Disinflation and the Recession-Now-Versus-Recession-Later Hypothesis: Evidence From Uruguay

IMF Working Papers, October 1, 1995

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Both analytical models and casual empiricism suggest that the timing of the recessionary costs associated with inflation stabilization in chronic inflation countries may depend on the nominal anchor which is used.
Under money-based stabilization, the recession occurs at the beginning of the program, while under exchange rate-based stabilization the recession occurs later in the program.
This paper provides a first attempt to formally test this hypothesis using a vector-autoregression model for Uruguay.
The impulse response of output to different stabilization policies is broadly consistent with the “recession-now-versus-recession-later” hypothesis.
The evidence also suggests that the effectiveness of a monetary anchor in reducing inflation is hindered by the high degree of dollarization of the Uruguayan economy.

Empirical approach: vector-autoregression model applied to Uruguay.
Objective: test timing of output responses (recession now versus recession later) under differing nominal anchors (money-based versus exchange rate-based stabilization).

Impulse responses of output to stabilization policies are broadly consistent with the “recession-now-versus-recession-later” hypothesis.
High degree of dollarization in the Uruguayan economy reduces the effectiveness of a monetary anchor in lowering inflation.

Choice of nominal anchor matters for the timing of recessionary costs associated with disinflation.
In highly dollarized economies, monetary-anchor strategies may be less effective for inflation reduction, implying trade-offs when selecting stabilization strategy.