Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance

Rashad Ahmed, Joshua Aizenman and Yothin Jinjarak

Journal of Macroeconomics, 2021, vol. 67, issue C

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 view of this consideration, we test for greater fiscal dominance over 2000-2017 under Inflation Targeting (IT) and non-IT regimes. We find that evidence of 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.

Date: 2021
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Working Paper: Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:67:y:2021:i:c:s0164070420302044

DOI: 10.1016/j.jmacro.2020.103281

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