This paper develops a model of money demand where the opportunity cost of holding money is subject to regime changes. The regimes are fully characterized by the mean and variance of inflation and are assumed to be the result of alternative government policies. Agents are unable to directly observe whether government actions are indeed consistent with the inflation rate targeted as part of a stabilization program but can construct probability inferences on the basis of available observations of inflation and money growth. Government announcements are assumed to provide agents with additional, possibly truthful information regarding the regime. This specification is estimated and tested using data from the Israeli and Argentine high inflation periods. Results indicate the successful stabilization program implemented in Israel in July 1985 was more credible than either the earlier Israeli attempt in November 1984 or the Argentine programs. Government’s signaling might substantially simplify the inference problem and increase the speed of learning on the part of the agents. However, under certain conditions, it might increase the volatility of inflation. After the introduction of an inflation stabilization plan, the welfare gains from a temporary increase in real balances might be high enough to induce agents to raise their real balances in the short-term, even if they are uncertain about the nature of government policy and the eventual outcome of the stabilization attempt. Statistically, the model restrictions cannot be rejected at the 1% significance level.
