Academic journal article Contemporary Economic Policy

Why Have So Many Disinflations Succeeded?

Academic journal article Contemporary Economic Policy

Why Have So Many Disinflations Succeeded?

Article excerpt

  "[...] the work of policy is not done: sustaining reasonable price
  stability presents its own challenges" [IMF, October 1999, p. 125]

I. INTRODUCTION

The 1970s marked the beginning of an inflationary era that would plague most of the world, albeit with varying intensity and duration. We illustrate below that despite numerous attempts to disinflate during the 1970s and 1980s, the ground gained in many of those disinflations was rapidly lost. Conversely, the most recent round of disinflations--implemented since the early 1990s--has had a more permanent effect on inflation, both in developing and in developed nations. In other words, disinflations of the 1970s and 1980s were less sustainable than those of the 1990s. What are the factors that contribute to making gains from a disinflation sustainable? That is the main question addressed in this paper.

The question is an important one for policymakers, more so if we note that one of the most remarkable macroeconomic features of the 1990s is precisely the low inflation achieved both by developed and by developing countries. Indeed, during the second half of the decade, developed nations exhibited median inflation rates below the 3% mark, while Latin American countries--notorious for their inflation during the 1970s and 1980s--achieved median inflation rates in the single-digit range (compared with a median inflation rate close to 40% in 1990). Figure 1 illustrates the evolution of the median inflation rates in both groups of countries since 1972.

Similar questions have been asked in the literature on stabilization, that is, the branch dealing with disinflations from high inflation peaks (e.g., Calvo and Vegh, 1999; Hamann and Prati, 2002). Nevertheless, after the worldwide disinflation of the 1990s, it has become apparent that disinflations from high inflation rates no longer constitute the norm, not even in Latin America and the Caribbean (LAC). Most policymakers will face, in the present and the near future, questions related to disinflations from moderate or low inflation rates and sustaining reasonable price stability. Unfortunately, very little is known about the sustainability of such disinflations, a gap our paper begins to fill. (1)

Our study is unique in that it tackles the analysis of the sustainability of disinflations from a novel perspective. Rather than focusing on the time-series evidence of a single country as other studies do (e.g., Shapiro, 1994), we use a sample of disinflations from developing (LAC) and developed (G7) nations identified in Hofstetter (2007). The method used to identify disinflations starting from low and moderate peaks is a rules-based approach similar to Ball's (1994). We then propose a sustainability index based on the behavior of consumer price index (CPI) inflation following the end of a period of disinflation. The index represents the proportion of the original fall in the inflation rate that is sustained after the disinflation is over.

[FIGURE 1 OMITTED]

After estimating the index, we investigate its behavior in our sample. We show that (not surprisingly) developed countries have better sustainability records than LAC ones. Interestingly, though, the gap between the two has been shrinking. Moreover, both developed nations and developing countries experienced a notable improvement in the sustainability of disinflations during the 1990s.

Then, we take steps to understand what determined the success or failure of these episodes by exploiting the cross-episode variation in the sustainability index. There are several potentially relevant determinants underlying the cross-episode variation in the sustainability of disinflations. Among them, supply shocks, openness, exchange rate regimes, inflation targeting (IT), political economy variables, the inflation rate achieved during the disinflation, and foreign inflation are some of the factors we explore along the paper. …

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