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          Home Index Economics Macroeconomics Why currency appreciates in real terms during inflation stabilization?

          Why currency appreciates in real terms during inflation stabilization?

          Yang Yang by Yang Yang
          March 31, 2011
          in Macroeconomics, Public Economics & Finance
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          A common thread in the exchange rate-based stabilization experiences we have reviewed is a real currency appreciation accompanied by a growing deficit on current account. Only countries like Israel and Chile, which have avoided drastic real currency appreciation, have been able to reduce inflation without generating subsequent crisis and pressures for policy reversals. Thus, an understanding of why real appreciation occurs after the government targets the exchange rate is central to understanding why many stabilization efforts fail. There are three main theories explaining real appreciation.

          1. Productivity gains. Inflation stabilization indirectly raises the economy’s productivity by reducing uncertainty about relative prices and encouraging investment. Economic reforms such as privatization, deregulation, and lower trade barriers, which often accompany macroeconomic stabilization, also raise productivity. Since much of the productivity gain is concentrated in the tradable good sector, the Balassa-Samuelson effect we studied in Chapter 15 implies that the currency will appreciate in real terms.
          2. Lagged wage indexation. As we noted earlier in this chapter, wages often are automatically indexed to past inflation in situations of high inflation. If the economic authorities suddenly slow the currency’s depreciation against foreign currencies, wages will nonetheless continue to rise for a time because inflation was high in the past. Thus, it will take time for the economy’s inflation rate to converge to the new depreciation rate of the currency, and in the first stages of the process domestic prices will rise more quickly than the exchange rate. Lagged indexation was a major cause of Chile’s massive real appreciation during its tablita program in the late 1970s.
          3. Lack of official credibility. Wage earners and price setters may not believe the government’s promises about the exchange rate’s future path. If so, they will make wage demands and set prices to guard their real incomes from a surprisingly large devaluation. Until the government does devalue, therefore, inflation will proceed at a clip more rapid than the rate of currency depreciation, causing a real appreciation. Failures to cut fiscal deficits are a leading cause of imperfect credibility. But exchange rate promises can lack credibility even when the government’s fiscal house is in order, for example, if there is a large current account deficit or unemployment that a surprise devaluation might cure.

          These three explanations are not mutually exclusive. The first is benign, however, while the last two usually spell trouble for a government trying to quell inflation.

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