Temporary stabilization: A stochastic analysis

This paper develops a stochastic model of exchange-rate-based inflation stabilization in which agents have expectations of devaluation driven by a mixed diffusion-jump process. In a richer stochastic environment where a Brownian motion drives the rate of devaluation and a Poisson process determines the probability of devaluation, we examine consumption and wealth equilibrium dynamics when a stabilization plan is implemented and contingent-claims markets are unavailable. We also assess the effects of exogenous shocks on consumption and welfare. Finally, we use the proposed model to carry out a simulation experiment of the equilibrium dynamics.