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Fiscal Policy and Inflation: Understanding the Role of Expectations in Mexico

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  • López-Martín, Bernabé
  • Ramírez de Aguilar, Alberto
  • Samano, Daniel

Abstract

We exploit a hidden Markov model where inflation is determined by government deficits financed through money creation and/or by destabilizing expectations dynamics (expectations can potentially divorce inflation from fundamentals). The baseline model, proposed by Sargent et al. (2009), is used to analyze the interaction between fiscal deficits, inflation expectations, and inflation in Mexico. The model is able to distinguish between causes and remedies of hyperinflation, such as persistent or transitory shocks to seigniorage-financed fiscal deficits, deanchoring of inflation expectations from fiscal fundamentals, and cosmetic (non-fundamental) monetary reforms. The behavior of monetized deficits provides an adequate account of high inflation episodes and stabilizations for the period 1969-1994. We then extend the model to analyze the possibility that fiscal policy can affect inflation expectations in a context of Central Bank independence, as is the case in Mexico after 1994. We find evidence that the exchange rate and sovereign interest rate spreads influence the evolution of aggregate prices.

Suggested Citation

  • López-Martín, Bernabé & Ramírez de Aguilar, Alberto & Samano, Daniel, 2018. "Fiscal Policy and Inflation: Understanding the Role of Expectations in Mexico," IDB Publications (Working Papers) 9025, Inter-American Development Bank.
    • Handle: RePEc:idb:brikps:9025
    DOI: http://dx.doi.org/10.18235/0001239
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    Cited by:

    1. Ramos Francia Manuel & García-Verdú Santiago & Sánchez-Martínez Manuel, 2018. "Inflation Dynamics under Fiscal Deficit Regime Switching in Mexico," Working Papers 2018-21, Banco de México.

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    More about this item

    Keywords

    Inflation expectations; Fiscal policy; Inflation;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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