State-Dependent Nominal Rigidities & Disinflation Programs in Small Open Economies

Empirical regularities from high-inflation economies, especially in Latin America, suggest that exchange rate-based (ERB) disinflations and money-based (MB) disinflations induce sharply different dynamics in consumption and GDP. I study the role of nominal rigidities to explain business cycle fluctuations associated to ERB and MB disinflations within a single framework. By building on Calvo's (1983) pricing theory, this paper introduces elements of state-dependent pricing at the firm level into an otherwise standard small open economy model. This new feature allows for endogenous variations in the aggregate degree of nominal rigidities. The model contains as a special case a time- dependent pricing model discussed in the literature. Nonlinear simulations show that the model with state-dependent nominal rigidities generates a dynamic behavior that is more consistent with the empirical evidence, compared to the model with time-dependent pricing.