Working Papers

"Enfoques ortodojos para el ajuste económico de corto plazo: Lecciones de la experiencia y temas de investigación"

Alejandro Foxley


This paper deals with short-term macro-economic adjustment policies in countries with high rates of inflation. It concentrates on one type of adjustment policies, identified as "orthodox" or "monetarist" stabilization policies, and focuses on Latin American Southern Cone type of economies. Although we describe a stylized case in the paper, we make clear in the Appendix that this stylized case is based on empirical facts observed in post-1973 Chile and post-1976 Argentina.

The first section of the paper identifies the theoretical framework and three principal phases observed in current orthodox adjustment policies in Latin America. Phase One is characterized by deregulation of prices, monetary contraction, and exchange rate devaluation. The theoretical reference for this phase is the so-called "closed economy monetarism." Phase Two corresponds to price de-indexation and reflects an attempt to rapidly reduce the rate of inflation, which proved unfeasible under Phase One policies. The nominal exchange rate and public utilities rate lag behind inflation, causing a real deterioration in the value of these variable, which is reinforced by a drastic reduction in tariffs. Phase Three is achieved once the domestic rate of inflation approaches international inflationary rates. Then, the nominal exchange rate is fixed and, under the assumption of the small open economy model, full automatic adjustment of the economy is expected. The theoretical basis for this phase is the so-called monetary approach to the balance of payments, or open economy monetarism.

The second section of the paper examines the behavior of our stylized economy vis-à-vis these various policy approaches. Phase One proves successful in turning around the deficitary balance of payments but fails in bringing the rate of inflation down significantly. Contractionary demand policies result in severe reduction in output and employment levels rather than in a deceleration of inflation. Excess supply in the goods and labor markets induce imbalance in other markets as well. Interest rates go up, typically four or five times the international rate in real terms, as a result of monetary contraction and sustained demand for credit on the part of firms in order to finance their stocks during what they perceive as a short-lived recession. This phase ends with generalized disequilibrium in the economy.

Phase Two, "price de-indexation," may lead to a successful outcome in terms of reducing inflation and in this case, it leads to Phase Three. An alternative scenario is possible, however, in which the rate of domestic inflation does not converge to the international one.

Phase Three begins with positive signs. Fixing the exchange rate has an immediate effect on domestic prices and inflation goes down to an "acceptable" two-digital level. Given slightly expansionary monetary policy in nominal terms and nominal wage readjustment geared to past inflation, real cash balances and real wages go up. Output picks up and the economy shows signs of coming out of the recession. Financial de-regulation and opening up to external credit produce a massive inflow of short and medium term financial capital that provides an additional stimulus to effective demand in the economy. But the real exchange rate deteriorates sharply due to a persistent divergence between domestic and international rates of inflation, and the economy runs a large deficit in the current account, matched by a surplus in the capital account. The process continues until the size of the current account deficit makes the fixed exchange rate policy not credible. Debt indicators also deteriorate sharply. These factors first induce a slowing down in the inflow of foreign funds and eventually a net outflow. The government is then forced to devalue, but the devaluation comes too late and is perceived by economic agents as insufficient. A run against the Peso in now underway, which shows in an accelerating loss of foreign exchange reserves. In order to stop the process, the government decides on drastic contractionary measures that inaugurate a new and deeper recession. In desperation, the government also resorts to the same type of controls that the monetarist, free-market policy had been designed to eliminate in the first place.

Some lessons from this experience are drawn in the third section of this paper, where we also indicate some of the themes of high priority on a research agenda on the subject.

An appendix presents an empirical study of the Chilean and Argentine cases that served as background for this paper.


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