Fixed Exchange Rates, Inflation and Macroeconomic Discipline

We use data from Guatemala and Honduras to investigate some implications of the Purchasing Power Parity theory over the long run. In particular, we address two questions. First, to what extent did the fixed exchange rate regime impose macroeconomic discipline on these countries. Second, what was the impact of terms of trade shocks and growth differentials on inflation rate differentials between those countries and the United States. We found that the fixed parities regime worked properly until the mid-1970s, providing some constraint on central bank behavior. However, the evidence suggests that the fixed exchange rate system was not sufficient to avoid inflation outbursts and balance of payments crises. Specifically, it was unable to accommodate large negative terms of trade shocks in the late 1970s and early 1980s.