Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance

88 Pages Posted: 1 Jul 2019 Last revised: 11 Jun 2021

See all articles by Rashad Ahmed

Rashad Ahmed

University of Southern California - Department of Economics

Joshua Aizenman

University of Southern California - Department of Economics; National Bureau of Economic Research (NBER)

Yothin Jinjarak

Victoria University of Wellington - School of Economics & Finance

Date Written: June 2019

Abstract

Countries have significantly increased their public-sector borrowing since the Global Financial Crisis. As a consequence, monetary authorities may face pressure to deviate from their policy targets in ways designed to ease the debt burden. In this context, we test for greater fiscal dominance over 2000-2017 under Inflation Targeting (IT) and non-IT regimes. We find that evidence consistent with fiscal dominance varies across countries and debt configurations. Higher ratios of public debt-to-GDP may appear associated with lower policy interest rates in advanced economies. However, a declining natural rate of interest largely explains the pattern of lower rates and higher debt in these countries. The most robust evidence of fiscal dominance lies among emerging markets under non-IT regimes, composed mostly of exchange rate targeters. For these countries, policy interest rates are non-linearly associated with public debt levels, depending on both the level of hard-currency public debt-to-GDP and the currency composition of public debt. We also show that emerging market economies with greater exchange rate volatility, inflation volatility, and underlying commodity exposure exhibit stronger associations between public debt and policy interest rates.

Suggested Citation

Ahmed, Rashad and Aizenman, Joshua and Jinjarak, Yothin, Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance (June 2019). NBER Working Paper No. w25996, Available at SSRN: https://ssrn.com/abstract=3411385

Rashad Ahmed (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States

Joshua Aizenman

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yothin Jinjarak

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6001
New Zealand

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