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The real effects of inflation in a developing economy with external debt and sovereign risk

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  • Assibey-Yeboah, Mark
  • Mohsin, Mohammed
Abstract
In this paper we develop an intertemporal optimizing model to examine the real effects of inflation induced by monetary policy in an open developing economy with external debt and sovereign risk. The economy faces an upward sloping supply curve of debt. In our model, households require real balances in advance for consumption expenditures, and monetary policy involves targeting the inflation rate. We show that an increase in the inflation rate leads to a decrease in the stock of foreign debt. It also leads to a decrease in consumption, employment, capital accumulation and output in the long run. Our results show that the accumulation of foreign debt exhibits non-monotonic adjustment. Particularly, an increase in the inflation rate leads to a current account surplus followed by a deficit. Along with this non-monotonicity, our model also explains the positive correlation between savings and investment during the transitional periods (Feldstein–Horioka puzzle).

Suggested Citation

  • Assibey-Yeboah, Mark & Mohsin, Mohammed, 2014. "The real effects of inflation in a developing economy with external debt and sovereign risk," The North American Journal of Economics and Finance, Elsevier, vol. 30(C), pages 40-55.
    • Handle: RePEc:eee:ecofin:v:30:y:2014:i:c:p:40-55
    DOI: 10.1016/j.najef.2014.07.004
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    More about this item

    Keywords

    Monetary policy; Cash-in-advance; External debt; Risk premium;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General

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