Multiple Exchange Rates, Fiscal Deficits and Inflation Dynamics

IMF Working Papers, May 1, 1996

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Multiple Exchange Rates, Fiscal Deficits and Inflation Dynamics

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Bibliographic details

• Authors: Vincent Bodart
• Published: May 1, 1996
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451968378.001

Summary

• The paper explores the inflationary implications of exchange rate regime reforms in a small open economy model combining the public finance view of inflation with multiple exchange markets.
• The analysis focuses on transitions to multiple official exchange markets to account for the experience of many developing countries.
• Multiple exchange rates were often announced as temporary in those countries.
• The paper shows that the dynamic response of inflation to the reform markedly differ whether the announcement is credible or not.
• The paper also compares the response of inflation under a fixed crawl of nominal official rates and under the presence of policy rules aimed at reducing the spread between the official and parallel exchange rates.

Model and scope

• Small open economy model combining:
  • public finance view of inflation
  • multiple exchange markets
• Focus on transitions to multiple official exchange markets, motivated by experiences in many developing countries.
• Consideration of announcement credibility (credible vs. non-credible temporary announcements).
• Comparative analysis of:
  • fixed crawl of nominal official rates
  • policy rules aimed at reducing the spread between official and parallel exchange rates

Key findings

• The dynamic response of inflation to the introduction of multiple exchange markets depends critically on whether the temporary nature of the reform is credible.
• Credibility of the announcement leads to markedly different inflation dynamics than non-credible announcements.
• Policy rules that aim to reduce the spread between official and parallel exchange rates alter the inflationary response compared with a fixed crawl of nominal official rates.

Policy implications and scenarios analyzed

• Credibility of reform announcements is a central determinant of inflationary outcomes following transitions to multiple official exchange markets.
• Two policy scenarios compared:
  • Fixed crawl of nominal official rates
  • Policy rules targeting reduction of the spread between official and parallel exchange rates
• Implication: choice of exchange rate adjustment mechanism and credibility management are important for inflation dynamics in economies adopting multiple official exchange markets.