Disinflation and the supply side

This paper studies the dynamics associated with permanent and temporary reductions in the devaluation rate. The analysis uses an intertemporal optimizing model of a small open economy with imperfect capital markets and endogenous labor supply. With a constant capital stock, the model predicts an initial reduction in real wages and an expansion in output. Consumption falls on impact but increases afterward. In addition, with a temporary shock, a current account deficit emerges and a recession sets in at a later stage. With endogenous capital accumulation, numerical simulations show that the model is also capable of predicting a boom in investment.