Essays on the Distributional and Welfare Consequences of Disinflation in Emerging Economies

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2011

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This study undertakes a quantitative investigation of the distributional and welfare consequences of a sharp reduction in inflation in a small open economy. In the first chapter, a monetary model of a small open economy with uninsured idiosyncratic earnings risk is analyzed. In this model, consumers hold non-interest bearing real balances (demand deposits) that economize transactions costs of consumption and internationally-traded risk-free bonds (term deposits) that are useful for consumption smoothing. Bonds are modeled as inflation-indexed to incorporate financial dollarization. The model is calibrated to Turkish data and is used to compare stationary equilibria with quarterly inflation rates of 14.25% (for 1987:1-2002:4) and 2.25% (for 2003:1-2010:3) under alternative fiscal arrangements. The results show that (i) when uniform transfers are endogenous, reducing inflation lowers aggregate

welfare by 1.25% in terms of compensating consumption variation. This is because the reduction in the costs of inflation for the poor is less than the reduction in their transfers income. This also tightens natural debt limits and increases precautionary savings motive. (ii) When endogenous transfers depend on individual-specific inflation tax payments, aggregate welfare increases by 0.45%. This is because proportional transfers do not drive redistributive effects. (iii) Welfare gains increase further (1.62%) if wasteful spending is endogenous. The model also generates a cross sectional portfolio consistent with the disaggregated deposits data and the literature.

The second chapter examines quantitative properties of the transitional dynamics produced by gradual disinflation (as opposed to the stationary equilibria analysis conducted in the first chapter). The main exercise is to feed the empirically observed declining path for inflation into the calibrated model and account for its macroeconomic, distributional and welfare effects under alternative fiscal arrangements. The results show that (i) when uniform transfers are endogenous, gradual decline in the inflation rate from 14.25% to 2.25% increases aggregate welfare by 0.28%. (ii) When wasteful spending is endogenous, aggregate welfare increases by 0.53%. These welfare effects are substantially different from those implied by steady

state comparisons. This is because when transition is accounted for, fiscal variables do not jump to their low inflation steady state levels immediately.

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