Fiscal sources of inflation risk in EMDEs: the role of the external channel

Ryan Banerjee, Valerie Boctor, Aaron Mehrotra and Fabrizio Zampolli

No 1110, BIS Working Papers from Bank for International Settlements

Abstract: We examine how changes in fiscal deficits affect near-term future inflation in a panel of emerging market and developing economies (EMDEs). Using a novel method for quantile panel regressions with fixed effects, we find that an increase in the fiscal deficit has highly non-linear effects on inflation - that is, a larger impact on upside tail risks than on average inflation. These effects are substantially larger in EMDEs than in advanced economies. We then show that an increase in the fiscal deficit raises the risk of future currency depreciation which magnifies the initial inflation response. This external channel is closely related to sovereign risk, being greater when the share of sovereign debt in foreign currency is large or when a sizeable share of sovereign debt is held by foreign residents. Finally, we find that the effects of fiscal deficits on future inflation are strongly attenuated in inflation targeting regimes and also influenced by constraints on monetary policy.

Keywords: fiscal deficit; inflation; exchange rate depreciation; sovereign risk; emerging market and developing economies; original sin; inflation targeting (search for similar items in EconPapers)
JEL-codes: E31 E52 E62 E63 (search for similar items in EconPapers)
Date: 2023-07
New Economics Papers: this item is included in nep-ifn, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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