STABILIZATION DYNAMICS AND BACKWARD-LOOKING CONTRACTS

Exchange rate-based stabilizations often result in an initial output e xpansion. One explanation for this phenomenon has been that, in the pr esence of inflation inertia, a reduction in the nominal interest rate causes the domestic real interest rate to fall, thus increasing aggreg ate demand. This paper reexamines this issue in the context of an inte rtemporal optimizing model. In contrast to previous results, the analy sis shows that, if the intertemporal elasticity of substitution is sma ller than the elasticity of substitution between traded and home goods , a permanent reduction in the rate of devaluation leads to a fall in aggregate demand.