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 March 2020
NBER Program(s):International Finance and Macroeconomics

Countries have increased significantly their public-sector borrowing since the Global Financial Crisis, potentially changing debt service costs sensitivity to tightening monetary policy. In this context, we test for greater fiscal dominance over 2000-2017 under Inflation Targeting (IT) and non-IT regimes. We find that evidence consistent with the presence 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, we find that the pattern of lower rates and higher debt in these countries is largely explained by a declining natural rate of interest. 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. Sorting countries into low, medium, and high nominal exchange rate volatility bins, we also find that Emerging Market economies with more flexible exchange rates and high commodity exposure exhibit a robust association between public debt levels and policy interest rates.

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Document Object Identifier (DOI): 10.3386/w25996

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