## Multiple Exchange Rates, Fiscal Deficits and Inflation Dynamics

_IMF Working Papers, May 1, 1996_

## Source details

**Canonical URL:** [Multiple Exchange Rates, Fiscal Deficits and Inflation Dynamics](https://www.imf.org/en/publications/wp/issues/2016/12/30/multiple-exchange-rates-fiscal-deficits-and-inflation-dynamics-2031)

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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

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### 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.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/30/multiple-exchange-rates-fiscal-deficits-and-inflation-dynamics-2031_