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The Effect of Monetary and Fiscal Credibility on Exchange Rate Pass-Through in an Emerging Economy

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Abstract

This study relates to the literature on the exchange rate pass-through effect on inflation for developing economies under inflation targeting. The novelty concerns the investigation of the effect of both monetary and fiscal credibility on pass-through. The article addresses empirical evidence, based on the Brazilian experience, regarding the idea that high credibility might reduce the exchange rate pass-through on inflation. The findings suggest that although monetary credibility is relevant only for pass-through on inflation of market prices, fiscal credibility is an important tool to reduce the pass-through on both inflation and inflation expectations.

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Notes

  1. For an analysis on the relevance of public debt/GDP as a fiscal indicator, see Calvo (1988); Giavazzi and Pagano (1990); Drudi and Giordano (2000); Lloyd-Ellis and Zhu (2001); Angeletos (2002); Giavazzi and Missale (2004); Faraglia et al. (2008); Mehl and Reynauld (2010).

  2. See Garcia and Restrepo (2001); An and Wang (2012) and Boug et al. (2013).

  3. See, for example, Ball (1999), and Gagnon and Ihrig (2004).

  4. For an analysis on the most important lessons on exchange rate policies in emerging countries, see Edwards (2011).

  5. See, Mishkin and Savastano (2001); Minella et al. (2003); Edwards (2006); Nogueira Jr. (2007); Nogueira Jr. and Léon-Ledesma (2009); Odria et al. (2012); Frankel et al. (2012).

  6. Before Reyes (2007); Gagnon and Ihrig (2004) suggested that the decreased pass-through observed in several countries is a result of a greater credibility of central banks in maintaining low inflation.

  7. See, Mishkin and Savastano (2001); Schmidt-Hebbel and Werner (2002); Eichengreen (2002); Gagnon and Ihrig (2004), and Batini and Tereanu (2010).

  8. For several examples of the use of this credibility index and its variations in the literature, see Fernandes (2013); Salle et al. (2013); Montes (2013); Khemiri and Ali (2012), and Dieters (2010).

  9. Cecchetti and Krause (2002) also developed a credibility index essentially along the same lines. However, they fix 2 % as inflation target and consider an inflation limit of 20 %. Therefore, this index is not capable of capturing xxx the inflation targeting credibility.

  10. Furthermore, “unlike other countries, net debt includes Central Bank assets and liabilities including, among other items, international reserves (assets) and the monetary base (liabilities)” (Silva et al. 2010, p. 92).

  11. For examples of applications of this index in the literature, see Kanoun (2014), and Rutkauskas et al. (2014).

  12. See, for example, Goldfajn and Werlang (2000); Gagnon and Ihrig (2004); Choudhri and Hakura (2006); Correa and Minella (2010); Edwards (2006); Faruqee (2006); McCarthy (2007); Bouakez and Rebei (2008); Nogueira Jr. and Leon Ledesma (2009); Nogueira Jr. (2010); Takhtamanova (2010); Beirne and Bijsterbosch (2011), and An and Wang (2012).

  13. See, for example, Tombini and Alves (2006); Areosa and Medeiros (2007); de Mendonça and Valerio (2010), and de Mendonça and Galveas (2013).

  14. See Table 5 (Appendix) for sources of data and description of the variables.

  15. Administered prices considered in the composition of IPCA are divided into tax, public utility services, and petroleum derivatives.

  16. Taking into account the three tests, at least two indicate that the series under analysis is I(0).

  17. To eliminate any possibility of skewing the results, the maximum of lags applied for each instrument was 6. Furthermore the number of instruments used for all models is lower than 20 (less than 14 % in relation to the number of observations).

  18. Regarding the advantage of this method see Koop et al. (1996), and Pesaran and Shin (1998).

  19. See, for example, Calvo and Reinhart (2002) and Choudhri and Hakura (2006).

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Authors and Affiliations

  1. Department of Economics and National Council for Scientific and Technological Development (CNPq), Fluminense Federal University, Rua Dr. Sodré, 59, Vila Suíça, Miguel Pereira, Rio de Janeiro, Brazil, 26900-000

    Helder Ferreira de Mendonça & Felipe Santos Tostes

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  1. Helder Ferreira de Mendonça
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  2. Felipe Santos Tostes
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Correspondence to Helder Ferreira de Mendonça.

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We thank an anonymous referee for helpful comments on an earlier version of this paper. Any remaining errors are the sole responsibility of the authors.

Appendix

Appendix

Table 5 Sources of data and description of the variables
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Table 6 Descriptive statistics
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Table 7 Unit root tests (ADF, DF-GLS, and PP)
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Table 8 SIC and HQ criteria for VAR
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Fig. 8
figure 8

Inverse Roots of AR Characteristic Polynomial. Note: Endogenous variables: INF, E(INF), GAP, Δ(WPI + EX), ΔCRED M [Δ(WPI + EX)], and ΔCRED AF [Δ(WPI + EX)]

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de Mendonça, H.F., Tostes, F.S. The Effect of Monetary and Fiscal Credibility on Exchange Rate Pass-Through in an Emerging Economy. Open Econ Rev 26, 787–816 (2015). https://doi.org/10.1007/s11079-014-9339-3

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