Abstract

The purpose of this study is to analyze the business cycle associated with the exchange rate-based inflation stabilization policy. We develop a stochastic dynamic general equilibrium small open economy model characterized by two sectors of economic activities (tradable and non-tradable), imperfect competition and sticky price in the non-tradable sector, a cash in advance constraint for consumption goods, and endogenous labour supply. The model is calibrated and solved numerically to examine the resulting equilibrium dynamics. Result shows that the model can replicate quantitatively the stylized facts of the credible exchange rate-based stabilization programs, the slow convergence of the inflation to the target rate and the sustained expansion of domestic sector. The model can also produce the “boom-recession cycle” and inflation persistence in the case of temporary stabilizations.

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