Temporary stabilization in developing countries and real options on consumption

This paper develops, in a small open economy framework, a stochastic model of an exchange-rate-based inflation stabilization plan with imperfect credibility. In the proposal, agents have expectations of devaluation driven by a mixed diffusion-jump process where the expected size of a possible devaluation has an extreme valued distribution of the Fréchet type; as the stylized facts from the Mexican's 1994 and Argentinean's 2001 extreme devaluations have shown. Consumption and wealth equilibrium dynamics are examined when a stabilization plan with is implemented. We also assess the effects of exogenous shocks on consumption and economic welfare. We use the proposed model to carry out simulation experiments that reproduces the booms of private consumption in Mexico (1989-1994) and Argentina (2001-2003) when extreme devaluations took place. Finally, we value the real option of waiting for delaying consumption when a stabilization plan is expected to be abandoned, and numerical approximations for such a real option are provided.