Real Balances, the Exchange Rate, and Indexation: Real Variables in Disinflation. National Bureau of Economic Research Working Paper 1497

The paper shows first that real exchange rate appreciation typically reduces, but may increase, the output costs of disinflation. The direct favorable effects of cheaper imports on consumer prices, on the prices of imported inputs, on wage demands, and on the demand for money may be outweighed by the unemployment caused by the trade deficit. Second, the effects of wage indexation on the costs of disinflation are reexamined. Ex ante indexation speeds up disinflation. Ex post indexation, the type observed in practice, automatically increases the real wage at the start of a disinflation and may therefore increase the sacrifice ratio. It has long been known that at some stage in a disinflation process initiated by a discrete reduction in the growth rate of the money stock, the rate of inflation must fall by more than the reduction in money growth. The reason is that the demand for real balances in the new low inflation steady state will be higher than in the high inflation equilibrium: the economy produces real balances by causing the price level to grow more slowly than the nominal money stock. In an economy with fully flexible prices, credible government policy, and rational expectations, the start of a disinflation program can be accompanied by a discrete rise in the money stock that will prevent the price level jumping and thus inflicting capital gains and losses on nominal creditors and debtors. However, the credibility problem posed by such a policy is obvious: to start a disinflation program with an increase in the money stock is to court the suspicion that announcements and actions are not closely related. The difficulty is compounded by the similarity between a stock increase in the money stock and an increase in its growth rate when data are reported at discrete intervals. In an economy where prices are not perfectly flexible in the short run, as a result, for example, of long-term contracts, the *An earlier version of this paper was written while I was Max Bogen Visitin