Real Effects of Inflation on External Debt in Developing Economies

• Author: Sushanta Mallick,Mohammed Mohsin,Mark Assibey‐Yeboah
• DOI: http://doi.org/10.1002/ijfe.1553
• Date: 01 October 2016
• Published date: 01 October 2016

INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS

Int. J. Fin. Econ.21: 398–416 (2016)

Published online 11 July 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1553

REAL EFFECTS OF INFLATION ON EXTERNAL DEBT

IN DEVELOPING ECONOMIES‡

MARK ASSIBEY-YEBOAH1,SUSHANTA MALLICK2,,and MOHAMMED MOHSIN3

1Parliament of Ghana, Parliament House, Accra, Ghana

2School of Business and Management, Queen Mary University of London, London, UK

3Department of Economics, The University of Tennessee,Knoxville, USA

ABSTRACT

This paper uses an intertemporal optimizing model with country-specific risk premium to evaluate the real effects of inflation

in a small open developing economy. In the model, a central bank targets inflation, and the consumer requires real balances in

advance for consumption spending. We show that a positive inflation shock (either due to growth in money supply or depre-

ciation of the domestic currency) yields a decrease in real output and consumption—as inflation creates a tax wedge in the

intratemporal condition between consumption and leisure—leading to a decrease in the stock of real debt in domestic currency.

Employing these theoretical predictions and using annual data from a set of six developing countries (Chile, Ghana, Indonesia,

Kenya, Malaysia and Thailand), we estimate a sign-restriction based structural vector autoregression model along with a panel

vector autoregression model for robustness analysis. The empirical results support the trade-off of inflation with reference to the

key real variables including the external debt position, which is a significant result giventhe ambiguity in the empirical literature

as to whether governments can escape from debt crisis via higher inflation. Copyright © 2016 John Wiley & Sons, Ltd.

Received 4 March 2015; Revised 6 February 2016; Accepted 12 April 2016

JEL CODE: F31; F32; F41; O40

KEY WORDS: Devaluation; cash-in-advance; debt; risk premium

1. INTRODUCTION

In the post-war era, high and persistent inflation has been one of the greatest challenges facing developing coun-

tries. Indeed, low inflation is the central objective of macroeconomic policy in many emerging market economies.

Although inflation in emerging market and developing economies took longer to come down, it has been low and

stable since the mid-1990s. The drop in inflation is in part due to better monetary policy, with some developing

countries officially adopting inflation targeting. Whether lower inflation has been driven by policy or other factors,

the objective of this study is to examine the real effects of such inflationary shocks on macroeconomic activity in

developing economies, including the effect on its external account, as inflation is still harmful even at relatively

moderate annual rates of 5–10% that we currently observe in many emerging market economies. We specifically

examine the response of a small open economy to inflationary shocks from two perspectives: First, we develop

an optimizing dynamic monetary equilibrium model to study the real effects of inflation, as both households and

firms are generally believed to perform poorly when inflation is high giving rise to a decline in real interest rates,

and second, the predictions of the model are used to estimate a structural vector autoregression (SVAR) model, fol-

lowing the methodology in Uhlig (2005). From both fronts, we claim that higher inflation leads to decline in real

consumption, output and external debt.

Correspondence to: Sushanta Mallick, School of Business and Management, Queen Mary University of London, London, UK.

E-mail: s.k.mallick@qmul.ac.uk

The authors would like to thank the editor and the two anonymous referees for their very helpful comments. The usual disclaimer

applies.

Copyright © 2016 John Wiley & Sons, Ltd.

REAL EFFECTS OF INFLATIONON EXTERNAL DEBT 399

The literature on the effects of monetary policies—both at the theoretical and empirical levels—offers inconclu-

sive evidence. A big part of the literature is dedicated to the closed economy set-up. There are a number of studies

that support the Tobin effect.1At the same time, many other studies support the super-neutrality results, whereas

the opposite of Tobin’s results is equally popular. The open economy literature on the effects of monetary policies

has also grown accordingly. Many of the empirical models in the money and growth literature analyse the impact

of inflation on the macroeconomic variables in the long run. The bulk of these studies is conducted in the context

of highly developed economies. Because our aim is to evaluate the effects of inflation in a small open developing

economy, we will focus exclusively on previous empirical studies.

Some researchers find positive effects of inflation on economic performance. Grier and Grier (2006) investigate

the effects of both inflation and inflation uncertainty on output growth in Mexico at business cycle frequencies.

They estimate an augmented multivariate GARCH-M model for inflation and output growth using monthly data

from 1972 to 2001. They find that inflation uncertainty lowers output growth, while the direct effect of aver-

age inflation on output is actually positive and significant. This result is consistent with the Tobin effect. A few

other empirical studies find no long-run effects of inflation. Using data from high inflation countries, Israel and

Turkey, Mallick and Mohsin (2007) show that inflation has no long-run real effects on consumption, investment

and the current account. Their results are robust even after allowing for inflation volatility. In a related study,

Carneiro and Faria (2001) investigate the relationship between inflation and output for another high inflation

country—Brazil. Employing a bivariate vector autoregression (VAR) model for the period 1980:1–1995:7, theyuse

a Blanchard and Quah decomposition to assess the effects of temporary and permanent shocks and find that infla-

tion does not impact real output in the long run, but that in the short-run, there exists a negative effect of inflation

on output.

Furthermore, among the early studies, Barro (1996) carried out an empirical research on the relation between

inflation and economic performance using cross-sectional data from over one hundred countries. He finds that a

10% increase in the annual inflation rate leads to a 0.24% decrease in the annual growth rate of real GDP. Also,

there are country-specific studies finding that inflation has negative effects. For example, Singh and Kalirajan

(2003) empirically examine the inflation-growth nexus in India for the period 1971–1988 to show whether there

is a threshold level of inflation for India. They conclude that there is no need to be concerned about the threshold

level because any increase in inflation from the previous period negatively affects growth.

The empirical business cycle studies mostly employ VAR models. A very important step in the use of VAR

methodology is the identification of shocks. The conventional identification strategy has been criticized in several

ways. Unlike the recursive Choleski decomposition used in previous studies, this study examines the effects of

inflation shocks in a small open developing economy with external debt using Uhlig’s (2005) identification pro-

cedure. There are many compelling reasons that justify the need for this study. First, the empirical evidence on

the effects of monetary policy is inconclusive. Second, most studies rely on the ad hoc Choleski decomposition to

identify the effects of inflation shocks. Third, although a few studies develop open economy models to examine the

effects of inflation, the theoretical motivations are not completely satisfactory. Finally, there is a need to understand

the long-run effects of changes in inflation in developing economies who borrowextensively from the external debt

market. To the best of our knowledge, there is no empirical study that examines the real effects of inflation in a

small open developing economy, including external debt. The present study attempts to fill this gap.

In the present paper, we use a monetary model and adopt an optimizing framework in order to examine the

effects of inflation on aggregate consumption, employment, output and the accumulation of foreign debt in the

economy. In this infinite horizon model with a fixed rate of time preference, the representative household can

make labour-leisure decisions. Firms produce output with labour as the only input. In developing this model, a

few additional simplifying assumptions are helpful. In accordance with Obstfeld (1981a), Calvo (1981), Djajic

(1982) and Mishkin (2000), we also assume that the central bank targets inflation rate (not the rate of growth of

money per se). Second, following the asset pricing literature, we assume that households face a cash-in-advance

(CIA) constraint on their consumption expenditures. Other papers that employ CIA constraints in an open economy

setting in order to study various policy issues include Calvo (1987), Calvo and Vegh (1995, 1995), and Edwards

and Vegh (1997) has not been included in the Reference List, please supply full publication details. Calvo and

Vegh (1994), (1995) and Edwards and Vegh (1997). Also, to incorporate one of the most important characteristics

of a developing country, we assume that the model economy faces an upward-sloping supply curve of debt. This

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ.21: 398–416 (2016)

DOI: 10.1002/ijfe