Devaluation Risk and the Syndrome of Exchange-Rate-Based Stabilizations

Enrique G. Mendoza, Martin Uribe

NBER Working Paper No. 7014
Issued in March 1999
NBER Program(s):International Finance and Macroeconomics Program

This paper shows that the risk of devaluation can be an important factor accounting for the stylized facts of exchange-rate-based stabilizations. This conclusion follows from studying the quantitative implications of a two-sector equilibrium business cycle model of a small open economy calibrated to Mexico's 1987-1994 stabilization plan. In the model a time-variant interest rate differential that acts as a stochastic tax on money demand, labor supply, investment, and saving. Under incomplete markets, this tax induces endogenous state-contingent wealth effects via fiscal adjustment and suboptimal investment. Devaluation risk entails large welfare costs in this environment.

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Document Object Identifier (DOI): 10.3386/w7014

Carnegie-Rochester Conference Series on Public Policy, Vol. 53 (2000),forthcoming.

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