Exchange rates, fiscal deficits, and inflation: A case study of Mexico

Ana Felisa Zapata, Fordham University


The aim of this study is to quantify the impact of the exchange rate on the fiscal deficit and inflation in Mexico in the context of an open economy. We combine the Olivera-Tanzi effect on government revenues with the direct effect of the exchange rate to determine their overall influence on deficits and inflation. In an open economy, the exchange rate plays a crucial role in the inflationary process because it affects government expenditures and revenues, the growth rate of money, and price expectations. These factors can make inflation explosive. If exchange rate change causes changes in money supply and deficits, the normal dynamics of inflation can become inverted. Exchange rate changes can become self-perpetuating, driving the economy into a circular spiral of higher inflation and inertia. This dynamic could explain recent use of a nominal anchor in stabilization. If the exchange rate plays an important role in the inflationary process, and if the money supply and the deficit are endogenous, then the necessary stabilization program would require to reset the dials through a price freeze. Thus, the importance of this work is that it provides a justification of the new stabilization attempts that freeze the exchange rate as part of the stabilization program. We perform structural VAR estimation, causality tests, and estimate the Aghevli and Khan (A-K) model by Ordinary Least Squares (OLS) and Three-Stage Least Squares (3-SLS). An econometric model of a simultaneous equations similar to the A-K model is constructed and estimated by OLS and 3-SLS methods for the period from 1977.1 to 1989.2. We include rational expectations in the model. Our results show that the exchange rate is an important determinant in the inflationary process. Its inclusion in the revenues equation counteracts the Olivera-Tanzi effect. The channels through which it affects the deficit and inflation are (a) tax revenues from oil, (b) the external public debt, and (c) the parity rate.

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Recommended Citation

Zapata, Ana Felisa, "Exchange rates, fiscal deficits, and inflation: A case study of Mexico" (1992). ETD Collection for Fordham University. AAI9223830.