~)Pergamon Journal ofilnternational Mon~ 3, and Finance, Vol. 16, No. 1, pp. 37 54, 1t)97 © 1997 Elsevier Sciencc Ltd. All rights reserved Printed in Great Britain PII: S0261-5606(96)00042-3 0261-5606/97 $17.01) + (}.(10 On gradual disinflation, the real exchange rate, and the current account JORGE E ROLDOS* International Monetary Fund, WashingtonDC 20431, USA We study the effects of a credible, gradual exchange-rate-based disinfla- tion program in a two sector economy. After an initial exchange rate depreciation, the reductions in the rate of devaluation reduce the mone- tary wedge generated by the cash-in-advance constraint, leading to a gradual increase in absorption that yields progressive real exchange rate appreciations and current account deficits. An initial boom in economic activity is not followed by a later contraction, as labour supply expands during the whole length of the program. Many of the model's predictions are in accordance with the stylized facts on disinflation in chronic-infla- tion countries, in particular those of the Mexican program of 1988-1992. © 1997 Elsevier Science Ltd The effects of disinflation on small open economies have been the object of extensive research (see Kiguel and Liviatan, 1992, and Vrgh, 1992, for surveys on these issues). However, despite the appeal of a gradual approach to disinflation only a few studies have tried to explore it analytically. In this paper, we present a model where most of the stylized facts of disinflation are derived as the equilibrium result to a credible but gradual reduction in the rate of devaluation. The progressive reduction of the monetary wedge generated by a cash-in-advance constraint leads to gradual but steady increases in consump- tion and labor supply, which induce persistent real exchange rate appreciations, current account deficits and output expansions. The main 'stylized facts' from the attempts to stop chronic inflation using reductions in the rate of the devaluation are (Vrgh, 1992): (i) a slow conver- gence of the rate of inflation to the rate of devaluation, i.e. a sustained appreciation of the domestic currency; (ii) cumulative current account deficits; *This paper is a substantially revised version of Chapter V of my dissertation at the University of Rochester. I would like to thank Alan C. Stockman and Carlos A. VEgh for many useful discussions on these issues. Comments by Pierre-Richard AgEnor, Carlos Asilis, Jose DeGregorio, Don Mathieson, Gian Maria Milesi-Ferretti, Julio Santaella and an anonymous referee are gratefully acknowledged. A previous version of this paper was circulated as IMF Working Paper WP/93/90 under the title 'On Credible Disinflation'. The views expressed in this paper do not necessarily reflect those of the International Monetary Fund. 37