A defining stylized fact associated with exchange-rate-based (ERB) stabilization programs is that their
initial phase is characterized by several years of expansion in private consumption and a gradual appreciation
of the real exchange rate. In this paper, I argue that standard optimizing models are unable to account for this empirical
regularity, as they predict that, except for the date of announcement of the program, an appreciation of the real
exchange rate must necessarily be accompanied by a decline in consumption. I show that this price-consumption
problem can be resolved by relaxing the assumption of time separability in preferences. Specifically, under habit
formation a permanent ERB program generates a smooth boom in consumption and gradual real exchange rate
appreciation. A temporary program induces, in addition, a smooth boom-recession cycle with the recession beginning
before the abandonment of the program.
Home | IFDPs | List of 1997 IFDPs
To comment on this site, please fill out our feedback form.
Last update: July 19, 2001