The Effects of Temporary Exchange-Rate-Based Stabilizations when Money Serves a Productive Role

This paper investigates the effects on production, consumption, and welfare that result from a temporary exchange-rate-based (ERB) stabilization plan. The analysis is based on a dynamic optimizing model of a small open economy where real money is assumed to be a factor that is used in the production of goods. The assumption of money serving a productive role makes the model capable of generating a boom-bust cycle in output, as is often experienced during ERB stabilization plans. It is shown that if the stabilization plan is expected not to be too short and/or the costs associated with the breakdown of the plan are not too high, a temporary decrease in the rate of exchange rate devaluation will increase economic welfare. It is also found that if some of the increase in output in the initial phase of the stabilization plan is saved for periods after the plan has broken down, there is a greater chance that the ERB plan will increase economic welfare. On the other hand, if the plan is not sufficiently credible at the outset, or there is not enough intertemporal transference of output, the stabilization plan is likely to be harmful to economic welfare.

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