PART I

Rudiger Dornbusch, Policies to Move from Stabilization to Growth. Proceedings of the World Bank Annual Conference on Development Economics 1990, pages 19-48.

The typical stabilization program for an economy emerging from high inflation involves freezing wages and prices and making little fiscal adjustment. For the first month of two this program is successful, partly because expectations of a freeze will have led to prior price hikes. Soon the freeze wears off, however, and the deferred rise in public sector prices, the lifting of export taxes, and real appreciation combine to erode the budget position. Then, in phase two, policy-makers implement tight money. This gives an unsustainable program another few months of life, but of course it also increases public indebtedness sharply. Next, in phase three, the problems with the program become widely perceived, and debtors plead distress due to high real interest rates. When tight money goes, the house of cards collapses; the exchange rate collapses, inflation surges, and real interest rates turn very negative. Soon, another stabilization is under construction, ready for spring, tottering in the summer, and blown away by fall.

The important lesson to draw is this: tight money is not a substitute for a balanced budget. Real interest rates ultimately should be low, and the only way such a situation is sustainable is by basically sound fiscal and real exchange rate policies. Here we note that tight monetary policy is a signal of serious misalignment in the budget, the real exchange rate, or both. Realized real interest rates of 30 or 40 percent, in the presence of domestic debt, soon give rise to fiscal problems (p.26).

According to the same text:

Item 1 - Factors contributing to the budget deficit include: postponement of public sector price hikes, real appreciation of the exchange rate, and exemption of export taxes.