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Explaining Inflation with a Classical Dichotomy Model and Switching Monetary Regimes: Mexico 1932-2013

Garcés Díaz Daniel

No 2017-20, Working Papers from Banco de México

Abstract: This paper applies a novel approach to study the impact of different shocks on the price level. It uses a classical dichotomy model with monetary policy regime shifts at known dates. First, there was a regime dominated by money, afterwards a regime driven by the exchange rate and a third one with inflation targeting. The result is a CVAR with constant long-run parameters but regime-dependent adjustment coefficients. This overcomes the challenge of explaining, within a single theoretical framework, inflation dynamics in Mexico since the country abandoned the gold standard. The model encompasses known results, offers new insights and clarifies decades-old debates on key aspects of the inflationary process such as inertia, the role of money, the exchange rate pass-through and the impact profile of other variables. The model proposed here is very parsimonious, it does not require inflation lags nor dummy variables. It also displays a very good pseudo out-of-sample forecasting performance.

Keywords: Money Velocity; Exchange Rate; Inflation; PPP; Fiscal Deficit; Cointegration; Monetary Regimes; Unbalanced Regressions (search for similar items in EconPapers)
JEL-codes: C32 E41 E42 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2017-12
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