Inflation dynamics in a small emerging market

Abstract

This study investigates the determinants of inflation in the Dominican Republic during 1991 to 2002, a period characterized by remarkable macroeconomic stability and growth. By developing a parsimonious and empirically stable error correction model using quarterly observations, the study finds that inflation is explained by changes in monetary aggregates, real output, foreign inflation and the exchange rate. Long-run relationships in the money and traded goods markets are found to exist, but only the disequilibrium from the money market exerts a significant impact on inflation.

Acknowledgements

We acknowledge and thank P. Cashin, H. Leon, E. Kalter, G. Meredith and José Roberto Sanchez-Fung for providing useful comments and suggestions. The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board or its management. All remaining errors are attributed to the authors' responsibility.

Notes

¹ The official exchange rate was set daily by the BCRD as a weighted average of the previous week's rate at commercial banks and exchange houses. A foreign exchange desk has been created to manage purchases and sales of foreign exchange for the BCRD through auctions, although this system is used only occasionally.

² Although CPs are now issued through auctions, no fixed schedule has been established.

³ All variables are expressed in logs.

⁴ In the absence of indicators such as the real price of land, the real money demand function is specified as if economic agents have two options: to invest in pesos or foreign-denominated assets.

⁵ This specification assumes that the semi elasticities on the two interest rates are of equal magnitude but opposite signs, as economic theory would suggest.

⁶ In a system of error correction equations, if the error-correction term is statistically insignificant in the equation for a particular variable, that variable is considered to be weakly exogenous. See Ericsson and Irons (1994), for detailed discussions on weak exogeneity tests.

⁷ In Equation 10, the foreign price is proxied by wholesale price index, which is a better proxy for the price of tradables relative to CPI (Kakkar and Ogaki, 1999). In the absence of data on wholesale price index for the DR, the CPI index is used.

⁸ The results have to be interpreted with a caution, as we recognize that the results could be sensitive to the sample size used in the analysis. For further discussions on finite-sample estimation biases see Meredith (2003).