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Credible Anti-inflation Policies Lead To Boom Then Bust In Spending On Consumer Durables

In many developing countries, inflation stabilisation programmes are often accompanied by a sharp rise in economic activity, particularly consumption of durable goods like television sets, VCRs and cars, followed by a fall. This is in sharp contrast to the immediate contraction of economic activity that developed countries typically experience when pursuing price stability. According to José De Gregorio, Pablo Guidotti and Carlos A Végh, writing in the latest Economic Journal, the reason for this puzzling effect is not that the public expect the programme to be abandoned in the future. Rather, it is because consumers believe in the programme and, as a result, feel wealthier. Policy-makers should therefore sit back, relax and enjoy their success.

The researchers demonstrate how pronounced the boom-recession cycle can be for consumer durables. For example, in the Israeli 1985 stabilisation plan, which put an end to a long period of chronic inflation, private consumption as a whole increased by an annual rate of 10% in the early stages of the programme, while durable goods consumption rose by an annual rate of 28%. In Argentina''s highly successful convertibility plan of 1991, the figures were 8% and 62% respectively; later on, consumption of durables fell much more sharply than private consumption.

A popular explanation for this phenomenon is based on the idea that stabilisation programmes in chronic inflation countries are often not credible, in the light of a history of failed stabilisations. The public will be highly sceptical of any new finance minister who vows to eradicate inflation within a year since they have heard this claim so many times before.

While the stabilisation plan is in effect, however, the lower rate of depreciation of the domestic currency reduces interest rates, which makes consumption more affordable. The public thus chooses to embark on a consumption binge before the programme ends and interest rates rise again: lack of credibility leads to an initial consumption boom followed by a contraction.

Végh and his colleagues offer a very different explanation, which does not rely on the notion that the public expects the programme to be abandoned in the future. In their story, the implementation of a stabilisation plan leads to a ''wealth effect'': the newly-achieved monetary stability frees resources, which were previously used in costly activities aimed at avoiding the devastating effects of inflation, for productive activities.

Since consumers feel wealthier, many of them decide to bring forward planned purchases of durable goods. In addition, they choose to buy more costly durables: next year''s planned purchase of a new Honda becomes today''s purchase of a BMW. This ''bunching'' in purchases of durable goods at the beginning of the programme results in a consumption binge. Since most consumers choose to replace their durables early on in the programme, there will be few purchases later on (no new Hondas will be sold next year), which explains the eventual bust in consumption.

The policy implications of the two explanations differ drastically. In the case of lack of credibility, the initial boom is a clear indication that policy-makers have not done enough to convince the public that the programme will be sustained over time. Policy-makers should therefore take some action to increase the programme''s credibility.

In sharp contrast, under the explanation proposed by these researchers, the boom-recession cycle is a direct consequence of policy-makers'' ability to implement a successful plan. In this interpretation, policy-makers should sit back, relax, and enjoy their success.

''Inflation Stabilisation and the Consumption of Durable Goods'' by José De Gregorio, Pablo Guidotti and Carlos A. Végh, is published in the January 1998 issue of the Economic Journal. De Gregorio is at the Universidad de Chile; Guidotti in Argentina''s Ministry of Finance; and Végh in the Department of Economics, University of California at Los Angeles, Box 951477, Los Angeles, CA 90095-1477, USA.