Essays on inflation stabilization in a small open economy

The main objective of this dissertation is to develop models to explain the stylized facts of various stabilization programs observed in developing countries in a single unified framework. The basic model is Obstfeld and Rogoff's dynamic general equilibrium Mundell-Fleming model with cash-in-advance constraints. I extend the model to allow for sticky inflation. With this framework I simulate the disinflation experiments in high inflation environments.; Chapter 1. "Exchange-Rate-Based Stabilization" examines inflation stabilization using the rate of devaluation as a nominal anchor under a fixed or predetermined exchange rate regime. This study shows that the credible reduction in the devaluation rate induces initial expansion of non-tradable output and produces sustained expansion. The inflation rate, however, shows substantial persistence even if the policy is fully credible. This is because of backward-looking wage contracts. This result is quite consistent with the stylized fact of successful exchange rate-based stabilization programs. An incredible reduction of the devaluation rate results in a "boom-recession cycle" and inflation inertia, which has been observed in stabilization programs. Therefore, I conclude that as long as the indexation mechanism has a backward-looking component, credible disinflation can not reduce the rate of inflation rapidly and inflation shows inertia. I also point out that the credible disinflation can be welfare-improving regardless of inflation persistence.; Chapter 2. "Money-based stabilization" analyzes the disinflation attempt in which the growth rate of the money supply is used as the nominal anchor under the flexible exchange rate regime. This study shows the initial contraction in the non-tradable sector when the growth rate of the money supply is reduced. This is because the initial appreciation of the nominal and real exchange rates. When the supply-side effect, however, dominates, we observe long-run expansion of the non-tradable sector. In the case of an incredible policy, we can replicate the "recession-boom cycle" that we observed in money-based stabilization programs. In both cases, inflation persistence is obtained. This is mainly due to the backward-looking indexation in wage contracts. This study also suggests that the credible money-based disinflation can be welfare-enhancing regardless of initial recession and inflation persistence.; Chapter 3. "Interest rate rule for inflation targeting" analyzes the nominal interest rate policy for reducing high inflation. I use the same model and same approach as in the previous chapters. However, I look at the effect of an inflation targeting interest rate rule. The interest rate policy generates a severe recession with inflation inertia throughout the inflation stabilization program is observed even if the policy is fully credible. Therefore I argue that the nominal interest rate is not the appropriate policy instrument for fighting high inflation.