Temporary stabilization: a Fréchet-Weibull extreme value distribution approach

Abstract

This paper develops, in a small open economy of pure exchange framework, a stochastic model of exchange-rate-based inflation stabilization plan that is expected to be temporary. Agents have expectations of devaluation driven by a mixed diffusion jump process where the expected size of a possible devaluation is supposed to have an extreme value distribution of the Fréchet-Weibull type. Consumption and wealth equilibrium dynamics are examined when such a stabilization plan is implemented. It is assumed that financial markets are incomplete, that is, there are more risk factors than risky assets. Finally, the effects of exogenous shocks on economic welfare are assessed.