The inflation rate and financial premium

Abstract

The conventional wisdom recognizes that depreciating the official exchange rate reduces the spread between official and financial exchange rates and hence financial premium decreases in the financial market. This article aims to investigate whether a trade-off between the inflation rate and financial premium does exist. Both theoretical examinations and numerical simulations indicate that the support for this property is extremely fragile. We also find that the less patient the government, the more stability of domestic price and financial premium.

Acknowledgements

I thank Somnath Sen, Paul Levine, referees and the editor for comments on an earlier draft. The financial support from National Science Council in Taiwan, under Contract NSC 92-2415-H-006-003 is herewith gratefully acknowledged. All errors are mine.

Notes

¹ In some cases, governments create a legal dual (or parallel) foreign exchange market for financial transactions to respond to a balance of payments crisis. In other cases, governments restrict access to official markets, leading to the emergence of an illegal parallel (or black) market. Moore and Phylaktis (2000) indicated that after a once and for all official devaluation, being anticipated, the premium declines. In the long-run, the premium remains unchanged.

² A serious of articles in this and its companion journals, including Arize and Malindretos (1997), Alberola et al. (2000), Akinlo and Odusola (2003), Camarero et al. (2006), attempt to assess the impact of depreciation on output and inflation. Examples from other journals include Horn and Persson (1985), Rogers and Wang (1995).

³ Reputation problem was first noted by Kydland and Prescott (1977) and applied to monetary policy for the first time by Barro and Gorden (1983). Barro (1983), Grossman and Huyck (1986) employed it to the decision about inflation tax. Uribe (1997), Leitemo et al. (2005) found that a credible exchange rate policy could reduce the costs of inflation policies.