wr prcivd as a crdibl long-run policy shif no jus as a shor-run amp o figh inflaion. long wih Lain mrica counris Isral in provids a canonical xampl of an conomy wih chronic high inflaion. During his priod inflaion movd from h wo-digi o h hr-digi rang so y nvr bcam hyprinflaion. Th mos dramaic pisod of inflaion innsificaion was in By h nd of 984 h inflaion ra was clos o 5 prcn on an annual basis s Fig Inflaion in Isral was characrizd by vry srong inria du o indxaion insiuion and ohr facors somhing ha has provd o b a common phnomnon in highinflaion counris. Indd Fig. 5.3 suggss ha mony growh was simply accommodaing an incrasing inflaion ra. nd his may indd b h cas. Nvrhlss i is possibl o aribu a significan par of h incras in mony o h financing of h budg dfici. s Tabl 5. shows signiorag craion of bas mony playd a rahr significan par in his procss. aring from h mid-97s h govrnmn ran vry high dficis wo-digi prcn of GNP. Takn oghr wih monizaion which ld o an scalaion in inflaion h dficis rsuld in a dramaic growh of inrnal and xrnal public db. Bfor h oil-pric shock and h Yom Kippur War in 973 Isral was in is Goldn g of growh ha was. prcn in and 9.7 prcn in annually on avrag. Undr hs condiions larg fiscal dficis alhough hy wr no as larg as lar on did no lad o an unsusainabl growh of public db. Howvr afr 973 conomic growh bcam much slowr: 3.4 prcn in and.9 prcn in Incrasing budg dficis mad public db highly unsusainabl. In h mid-98s h public db bcam highr han prcn of GNP and rachd is hisorical maximum of 4 prcn of GNP. abilizaion of chronic high inflaion is a difficul ask. Isral s 985 sabilizaion program is a rar xampl of succss. In inflaion was brough down o h wo-digi rang and was sabilizd hr a h lvl bwn 5 and prcn. fr ha in h 99s inflaion dcrasd o h singl-digi rang. Th sabilizaion procss was complx and involvd a hos of masurs on h par of boh h govrnmn and h cnral bank. mong hm hr ar wo major lmns: h Bank of Isral succssfully squzd mony mission whil h govrnmn cu is budg dficis. Tabl 5. confirms his drasic policy shif. Th ohr lmns of gras imporanc wr: pgging h nominal xchang ra pric conrol policy and various dircions of sruc- Th discussion and saisical daa prsnd in his subscion is basd mainly on Bruno 993. also Bruno and Mridor 99. Fischr ahay and Vgh found ha his is a prvailing parn during inflaionary pisods. 4

12 ural adjusmn of h conomy. On should also no a vry imporan lmn namly h poliical and social amosphr a h im ha mad h public prciv h sabilizaion plan of h Naional Uniy Govrnmn as crdibl a las vnually. 5 Prcn annual monh o monh of h prvious ya Tim Growh ra of mony CPI Inflaion ourc: Bank of Isral. Fig Inflaion and growh ra of mony in Isral Tabl 5.. Budg dfici financ in Isral prcn of GNP Priod Budg dfici Bas Mony Craion Domsic db financ Forign db financ Unaccound financ ourc: Bruno 993 xrac from Tabl 3. p. 46. W can illusra h crdibiliy or susainabiliy of his sabilizaion program by h logic xplaind in cion 5.4. s was discussd arlir an anicipad prmann dcras in h growh ra of bas mony can produc an incras in h prsn discound valu of fuur signiorag in h cas of high inrs ras s Fig. 5.. Howvr i can also produc a lowr prsn valu of signiorag whn h inrs ra is rlaivly low. Thus in gnral a prmann dcras in h 5

13 growh ra of bas mony may no b prcivd as a crdibl fuur monary policy if only bcaus i may rsul in unsusainabl public db dynamics. Dspi h vidnc ha inrs ras wr vry high in h 98s h mr fac ha h public db o GNP raio was highr han prcn lavs lil room o suppos ha h Bank of Isral s unilaral radical shif o a igh monary policy would b prcivd as crdibl. Howvr as long as i was suppord by xpcaions of a fuur cu in dficis h monary squz should b viwd as crdibl. Evn if h prsn valu of signiorag did no incras following a dcras in h growh ra of bas mony a dcras in h prsn valu of fuur budg dficis may produc an incras in h susainabl lvl of public db ha is in rms of Fig. 5. hr is an upward jump in b a im and h nw sady sa lvl of b afr im may b vn highr han h iniial sady sa bfor. Thus a igh monary policy ha is aimd o figh high inflaion is much mor likly o b crdibl if i is suppord by fiscal adjusmn. fr all his policy mix maks h currn lvl of public db susainabl. Chil Chilan macroconomic policy afr h miliary coup in pmbr 973 provids anohr xampl of a rahr succssful sabilizaion program. long wih ohr Lain mrican counris Chil in h 96s was a ypical high inflaion counry wih an avrag annual inflaion ra wll abov prcn. Th conomic siuaion bcam wors in 97 undr h socialis-populis policy of llnd. Is govrnmn ran xrmly high fiscal dficis s Fig h sam im inflaion movd from h wo-digi o h hr-digi rang s Fig In 974 and 975 h nw miliary govrnmn carrid ou an orhodox program o sop acclraing inflaion. major ax rform was inroducd. Govrnmn spnding was drasically cu and som govrnmn asss wr sold. Budg dficis wr rducd and in som im hr appard fiscal surpluss. Howvr dspi h disapparanc of h main sourc of inflaion h ra of inflaion dcrasd rlaivly slowly rurning o h wo-digi rang only in 977 i coninud o furhr dcras raching h on-digi rang in 98. Corbo and olimano 99 aribu his failur o h vry high dgr of immann inflaion inria h xchang ra policy of dvaluing h pso bwn 978 and 98 3 and ffcs from backward-looking wag indxaion schms. Indd in comparison wih aggrssiv fiscal adjusmn Chilan monary policy was no vry igh bu rahr accommodaiv. ddiional hlpful facors wr a rollovr of 3 prcn of db ousanding and rlaivly high prics of xporabl coppr. 3 I was calld Tablia - a kind of crawling pg. Bruno 993 also rfrs o his policy of a pr-announcd dcrasing crawl blow h prvious monh s inflaion ra as a major macro-policy rror ha mad h dcras in inflaion vn slowr. 6

14 ourc: Inrnaional Financial aisics IMF. Budg dfici+/surplus- prcn of GDP Fig Budg dfici in Chil Prcn monh o monh of h prvious ya Growh ra of mony CPI Inflaion ourc: Inrnaional Financial aisics IMF. Fig Inflaion and growh ra of mony in Chil cually h problms of a nominal synchronizaion undr inflaion inria ha ar ssnial in sabilizing chronic high inflaion ar no capurd in our flxibl-pric modl. From a hisorical prspciv his lsson gav ris o h conclusion ha orhodox sabilizaion is a ncssarily bu no 7

15 a sufficin condiion for succssful high inflaion sabilizaion. ddiional lmns of incom policy daling wih inflaion inria ha ar a h cor of a hrodox sabilizaion ar also ndd. 4 Howvr orhodox lmns of sabilizaion i.. fiscal rsrain and monary ighnss ar sill ncssary. Thrfor h modl applid o inrpr Isral s sabilizaion works hr as wll. 5 Hrodox lmns drmin mainly h coss of h sabilizaion program. Mxico Th Mxican sabilizaion program was iniiad in 987. This program was comprisd of a Pac for Economic olidariy and a Pac for abiliy and Growh and i provids anohr xampl of a succssful combinaion of orhodox and hrodox sabilizaion. 6 Unlik ohr Lain mrican counris Mxico xprincd high inflaion ovr a rlaivly shor priod. Unil 98 h inflaion ra was wll blow 3 prcn annually 7 whil annual GDP growh was wll abov 6 prcn. In 98 Mxico undrwn a srious db crisis rpudiaing is xrnal db. Th xchang ra was dvalud by 466 prcn CPI incrasd by 99 prcn. For svral yars h conomy bcam xrmly unsabl. Iniial amps o sabiliz h conomy wr undrakn in h righ dircion: h budg dfici was cu and a rahr igh monary policy was implmnd. Howvr h siz of h adjusmn was no sufficin. Th inflaion ra rurnd o h wo-digi rang and y i sill rmaind vry high s Fig fr h arhquak of 985 in Mxico and h fall of oil prics in arly 986 h balanc of paymn driorad and h inflaion ra again bgan o acclra. Finally in Ocobr 987 h sock mark crashd. By h nd of 987 h Pac for Economic olidariy was announcd and i was joinly signd by h govrnmn and by rprsnaivs from indusrial and agriculural workrs and from businss. Th Pac was wrin afr Isral s succssful sabilizaion in I includd boh orhodox and hrodox lmns and rlid ruly on social solidariy as in Isral s cas. Th main agrmn was a furhr incras in h primary budg surplus a dcras in h hug opraional budg dfici smming from high inrs paymns. This was don in 988 and 989 s Fig Monary policy was significanly ighnd in paricular vry igh crdi cilings wr announcd. Th Chilan policy rror was also akn ino accoun: an agrmn bwn h diffrn scors of h conomy upon ky pricing ruls lad o a rahr rapid dclin in inflaion s Fig. 4 Obviously his lsson was akn ino accoun in Isral s sabilizaion discussd abov. 5 In h cas of Chil on should also ak ino accoun xrmly high ral inrs ras and a srious dclin in oupu following h fiscal conracion coupld wih advrs xrnal shocks h world-wid oil pric shock and h drop of coppr prics in 975. Corbo and olimano 99 for dails. 6 Th discussion hr rlis on Oriz 99 and Bruno 993. also Diaz and Trcro 988 and Dornbusch and Fischr Bfor h 973 oil shock inflaion was vn in h singl-digi rang. Doubl-digi inflaion bcam chronic only afr

16 5.6. Public db was mor han halvd ovr h following fiv yars. Thus w can again rfr o h succssful logic of sabilizing inflaion via a crdibl ighning of fiscal and monary policy suppord by masurs o brak inflaion inria. Prcn monh o monh of h prvious ya Growh ra of bas mony CPI Inflaion ourc: Inrnaional Financial aisics IMF. Fig Inflaion and growh ra of bas mony in Mxico Budg dfici+/surplus- prcn of GDP Public db prcn of GDP ourc: Inrnaional Financial aisics IMF. Fig Budg dfici and public db in Mxico

17 5.6 mporary dcras in h growh ra of bas mony L us considr now a policy swich ha is no prmann. ssum as usual ha iniially h mony mark and h fiscal sphr ar in sady sas. im h cnral bank announcs a dcras in h growh ra of bas mony ha will ak plac a im. ssum furhr ha i is xpcd ha afr im monary policy will again bcom loos so ha > whr is h growh ra of bas mony for. In h simpls cas h mporary naur of a ighning of monary policy may b announcd a im as wll. In gnral on can infr ha h currn policy swich canno b prmann if only bcaus his would viola h susainabiliy and fasibiliy consrains. Equaions dscrib h dynamics of h conomy for his yp of policy. Th corrsponding im pahs ar illusrad in Fig = = + = = + + =. d d d d d x τ τ τ τ τ τ τ τ τ τ 5.9 > =. π 5. =. 5.

18 π x b Fig Dynamics of inflaion h log of ral mony balancs signiorag and h susainabl lvl of public db for a mporary dcras in h growh ra of bas mony Th dynamics of h mony mark dpnd on h smi-lasiciy of dmand h lngh of h im inrval If h condiion and h rlaiv magniud of chang in h growh ra of bas mony. > 5.

19 holds hn ral mony balancs undrgo a discr downward jump and monoonically dcras o hir nw sady sa lvl which is rachd a im im inflaion riss and signiorag dcrass. h solid lin in Fig h sam Howvr hr is anohr possibl scnario. Whn condiion 5. fails o hold ral mony balancs undrgo an upward jump afr h announcmn. Thy coninu o incras gradually up o im and only hn hy sar o dcras s h dod lin in Fig ssum for concrnss ha h conomy is on h righ sid of h inflaion ax Laffr curv. Th nw sady sa lvl of signiorag will hn b highr han i was iniially. I is also clar ha h prsn valu of signiorag in h scond scnario is highr han in h firs scnario. Howvr i dpnds on paramrs of h conomy and policy swich in ihr cas whhr or no h prsn valu of signiorag will ris or fall. Th consquncs for h fiscal sphr and h mhods for mainaining h susainabiliy of h public db ar qualiaivly h sam as in cion 5.3. Cris paribus whn h inrs ra is low no only h nar fuur is imporan in h valuaion of h prsn valu bu h disan fuur as wll. Thus a long-rm ris in h sady sa of signiorag implis an incras in b a im for h sam fiscal policy. Givn his siuaion h govrnmn has h opion o incras h primary budg dfici liminaing h gap bwn h acual prdrmind and susainabl lvls of db. Th valu of b gradually incrass saring from im o is nw sady sa lvl h solid lin in Fig. 5.8; if w accoun for h fiscal corrcion dscribd abov his lin should b shifd down o b coninuous. On h ohr hand if h inrs ra is high nough his kind of monary policy will rsul in a dcras in h prsn valu of fuur signiorag rvnus a im. To mainain susainabiliy in h fiscal sphr h govrnmn should rduc h primary budg dfici. Th public db will gradually dcras unil im and hn ris o is nw sady sa lvl on should imagin a lin paralll o h dod lin for b in Fig. 5.8 o accoun for a fiscal corrcion o limina disconinuiy and unsusainabiliy. Finally hr is a horical knif-dg possibiliy ha h dscribd changs in h growh ra of bas mony will no chang h prsn valu of signiorag a all. Thus hr is no nd and no opion for fiscal adjusmn. 8 Tabls 5.. and 5.. in h ppndix conain h spcificaions of numrical xprimns ha suppor hs conclusions. 8 W do no dpic his cas in Fig. 5.8.

20 5.7 Raganomics II: a forward-looking inrpraion In scion 4.7 w proposd an xplanaion of h dcras in inflaion in in h U.. ha ook plac dspi a subsanial as in monary policy; ha was ssnially a backwardlooking xplanaion. Hr w suggs an alrnaiv inrpraion of h vn on ha is basd on forward-looking considraions. For convninc w rproduc h dynamics of h growh ra of bas mony fdral funds ra and inflaion in Fig o quarr of h prvious ya Prcn quarr Tim Growh ra of bas mony CPI inflaion Fdral funds ra ourc: Inrnaional Financial aisics IMF. Fig Monary policy and inflaion in h U lhough a firs in 979 Volckr s amp o figh inflaion was no prcivd as a crdibl policy shif inflaion sard o dcras in 98. nd wih h xcpion of a mods incras in h inflaion ra in 983 disinflaion was prsn unil 986. L us considr h following horical xprimn ha rsmbls h acual Fdral Rsrv policy in h im inrval from 98 unil 985. ssum ha a som da h public bgan o xpc ha monary policy would b mporally asd in h fuur im inrval [ ]. I was also xpcd ha afr monary policy would b vn ighr han i was originally:. This xprimn s sing is simply h rgular rflcion of h cas sudid in h cion 4.4 in which monary policy was mporarily ighnd and hn asd. I follows ha h rajcoris of ohr variabls can b consrucd and inrprd as h rgular rflcion of rajcoris in Fig. 5.8 and so w do no rpa h discussion hr. ssum furhr ha condiion 5. holds. Fig. 5. illusras h dynamics of h sysm. 3

21 π x b Fig. 5.. Dynamics of inflaion h log of ral mony balancs signiorag and h susainabl lvl of public db for a mporary incras in h growh ra of bas mony Dspi h mporary as in monary policy h inflaion ra dclins as long as h public xpcs ha h disinflaion policy will b rnwd in h fuur. This can b a probabl xplanaion of acual blifs. Indd as was discussd in cion 4.7 h Fdral Rsrv was forcd o rduc h fdral funds ra in h fac of a hra ha h Mxican financial crisis may hav a ngaiv impac on h mrican conomy du o vry high inrs ras a h im. Thus i could hav bn xpcd ha h policy shif was mporary and afr h passing of som im h Fdral Rsrv would coninu o figh inflaion. 4

22 W can also s ha whil h sady sa lvl of signiorag bcoms lowr for > i will mporarily bcom highr during h inrval [ ]. I hn follows ha is prsn discound valu may incras a im which is mos likly if h inrs ra on public db is sufficinly high. Indd as w nod h inrs ras in U.. conomy wr rlaivly high during ha priod. If h prsn valu of signiorag indd incrass a im hn assuming no chang in xpcd fuur budg dficis h susainabl lvl of public db also incrass a im. 9 fr ha i incrass gradually for som im and hn dcrass. Evnually i rachs a consan lvl ha is lowr han h iniial lvl. This follows from h fac ha h nw sady sa lvl of signiorag bcoms lowr han i was iniially. This obsrvaion has imporan implicaion for fuur policy: a lowr susainabl lvl of public db imposs srongr rsricions on h govrnmn s abiliy o run budg dficis. Thus disinflaion ha was a rsul of h policy xprimn considrd in his scion and in acual hisory dos no solv h problm srssd by argn : igh monary policy and fiscal imbalancs ar no crdibl in h long run. las on agn will chickn ou soonr or lar. If w ak monary policy as xognous dominan hn h public should xpc ha h govrnmn will b abl o provid fiscal surpluss in a sufficin amoun and ovr a sufficinly long priod. 5.8 Tmporary changs in policy and unplasan monaris arihmic s shown abov whn an conomy is funcioning on h righ sid of h inflaion ax Laffr curv a prmann rducion in h growh ra of bas mony can lad o a fall in h prsn valu of fuur signiorag rvnus and hus mak h public db unsusainabl. In principl h govrnmn should adjus is fiscal policy and rduc h primary budg dfici. I is howvr possibl ha h govrnmn ihr dos no wan o do his bcaus of crain poliical or conomic considraions or bcaus of h xisnc of a lowr bound on d. In his cas a swich in monary policy of his sor canno b prmann. I is also naural o assum ha priva agns will raliz his fac and ak i ino considraion. ssum ha boh h yp and h iming of policy changs ar known in advanc as if hy wr an announcd commimn. In raliy of cours conomic agns fac uncrainis abou h yp and iming of policy swichs. W will rurn o his poin in cions Inroducion of hs simplifying assumpions brings our analysis closr o h logic of h clbrad unpla- 9 No ha his is h susainabl no acual lvl of public db and hrfor w can apply his rsul o inrpr h acual public db dynamics during h priod bing considrd. W discuss his problm lar in cion

23 san monaris arihmic. im monary policy bcoms loos as was known in advanc a im. Howvr if his policy dsroys h susainabiliy of public db i canno b prmann. a crain im h cnral bank has o bring h conomy back o a sady sa. Mus i always b ru ha h conomy will vnually suffr from a highr sady sa ra of inflaion a highr growh ra of bas mony? In ohr words should priva agns form xpcaions ha is h only possibl oucom? Th scnario ha w considrd arlir Fig. 5.8 can b viwd as a corroboraion of h argn-wallac rsul: monary policy canno b ighnd prmannly; lowr inflaion now if i is possibl a all vnually rsuls in highr inflaion in h fuur. urprisingly for crain valus of h paramrs i is qui possibl o kp h prsn valu of signiorag consan or vn incras i whn ha is whn h ulima monary policy nd no b mor xpansionary han i was iniially. In ohr words w will show ha in a crain sns monary policy can b ighnd in h long run wihou violaing fiscal susainabiliy and mor imporanly wihou long-run inflaionary consquncs. Fig. 5. illusras h logic. From quaions and h cririon 5. on can unambiguously conclud ha for h log of ral mony balancs and hnc signiorag incras on h inrval [ ] [ ] including a discr incras a whil inflaion dcrass. Thn for h im inrval h log of ral mony balancs sars o dcras o is nw sady sa and rachs i a im inflaion consqunly incrass. Th nw sady sa lvl of ral mony balancs inflaion is highr lowr han i was iniially. On can viw his as somhing lik plasan monaris arihmic. Dspi h mporary as in monary policy h inflaion ra dclins as long as h public xpcs ha h disinflaion policy will b rnwd in h fuur. This can b a probabl xplanaion of acual blifs. Indd as was discussd in cion 4.7 h Fdral Rsrv was forcd o rduc h fdral funds ra in h fac of a hra ha h Mxican financial crisis may hav a ngaiv impac on h mrican conomy du o vry high inrs ras a h im. Thus i could hav bn xpcd ha h policy shif was mporary and afr h passing of som im h Fdral Rsrv would coninu o figh inflaion. W can also s ha whil h sady sa lvl of signiorag bcoms lowr for will mporarily bcom highr during h inrval [ ] > i. I hn follows ha is prsn discound valu may incras a im which is mos likly if h inrs ra on public db is sufficinly high. Indd as w nod h inrs ras in U.. conomy wr rlaivly high during ha priod. 6

24 π x b Fig. 5.. Dynamics of inflaion h log of ral mony balancs signiorag and h susainabl lvl of public db for a mporary dcras in h growh ra of bas mony If h prsn valu of signiorag indd incrass a im hn assuming no chang in xpcd fuur budg dficis h susainabl lvl of public db also incrass a im. fr ha i incrass gradually for som im and hn dcrass. Evnually i rachs a consan lvl ha is lowr han h iniial lvl. This follows from h fac ha h nw sady sa lvl of signiorag bcoms lowr han i was iniially. This obsrvaion has imporan implicaion for fuur No ha his is h susainabl no acual lvl of public db and hrfor w can apply his rsul o inrpr h acual public db dynamics during h priod bing considrd. 7

25 policy: a lowr susainabl lvl of public db imposs srongr rsricions on h govrnmn s abiliy o run budg dficis. Thus disinflaion ha was a rsul of h policy xprimn considrd in his scion and in acual hisory dos no solv h problm srssd by argn : igh monary policy and fiscal imbalancs ar no crdibl in h long run. las on agn will chickn ou soonr or lar. If w ak monary policy as xognous dominan hn h public should xpc ha h govrnmn will b abl o provid fiscal surpluss in a sufficin amoun and ovr a sufficinly long priod. h sam im signiorag jumps up a ; i hn gradually incrass unil jumps down and dcrass on h inrval [ ] ; vnually afr a final discr incras a im i will say a a nw sady sa lvl ha is lowr han i was iniially assuming h conomy is on h incrasing branch of h Laffr curv. Evn so h prsn valu of signiorag a im rmain consan or vn incras for h simpl rason ha on h im inrval [ ] may signiorag will b highr hn i was iniially. This is likly o b possibl for high inrs ras which mak h fall in signiorag in h disan fuur lss imporan for h valuaion of prsn valu han is incras in h shor run. Consqunly fiscal susainabiliy is no violad and hr is vn an opion for h govrnmn o xpand. Fig. 5. illusras his plasan monaris scnario. Th primary budg dfici rmains consan. im h valu of b may discrly fall cris paribus for low inrs ras ris for high inrs ras or simply rmain unchangd shown by h solid dod and chain lins rspcivly in Fig. 5.. If h paramrs of h conomy ar such ha i is possibl o find h ndd paramrizaion for his kind of monary policy h public db may b kp on a susainabl pah. fr a gradual dcras during h inrval [ ] i incrass o is nw sady sa lvl which is lowr han h iniial on. Tabl 5.3 in h ppndix prsns concr spcificaions of h paramrs in h modl and a numrical xprimn ha dmonsras h fall and ris of. gain du o compuaional complxiy w do no illusra numrically h knif-dg cas of an unchangd b ha sms nvrhlss possibl. b Of cours his is ru undr h assumpion ha priva agns do know prcisly which kind of policy will b chosn by policymakrs. 8

26 5.9 Unplasan monaris arihmic a work: Th failur of h usral Plan in rgnina In cion 5.5 w discussd xampls of a mor or lss succssful sabilizaion of high inflaion and public db in wo Lain mrican counris namly Chil and Mxico and in Isral. Th sabilizaion program in rgnina h so-calld usral Plan sard roughly a h sam im as Isral s sabilizaion program. Howvr rgnina s sabilizaion ffor along wih h Crusado Plan in Brazil in 986 provids an xampl of an incompl and unsuccssful program. Wha is mos inrsing for us is ha his failur rsmbls h logic of unplasan monaris arihmic. 3 Th conomic siuaion in rgnina in h la 97s and 98s was xrmly bad. vrag annual growh ra of GDP was abou.5 prcn bwn 975 and 985 i was posiiv in h 97 s and i bcam ngaiv in h 98s. During his priod inflaion was almos always in h hr-digi rang s Fig. 5.. I was brough down o h wo-digi rang in 98. oon afr howvr i again nrd h hr-digi rang and acclrad furhr. In May 985 h annual inflaion ra bcam highr han prcn. Th fiscal sanc was characrizd by chronic dfici. Public and publicly guarand db mor han ripld bwn 98 and 985 s Fig Prcn annual monh o monh of h prvious ya Growh ra of mony CPI Inflaion ourc: Inrnaional Financial aisics IMF. Fig. 5.. Inflaion and growh ra of mony in rgnina Discussion in his scion is basd on Hymann 99 and Bruno 993. also Canavs and Di Tlla 988 Machina and Fanlli 988 and Kigul and Liviaan 99. 9

27 6 5 billions currn U dollars Public and publicly guarand db ourc: World Dvlopmn Indicaors Th World Bank Group. Fig Db burdn in rgnina Th usral Plan was announcd in Jun 985. Lik Isral s sabilizaion program i combind orhodox masurs a cu in h budg dfici aimd a sopping inflaionary financ and a pric wag and xchang ra frz aimd a braking inflaion inria along wih an inroducion of a nw currncy h ausral pggd a UD.8. Th Plan was iniially succssful. Th govrnmn was indd abl o subsanially cu h dfici s Tabl 5.. Th annual inflaion ra dcrasd from 9 prcn in July 985 o 5 prcn in July 986. Howvr succss was vry shor livd. Th main problm was ha h govrnmn was no abl o succd in cuing h budg. Th iniial incras in ax rvnus was mainly associad wih h Olivra-Tanzi opposi ffc of h pric frz. By h nd of 986 h budg dfici was again vry high. Inflaion sard o acclra onc mor. Things wn ou of conrol undr opn hyprinflaion ha was sabilizd only in Brazil which was in roughly h sam conomic siuaion in h 98s inroducd h Crusado Plan in 986. Iniially Brazil was abl o rduc inflaion mainly via a pric frz bu as in rgnina s cas his vnually ld o vn highr inflaion. Rsarchrs conclud ha h usral Plan in rgnina was a las wll dsignd iniially whil hr was no amp o adjus h fiscal posiion or conduc igh monary policy during Brazil s sabilizaion. for xampl Cardoso 99 Dornbusch and Fischr 99 and Kigul and Lviaan 99. For his rason w pay lil anion o h Brazilian xprinc of h 98 s. 3

28 Tabl 5.. Budg dfici and signiorag in rgnina prcn of GDP Primary dfici Inrs paymns Opraional Dfici igniorag 984 I II III IV I II III IV I II III IV I II III IV I II III IV ourc: Hymann 99. For h purposs of our analysis w ar no inrsd in h paricular rasons why h govrnmn was no abl o susain a sufficin budg cu ovr a long priod. 5 Taking his fac as i is w can inrpr h usral Plan as an xampl of unplasan monaris arihmic a work. Indd wha was don alhough i was no plannd so badly was an ffor o figh inflaion by igh monary policy wihou implmning h corrsponding fiscal corrcion. s w discussd in cion 5.6 a prmann dcras in h growh ra of mony if no suppord by fiscal adjusmn may no b crdibl in gnral. This was ru in h cas of h usral Plan. In a siuaion of x- 5 a discussion on his subjc and a comparison wih Isral s sabilizaion in Bruno

29 rmly high public db whn h govrnmn bcam unabl o coninu is iniially igh fiscal policy in h fuur monary policy was pushd o financ h incrasing budg dfici. fr a priod of succssful dcras h inflaion ra sard o incras again. This scnario roughly rsmbls h im pah of inflaion dpicd by h dod lin in Fig Morovr signiorag rvnu which firs ros a h bginning of h sabilizaion program hn dcrasd and finally bcam highr again s Tabl 5. also corrsponds o h im pah in Fig Th sian crisis of 997: Tigh monary policy and prospciv dficis Usually conomiss ra h sian crisis of 997 as a currncy crisis. 6 Howvr hr ar crain fiscal and monary faurs of his crisis ha mak i a good hisorical xampl for our analysis. Burnsid Eichnbaum and Rblo suggs a horical modl and mpirical vidnc in suppor of h viw ha a currncy crisis may ak plac vn whn monary policy is rasonably igh and h fiscal sphr is currnly balancd so ha hr is no concrn abou insufficin rsrvs for mainaining a fixd xchang ra rgim or abou poor currn fiscal fundamnals. Th ky ida is ha a larg publicly guarand db accumulad by h priva scor cras xpcaions of larg prospciv fiscal dficis. This in urn cras fars of h monizaion of fuur dficis and hus highr inflaion now and in h fuur. W can srnghn his poin by mans of h horical xampls considrd abov. Burnsid Eichnbaum and Rblo considr h siuaion in h priod bfor h sian crisis in fiv counris: Indonsia ouh Kora Malaysia h Philippins and Thailand. In all hs counris h fiscal balanc was posiiv in as shown in Fig Howvr as w hav srssd hroughou h chapr h currn fiscal sanc is no ssnial in drmining h susainabiliy of h fiscal sphr. Indd wha is imporan is h fuur backing of govrnmn liabiliis ha is h govrnmn s abiliy o provid sufficin budg surpluss and/or signiorag in h fuur o m is currn obligaions. nd his was on of h main problms in all of h fiv chosn counris. Difficulis aros in h priva banking scor. Burnsid Eichnbaum and Rblo provid vidnc ha h public was xpcing a failur in h banking scor and du o implici bailou guaranis h consqun ris of larg govrnmn dficis. In fac for h purposs of our sudy i is no of much imporanc wha h ral sourc of xpcaions was ha h govrnmn would b srickn by hug fiscal dficis in h fuur. W ak xpcd fuur dficis as an assumpion bu w can indd s a rmndous urnovr in h fiscal sanc afr h crisis in Fig. 5.4 and a gnral discussion on h sian 997 crisis in Furman and igliz 998 Kaminski and chmuklr 999 Radl and achs 998 and Corsi Psni and Roubini 998a b among ohrs. 3

30 4 3 Budg surplus prcn of GDP Indonsia Thailand Kora Malasya Philippins ourc: Inrnaional Financial aisics IMF. Fig Budg surplus dfici in slcd counris Domsic and forign db prcn of GDP ourc: Inrnaional Financial aisics IMF. Indonsia Thailand Kora Malasya Fig Domsic and forign db in slcd counris Th qusion is: Do prospciv dficis ncssarily provok inflaion and was i ru for h sian counris? Th simpl arihmic providd in cion 5.3 shows ha an xpcd incras in fuur dficis can lad o highr inflaion. Indd a h im whn public chang xpcaions 33

31 abou h fuur fiscal balanc xpcd fuur surpluss ar rplacd by xpcd fuur dficis h currn lvl of public db may bcom unsusainabl or unbackd by h govrnmn islf. Traing his shif in fiscal policy as xognous sinc h govrnmn has o m is guaranis on bad priva loans on should xpc an ndognous incras in h prsn discound valu of fuur signiorag as an addiional sourc of financ. 7 This in urn can b achivd by mans of loos monary policy. Fig. 5. provids h simpls xampl of an incras in h prsn discound valu of signiorag suppord by a prmann incras in h consan growh ra of bas mony. Howvr as w srssd in cion 5.3 his is h policy opion ha holds only in h cas of a rlaivly low inrs ra. Whn h inrs ra on public db is rlaivly high a prmann incras in h growh ra of bas mony can produc a dcras in h prsn discound valu of fuur signiorag rvnus. This maks h currn public db vn mor unsusainabl and hus his is no a policy opion hr. cion 5.4 and Fig. 5. provid h logic of how a prmann dcras in h growh ra of bas mony can produc an incras in h prsn valu of signiorag in h cas of a rlaivly high inrs ra. cions 5.6 and 5.8 dvlop h similar argumnaion in h cas of mporary changs in macroconomic policy. ddrssing his logic for h cas of h sian crisis of 997 is no an asy ask. Thr ar wo spara problms. Th firs is drmining wha rlaivly low and rlaivly high inrs ras acually ar. In our modl diffrn policy opions appar no only bcaus of diffrn magniuds of h ral inrs ra bu also bcaus of diffrn smi-lasiciis of mony dmand and h im inrvals or hir combinaions o b prcis. Morovr in h cas of a mporary chang in h growh ra of bas mony w drivd a spcific condiion 5. ha drmins h possibl oucoms. fr all in h ral world inrs ras ar no consan hrough im and sas of naur as in our simpl modl and public db consiss of diffrn financial insrumns wih diffrn yilds. On on hand our logic hardly answrs h qusion of whhr prospciv dficis provokd inflaion in sia in 997. Howvr w can a las srss ha hr could b diffrn policy opions sad abov for diffrn conomis. 8 On h ohr hand having obsrvd monary xpansion and an incras in inflaion afr h crisis s Fig. 5.6 and Fig. 5.7 w can us h firs scnario in which an incras in h prsn valu of fuur signiorag rvnus may b providd by a prmann incras in h growh ra of bas mony o undrsand h logic of h crisis in rms of a problm of fiscal susainabiliy. 9 7 Burnsid Eichnbaum and Rblo argu ha i was hardly xpcd ha govrnmn will b abl o adjus is balanc. 8 This conradics h unambiguous samn of Burnsid Eichnbaum and Rblo. 9 This mans ha w bliv ha inrs ras wr rlaivly low. 34