Summary of WP/92/60
“Inflation and Monetary Reform” by Pierre-Richard Agénor and Anna Lennblad
The introduction of a new currency has often occurred as part of a comprehensive program aimed at fighting hyperinflation by curtailing the money stock. While a pure change in numeraire is neutral, governments can use nonuniform conversion rates for various categories of assets and liabilities to “force” a redistribution of wealth or eliminate a perceived “excess” of liquidity. Given these considerations, the introduction of a new currency is likely to exert a variety of real and financial effects on the economy depending, in particular, on the state of expectations.
This paper examines the anticipatory dynamics associated with nonuniform monetary reforms in a small open economy with optimizing and forward-looking agents. After a description of the model, the analysis focuses on the effect of alternative reform strategies on the path of inflation and the behavior of foreign currency holdings. A nonuniform conversion rate is shown to be equivalent to a permanent fall in the domestic money stock. The model suggests that a monetary reform that incorporates a confiscatory element has a deflationary effect upon announcement as well as during the transition period, leading ultimately to a “de-dollarization” of the economy. When the monetary reform occurs “overnight,” the fall in prices is more pronounced, but there is no change in foreign currency holdings.
The analytical framework also examines the case in which the monetary reform is assumed to take place at an unknown date in the future. Under uncertainty about the date of reform, a monetary reform leads to a downward jump in the price level at the time the reform is implemented, even if the behavior of prices in the post-reform regime is perfectly known by agents. Upon announcement, a monetary reform also leads to a jump in prices, the direction of which depends on the initial position of the economy.
The last part of the paper summarizes the main results and examines their implications for the choice between a preannounced and an overnight monetary reform. The former approach is preferable if there is no cost in delaying the reform and if cross-border speculative capital inflows can be prevented, because it allows agents gradually to work off excess balances in foreign currency. Once a preannouncement strategy is chosen, however, uncertainty about the actual reform date should be avoided. Keeping agents guessing about the date may have an adverse effect on prices and distort portfolio decisions.