Signaling 21

8/9/2019 Signaling 21

1/23

Signaling Output Costs: A Study of

the Perus 1990 Election

Cesar R. Sobrino

Universidad del Turabo

School of Business and Entrepreneurship

August, 2010

Abstract

In this paper, I represent the 1990s election in Peru in a signaling game. In that year,

FREDEMO announced an orthodox program to stabilize inflation, in contrast to CAMBIO90 that was against that stabilization program, supposing the application of a heterodox

program. Finally, the former, after signaling commitment, won applying the orthodoxprogram. To make this analysis, I replicate Kartik and McAfee (2007) where there are two

types of candidates: strategic (office-motivated) and non strategic (policy-motivated).

Types of candidates are non common knowledge. The first one signals commitment even

though he announces fake political preferences. His equilibrium strategies are different thatthat of Kartik and McAfee (2007).

JEL Classification: C72 - D72- E31

Keywords: Electoral Competition, Signaling Games, Inflation

Please address all correspondence to:

Cesar R. SobrinoSchool of Business and Entrepreneurship

University of Turabo

PO BOX 3030

Gurabo, PR [email protected]


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Introduction

According to Kartik and McAfee (2007), the theory of character in elections quashes the

median voter theorem because voters value both: character and campaign promises. In this

framework, the strategic candidate (office- motivated), located closed to the medium voter,

tends to move closer to the non strategic candidate (policy-motivated) who is located far

away to the medium voter and has character. Then, when moving closer to the non-

strategic candidate, the strategic candidate is trying to compesate his lack of character.

In this paper, the voters value campaign promises and commitment. The

commitment is no common knowledge. The commitment matters because there are output

costs that the voters could afford if the strategic candidate wins. The Perus 1990 election

motivates this framework. In that election, FREDEMO and CAMBIO 90 announced

different policies to stop the current inflationary process. FREDEMO, proposed the

orthodox policy which was the IMFs condition to return to the international financial

system while, by contrast, CAMBIO 90 was against the application of the orthodox

program due to its high output costs.

To represent Perus 1990 election, I replicate Kartik and McAfee (2007). I set two

types of candidates: committed (FREDEMO) and no committed (CAMBIO 90). The first

one announces its true platform and second one does not. The types of candidates are

private information although voters are convinced about the commitment of the first player

because he announces the highest-costs policy. Finally, known the IMFs sponsorship for

the orthodox program and the need of returning to the international financial system, voters

expect that CAMBIO 90 might apply the FREDEMO policy preferred.


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The paper is organized as follows. The first part presents the economic situation

previous to the election, political campaigns and the outcome of the polls; the second part

summarizes the differences between the orthodox and heterodox policies; the third part

presents some related literature; the fourth part presents the signaling game; and, the last

part concludes.

1. Peru in 1990: Economic Context, Political Campaign and PollsFor almost ten years, the high inflation rates had already been an unsolved problem for the

Peruvian governments whenAPRA (center-left) started its term in 1985. To control it and

spur the real economy, its heterodox program was successful but just for the first two

years. The increase in salaries and price controls led to an initial prosperity, however, those

policies and a growing fiscal deficit started to produce the later reborn of inflation.

In 1988, changing some guidelines of its initial economic program, the government

started to apply price shocks to change the inflationary trend but they failed due to the

fiscal liquidity constraint. The low prices of minerals, low tax revenues and inexistent

international funding1 determined that the Central Banks credits became the main source

of the fiscal deficit.

At the end of the 1980s, high inflation2; sluggish output growth; the state running

into bankruptcy; fall in living standards; and, shortages of food, water and electricity,

determined a hopeless future which was increased by two huge socio-political problems

such as terrorism and corruption. This entire situation determined the discredit of the

whole political system and old political parties (Schmidt: 1996).

1In 1985, the government reduced the debt service to 10 percent of export earnings. IMF did not accept this

unilateral measure, declaring Peru ineligible for new loans.2

3,398.6 percent in 1989.


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In this circumstance, the debate of the 1990 election was focused to stabilize and

decrease inflation. There were mainly four traditional political parties and a newcomer

running for the presidency3. Only one of them, FREDEMO (F)

4, announced an orthodox

stabilization program (pO)5. The other four: APRA, the lefties,IUandIS, and CAMBIO 90

(C)6, were against the application ofp

Owhich implied that they might apply a heterodox

stabilization program (pH). F and C qualified for the second round because no political

party got fifty percent plus one in the first round (Table 1).

Known the initial outcome, the Fs speech focused on that the only policy

sponsored by IMF wasp

O

, so the winner was going to be compelled to apply it to impulse

the eligibility of Peru for new loans. Moreover, Femphasized the application of a social

supporting program7 to reduce pOs costs (No one had it). Meanwhile, the Cs strategy

focused to preserve the status quo, indicating that pO

engage higher output costs to the

Peruvians. Finally, Cdefeated F(Table 1).

In July 1990, new advisers persuaded C to execute pO because, without it, Peru's

reentry into the international financial system would be not possible, eliminating the

possibility of international aid. Finally, on August 8th, 1990, Cimplemented precisely the

policy that it had campaigned against.

3Actually, there were ten candidates running for the presidency (Schmidt: 1996).4It was composed by two traditional parties AP and PPC, and two new parties ML and SODE. The famous

writer Mario Vargas Llosa was the candidate of this political covenant (Schmidt: 1996).5Fannounced to reduce inflation to ten percent with a radical cut in public spending, tight monetary policy

as immediate measures, mass firings of public workers, privatization of public enterprises, and radical

reduction of imports tariffs as medium term policies (Pastor Jr, and Wise: 1992).6

It was founded one year previous to the election and its candidate was Eng. Alberto Fujimori (Schmidt:

1996).7

Programa de Apoyo Social (PAS).


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2. Stylized Facts of the Stabilization Policies

According to Dornbusch and Simonsen (1988), Kiguel and Liviatan (1988), Dornbusch

(1992), Kiguel and Liviatan (1992), the main differences of those programs are related to

the output costs and monetary policy (Table 2). Sponsored by IMF, pO causes high output

losses. This policy considers tight monetary policy and fiscal policies as the tools of

stabilization along with price liberalization8.

At the beginning, there will be a price shock to break the inflationary trend. The

aggregate demand will go down because of the fiscal austerity and the fall of the money

growth rate, generating a large recession, immediately. Finally, the inflation rate will tend

to converge to the money growth rate in the medium term.

Opposing to conventional IMF programs, pH

focuses on not only demand-side but

also supply-side policies. This means a combination of fiscal adjustment, monetary reform

and income policy. In addition, price-wage controls are an important and transitory

complement to the fiscal stabilization because demand-side policies only consider high

inflation as a monetary phenomenon, but forgetting inflation inertia9. The objective is to

gradually reduce the inflation rate by reducing the money growth rate and applying an

income policy to defeat the inertial inflation10

. This indicates that it is necessary for a wage

setting policy to eliminate inflation inertia (indexation).

8

pO

can be either money-based, which relies on restrictions on the rate of monetary expansion to provide anominal anchor, or exchange-rate-based which relies on exchange-rate pegging to provide the nominal

anchor. Money-based stabilization causes a sharp contraction in economic activity at the beginning of the

programs. Under exchange rate-based stabilizations, the output cost would be paid later (Calvo and Vegh:

1994).9

It means that inflation today is approximately equal to what it was yesterday.10

Regarding Israel heterodox experience, the inflation rapidly fell in one year without recession. The success

of this program was the application of income policy and fiscal restraint which was different from Argentina

(Austral Plan), Brazil (Cruzado Plan) and Peru (Inti Plan) in which only income policies were applied

(Dornbusch :1992).


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3. Literature Review

In the median voter theorem (Hotelling (1929) and Downs (1957)), two office-motivated

candidates (just cares about winning) try to move close to each other at the mid-point of

the political spectrum line where the candidates and voters preferences are common

knowledge. Then, maximizing the probability of winning, candidates become more

moderate and rational voters choose the closest policy announced to their ideal point.

Banks (1990) relaxes the no noise of the signals from political parties to voters which

means candidates preferences are private information. Without this assumption,

candidates might announce their non policy preferred. So, once elected, the winner follows

his true preferences and the payoffs for the winner and voters are set.

The types of candidates vary across their motivations, intentions and/or

characteristics. Kartik and McAfee (2007) focus on the character of the candidates which

is desirable for voters. Huang (2007) argues that candidates may be liars or have weak

ideological preferences (new political party) where this second type of candidate may be

influenced by an external agent to apply a different platform. Callander and Wilkie (2007)

differentiate candidates between liars and cheap talkers. Callander (2008) studies policy-

(cares about winning and the quality of the policy) and office-motivated candidates. In this

case, voters know that a policy-motivated candidate may apply a good-quality policy

although he might be far away from the median voter.

According to Kartik and McAfee (2007), voters care about ideological positions

and character; and learn the nature of the candidates (exogenous) when candidates

choose a policy. Policies close to median voter might mean candidates without character.


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In this scenario, to cast their ballots, voters evaluate not only the policies announced but

also the nature of the candidates.

It follows that the non strategic candidate is far away from the median voter which

means that he has character. Then, the strategic candidate may move toward his

competitor, signaling character, within a range where the ideological utility of the median

voter is constant. However, when voters just care about the policy applied, they have to

update their beliefs following the policies announced and character is dropped off from

the utility of the voter. Here, the strategic candidate offers a constant ideological value to

the median voter and moves within the range of that constant value.

Known the first round outcome, the Fs strategy focused on that IMF just

sponsored pO and he had a social supporting program to reduce the p

O costs. Likewise, C

strongly opposed to the application ofpO. Then, according to F, C and F were non

committed and committed parties, respectively; and, according to C, he was againstpO11

.

In this sense, the announcements of the stabilization programs determine the

ideological locations of the parties. Due to the high output costs ofpO in contrast topH(See

Appendix), Fs location was far away to the median voter. Here, voters might infer that F

is a committed-type candidate because if he wants to win why he chooses the high output

costs policy. On the other hand, given that Cwas a newcomer, his ideological position was

practically unknown for the voters; they just knew the Cs policy announced (close to the

median voter). Then, according to Banks (1990), Callander and Wilkie (2007), and

Callander (2008), this candidate might be a liar or according to Huang (2007), he might

pander after the election which indicates that Cdid not know his optimal policy.

11The political campaign was very hard, enhancing racist, religious, economical and social tones. The media

exacerbated the existing polarization in the system by determining a campaign without any discussion about

the government plans.


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Therefore, Cis a strategic-type and Fis a non-strategic and, for this reason, Chas

to signal his commitment differentiating from F. Voters cast their ballots choosing the

closest political announcement; however, they have to infer about the types of the

candidates because there could be an additional cost if the winner applies another policy

different from the platform announced. Here, no commitment is a penalty for the voters

because the non committed candidate is not ready to apply another platform.

4. The Model

Kartik and McAfee (2007) present two kinds of candidates: strategic and non strategic. The

former announces a policy which maximizes his probability of winning; the latter

announces his preferred policy. The former is office-motivated and located close to the

median voter; the latter is policy-motivated and located far away from the median voter.

When the candidates announce their platforms, they are revealing their position and

signaling if they have or do not have character. The non strategic candidate is most

probably that has character. Here, character and commitment are synonymous.

Voters have to update their beliefs following candidates signals. Even though the

strategic candidate might announce his no policy preferred, to achieve more votes, he may

move along the political spectrum between the median voter and the non strategic

candidates policy announced to announce a platform that balances the ideological position

of the median voter and the demand of the median voter for commitment,

The policy spectrum is X= [0, 1]. The ideal point of each voter is Xand the

voters preferences are single picked. The utility function of a single voter is u(x, ) where

u1(x, )=0 and u12(x, ) > 0. The median voter location is m X. There are two

candidates/political parties, Fand C,which announces xiX. Voters learn platforms and


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cast their ballots following their expected utility. The candidate with greater ballot share

wins the runoff and ties are solved by a fair coin toss.

The commitment or not of the candidates is unknown by voters. It can be either

ci=1, the committed type or c

i=0, non committed type, where i= F, C. Both types are

independent each other and are represented by a Bernoulli distribution where Pr(ci=1)=

b>0. Unknow by voters, b is the probability that candidate is committed. If a candidate i is

committed-type, his policy choice, xi

is a random variable with cfd Kand density k(x)>0

for allxX. The candidate committed cannot make any choice because his type is non-

strategic. By contrast, the candidate uncommitted makes his choices playing strategically

to maximize his expected utility.

Each candidate has a policypi got from the cdfK. From here, each candidate knows

his type12

. The committed-type candidate will choosexi=p

z i: F,C; and z: O,H. For

the non-committed type (pander or liar), the candidate plays strategically xi to maximize

his expected utility13. The strategy of the no committed type is conditional on being

strategic. So, a strategy of candidate i {F,C} is represented by the cdf Gi and density gi

Voters care about the winners policy, so they choose candidate i with policy xi

maximizing their expected utility U(xi, ).

vxuExvxuxvxU xiiiiii ,1,, (A.1)

where xgbxbkxbk

xi

ii

)1( .i(xi) is the posterior probability that i is committed-

type given the platform choice xi. The expectation term is with respect to k(x), so it does

not depend on the platform announced. Moreover, the strategic candidate plays the same

12Actually, it is very difficult to infer that Cknew his true preferences and announced untrue preferences.

13Non committed politician plays the same distribution over platforms independent of his ideal point.


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distribution over policies independent of his ideal platform. Here, candidate i wins (or j

losses) if vxUvxU ji ,, , j i. The poll is tied when vxUvxU ji ,, , and both

candidates are elected with probability . The solution concept is the weak Perfect

Bayesian Equilibrium. Rewriting (A.1)

vxuEvxuxvxuEvxU xiiixi ,,,, (A.2)

Median voter theorem supposes symmetry, so a candidate must win with positive

probability if strategic. The only way that the non committed candidate wins with positive

probability, and, yet, maximizes his probability of winning, is if every platform that he

offers the same utility to the median voter. That value is *. Then,

vxuEvxuxvxuE xiiix ,,,* (A.3)

Solving for xgxg i

1

,

,,

1,0max

*mxuE

mxuEmxu

b

xbfxg

x

x

(A.4)

Where mmumxuEx ,,, such that x

dxxg 1* Here, C will offer at least

mxuEx , and at most mmu , . However, if voters expect that the strategic candidate

appliespO if win, they have to included the outcome of that policy in their utility function.

For that reason, the equilibrium strategies should been changed, so that, the strategic

candidate wins.

4.1 Equilibrium Strategies in Perus 1990 Election

In Perus 1990 election, voters know that Ccould applypO, so the limits of the constant

utility offered to the median voter can be changed. Voters care the winners policy, so, to

win, Chas to offer a higher utility than Fdoes to the median voter. In addition, the median


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voter knows that if C wins, he could apply an orthodox program, and, would be an

additional cost for not having a social supporting program.

The stabilization programs are correlated with the political positions so, given the

higher output costs of the orthodox program, if one candidate announces the orthodox

(heterodox) program, his position will be far from (close to) the median voter. Fannounces

orthodox program and Cannounces heterodox program. Then, ifFannounces xF=p

O, the

voter payoff is mxu F, , if C announces xC ( pH) the voter payoffs are between

mpxu HC , and mxmxu CF ,, , where is the additional cost for not having a

social supporting program if the Cwins and applies an orthodox policy. is decreasing at

x. If mxC ,>0. for allx; if FC xxm ,>0, for allx; and, if FC xx ,=0, for allx.

This means that if the strategic candidate announces a policy close to the median voter or

far away from the policy supported by IMF there is a cost for not having a social

supporting program.

The payoffs are as follows

mmumpxumxumxmxu HCFCF ,,,,,0

Setting a different nomenclature in (A.3) and xgxg i

mxvxuvxuxgbxbk

xbkmxvxu

CFCCF,,,

)1()(

)(,,

For the median voter

1

,,

,,,

1

)(,0max

*mxmxu

mxmxumpxu

b

xbkxg

CF

CFHC


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Where mmumxu F ,,, . Here, Cmay offer a policy greater than mxu F, and at

most mpxu HC , . In this case, * cannot be bounded by the expected value of the

policy applied because the voters may expect that the winner appliespF. The range of* is

different that that of Kartik and McAfee (2007). Here, *has to be smaller, so that, the

strategic candidate may win.

Table 3 shows the outcomes when >0. When xF


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announces his platform within a range that offers a constant utility to the median voter.

However, here, the equilibrium strategies must not include the expected value of the voters

because if it is included as Kartik and McAfee (2007) do, the strategic candidate may lose

or the electoral contest ends in a draw.

In Perus 1990 election, voters know that CAMBIO 90 might apply the policy

announced by FREDEMO. However, I cannot affirm that CAMBIO 90 was convinced of

the application of the orthodox program. However, for sure, he was convinced that the only

way to win was to be against the application of an orthodox program.

For a simple analysis, this paper only considers economic features such as the

output cost caused by the stabilization polices. However, it does not include other factors

such as religion, racism, politics in which that election was driven by the political parties,

journalists, etc. Those factors are very important for influencing voters decision, but it

supposes a complicated analysis.


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References

[1] Banks J (1990) A Model of Electoral Competition with Incomplete Information,Journal of Economic Theory, 50(2): 309-325.

[2] Callander S and Wilkie S (2007) Lies, Damned Lies, and Political Campaigns,Games and Economic Behavior, 60, 262-286.

[3] Callander S (2008) Political Motivations, Review of Economic Studies, 75, 671-697.

[4] Calvo GA and Vegh CA (1994) Inflation Stabilization and Nominal Anchors,Contemporary Economic Policy, Vol. XII, April, 35-45.

[5] Dornbusch R and Simonsen MH (1988) Inflation Stabilization: The Role ofIncome Policy and of Monetization. In Dornbush R. Ed., Exchange Rate and

Inflation, MIT Press, Cambridge, Massachusetts.

[6] Dornbusch R (1992) Lesson from Experiences with High Inflation, the World BankEconomic Review, 6(1): 13-31.

[7] Downs A (1957) An Economic Theory of Democracy, New York: Harper & Row.[8] Garavito C (1997) Empleo, Salarios Reales y Producto: 1970-1995, Pontificia

Universidad Catlica del Per, Departamento de Economa, Documento de Trabajo

140, Nov., Lima.

[9] Hotelling H (1929) Stability in Competition, the Economic Journal, 39 (153): 41-57.

[10] Huang H (2007) Electoral Campaigns When some Candidates Lie and OtherPander, Department of Political Science, Duke University, Mimeo


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[11] Kartik N and McAfee RP (2007) Signaling Character in Electoral Competition,American Economic Review, 97 (3), 852-870.

[12] Kiguel MA and Liviatan N (1988) Inflationary Rigidities and OrthodoxStabilization Policies: Lessons from Latin America, the World Bank Economic

Review, 2 (3): 273-298.

[13] Kiguel MA and Liviatan N (1992) When do Heterodox Stabilization ProgramsWork? Lessons from Experience, the World Bank Research Observer, 7 (1): 35-57.

[14] Pastor Jr. M and Wise C (1992) Peruvian Economic Policy in the 1980s: FromOrthodoxy to Heterodoxy and Back, Latin American Research Review, 27(2): 83-

117.

[15] Schmidt G (1996) Fujimoris 1990 Upset Victory in Peru: Electoral Rules,Contingencies and Adaptive Strategies, Comparative Politics, 28(3), 321-354.
http://econpapers.repec.org/article/aeaaecrev/http://econpapers.repec.org/article/aeaaecrev/


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Table 1: Peru: 1990s Polls Outcome

First Round Second Round

% %

FREDEMO 33 38

CAMBIO 90 29 62

APRA 22

IU 8

IS 5

OTROS* 3

Source: ONPE (www.onpe.gob.pe)

Null and blanks ballots are no included.

Table 2: Stabilization Policies

Orthodox Program Heterodox Program

Source(s) of the InflationMonetary phenomenon -Monetary phenomenon

-Inflation Inertial

Nominal Anchor Money Growth Rate Exchange Rate

Output Costs Higher in the Short-Run Lower in the Short-RunShock treatment Yes No (Gradualism)

Income Policy

(Supply-Side Policy) No Yes

Fiscal Adjustment(Demand-Side Policy) Yes Yes

Tight Monetary Policy

(Demand-Side Policy) Yes (tighter) Yes

Source: Dornbusch and Simonsen (1988), Kiguel and Liviatan (1988), Kiguel

and Liviatan (1992) and Dornbusch (1992)


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Table 3: Results when >0

AnnouncementExpected Utility Voting

for C

Expected Utility

Voting for FOutcome

xC=p

H mxu C, mxu F, C

xF


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APPENDIX

The standard supply function not including capital is

tttt

ywpy 0 (B.1)

wherettpy , , and

tw are the logs of the output, the price level and the nominal wage at

time t; y is the equilibrium rate of output; tis the supply shock, t~ N (0,2

)

The indexed wage growth rate can be represented by

e

t

c

nttww (B.2)

where

c

ntw and

e

t are the logs of the nominal wage at time t-n (contract wage) and the

expected inflation rate at time t; is the degree of indexation ( [0,1])14

.

The expected inflation is set following past inflations; and, it is the ad-hoc

procedure exponentially weighted moving average (EWMA)15. The equation is the

following one:

11

jt

jn

oj

e

t (B.3)

where is the average weight of the past inflations ( [0,1]) and n is the length of the

contract.

Plugging (B.3) into (B.2)

cnttttwww 11 1 (B.4)

The inflation is determined by its inertial component (wage indexed)16, its

fundamental component (money growth rate), and a random shock. The equation is the

following one17:

14ONE indicates full indexation and ZERO indicates no indexation.

15Based on adaptive expectations model, the equation ett

et 11 1 must be replicated n times to

get (A.3)


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ttttug 11 (B.5)

where gt is the money growth rate18

and ut denotes current period supply shocks which are

normally distributed with mean zero and variance 2

u. and (1- ) denote the average

weights (between zero and one) of the past inflation and money growth rate, respectively.

The money growth rate is entirely controlled by the policymaker.

Normalizing pt-1 = wt-1 = 0, yt-1 is equal to the output equilibrium rate plus the

random supply shock at time t-1 which is previous to pOandp

H 19. Also, the log of both

nominal wages (wt-i for all i: 2,3, ..,n)) and prices (pt-j for all j: 2,3,.., n ) are negative

because there is inflation and the real wage is falling20

(

0.....1122 ttttnt

c

nt pwpwpw ). Then

ttttppp 1 (B.6)

tttt

ywy (B.7)

02

c

ntttwpw (B.8)

The new inflation equation is:

ttttugp 12 (B.9)

The supply function with wage indexed

16Actually, after Cs winning, indexed salaries kept running (Garavito: 1997). For this reason, it is included

in the inflation equation. However, a Fs government would have eliminated indexed wages.17

Dornbusch and Simonsen (1988) present a similar equation, however they include a gap of the economycyclical position instead of money growth rate.18

1 ttt mmg , where mtis the log of the money supply at time t.19

This is not realistic because at that time the Peruvian economy was in a recession.20

After 1987, the real wage had a declining behavior by 8.9 percent. Real wages strongly declined because

of the shock treatment policies applied by the government in 1988. Government set indexed wages for the

private sector in 1988 every four months. At the beginning of 1990, the period of the contract began to be

quarterly. After 1990, labor policy drastically changed because indexed contracts were eliminated and the

government ruled that salaries must be set following labor productivity. Government only set minimum wage

(Garavito: 1997).


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20

t

c

nttttvywgpy 12 (B.10)

The social utilities functions must incorporate the stylized facts ofpO andp

H. To

apply pO, the policymaker choose the money growth rate, maximizing the next social

objective function:

22* ykyUPOt

O

t

O

t (B.11)

where ykO

is the level of output after the application ofpO (it is less than the output level

at time t-1, because ko ), and is the relative importance of the output target.

Plugging (B.9) and (B.10) into (B.11)

2

2

2

211

yzv

wgpugpfUGO

tc

nttttttO

O

t

(B.12)Where

2Ot

O

tUPUG , 21

Of , 01

OOkz

O

tgEUG

t

max

FOC

OO

c

nttO

O

tfyzwpfg 1

2(B.13)

However, the policymaker does not think about the effects of this policy on the aggregate

output because his only purpose ofpO is to stop hyperinflation. Then, iftends to zero and

normalizing 21*O = 0, at the limit, the optimal money growth is

12t

O

tpg (B.14)

21Actually, this is an unrealistic objective because it is not immediate. The objective ofp

O is to stabilize the

inflation in a determined period. Moreover, there is a shock price at the beginning.


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a negative money growth rate.

Plugging (B.14) into (B.10), the expected value for the output

ywpyE cntt

O

t 2

yyEwp Ot

c

ntt 02 (B.15)

This indicates that a recession is attained because the result in parenthesis is negative

(following (B.8)).

Plugging (B.15) into (B.10),

t

O

tu

, 0

OtE (B.16)

On the other hand, to applypH, the supply and inflation equations must incorporate

an income policy variable. The motivation of the income policy is to fix a higher nominal

wage (with respect to wt-1) to eliminate inflationary expectations (inertia) and not to lose

purchasing power22. Therefore, inflation and output targets are considered. Then, the

policymaker maximizes

2*2 HtHt

H

tykyUP (B.17)

and, -pt-2 > *H

>0,

where ykH

is the level of output after the application ofpH (it is less than the output level

at time t-1 because 1>kH>kO> 0).

The policymaker will set the nominal wage rate23

at

0* H

H

H

tyzw (B.18)

The new inflation equation is:

22The contracts can be longer than contracts of indexed salaries (Dornbusch and Simonsen: 1988).

23This wage rate was set at that value to achieve the P

Hinflation target.


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22

tt

H

ttugw 1

tt

H

Htugyz 1* (B.19)

Plugging (B.18) and (B.19) into (B.1), the supply function is:

t

H

Httvyyzgny *1 (B.20)

Plugging (B.20) and (B.19) into (B.18), the policymaker will maximize

2**2

*11

H

tt

H

HHH

tH

Ht

H

tugyzfyz

vyzgUG

(B.21)

Where

2Ht

H

tUPUG 21

Hf , 01 HH kz

H

tgEUG

t

max

FOC

HH

H

tyzg

*1

(B.22)

This result could be either negative or positive. According to Dornbusch (1992), the main

source of the failure of PH

in Argentina, Brazil and Peru in the mid-80s was that money

growth kept increasing. For this reason, I consider this result as negative (beingO

tg

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Signaling 21