NATIONAL BUREAU OF ECONOMIC RESEARCH
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Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance

Rashad Ahmed, Joshua Aizenman, Yothin Jinjarak

NBER Working Paper No. 25996
Issued in June 2019, Revised in September 2019
NBER Program(s):The International Finance and Macroeconomics Program

Countries have increased significantly their public-sector borrowing since the Global Financial Crisis. In this context, we document several potential fiscal dominance effects during 2000-2017 under Inflation Targeting (IT), and non IT regimes. Higher ratios of public debt-to-GDP are associated with lower policy interest rates in Advanced Economies. In Emerging Market economies under non-IT regimes, composed mostly of exchange rate targeters, the interest rate effect of higher public debt is non-linear, and depends both on the ratio of foreign-currency to total public debt, and on the ratio of hard-currency debt to GDP. For these Emerging Market economies under non-IT regimes, real exchange rate depreciations and international reserves accumulation are significantly associated with higher interest rates. Sorting countries into low, medium and high nominal exchange rate volatility bins, we find that the high nominal exchange rate volatility group of Emerging Market economies, composed mostly of commodity intensive countries, show the most persuasive evidence of debt levels influencing policy interest rates.

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Document Object Identifier (DOI): 10.3386/w25996

 
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