Inflation targeting in an import dependent indebted economy

Abstract

This paper develops a one-sector Kaleckian model of an import dependent indebted small open economy; where the mark-up rate is sensitive to both changes in the interest rate and the exchange rate and foreigners provide part of the long-term finance. The short-run consequences of an inflation targeting policy in the form of high interest rates and strong domestic currency are explored. Among the possible short-run scenarios, the one most relevant for developing countries involves a decline in the profit rate, the capacity utilization rate and the rate of accumulation as well as the employment rate and the real wage. Leverage ratio of the firms and the extent of external indebtedness play an important role in bringing about this result. Long-run analysis reveals that this scenario is associated with instability in the long run and that, also in the long run, the extent of foreign indebtedness and the responsiveness of capital inflows to the return on existing portfolios are important in determining the direction of the effects of inflation targeting on the equilibrium debt–capital ratio.

Keywords:

• inflation targeting
• Kaleckian model
• flexible mark-up
• industrial debt
• interest rate
• exchange rate

JEL Classifications:

• E12
• E44
• E52
• F34
• F43
• O42

Notes

1. Agenor (2000) provides a brief overview of industrial and developing country experiences with inflation targeting.

2. Here, the marginal propensities to save (mps) of the rentiers and the capitalists are different. In fact, the capitalists and the firms are one and the same and they don’t consume at all. An alternative formulation with a single mps for the whole economy where firms are detached from capitalist households and all investment is debt financed is possible. In this latter scenario, capitalist households collect dividend income, save according to the economy’s mps and their savings constitute part of the long-term finance. Then the long-run law of motion for the debt-capital ratio becomes a non-linear function of the short-run debt stock. This is perfectly consistent with the understanding of long run as a path dependent product of a series of short-run outcomes as mentioned in Setterfield (2009) but it leads to a rather complex long-run analysis. The present formulation is chosen because it allows for a manageable long-run analysis without non-linearity and path dependency.

3. Equation (4) implicitly assumes that the effects of inflation on the existing debt stock are ignored in profit accounting. This assumption is significant because it implies the firms’ retained earnings depend on the nominal interest rate and consequently so do their investment decisions.

4. For further discussion on the exchange rate sensitivity of the mark up rate see Blecker (1989).

5. For convenience of notation, it is assumed that the imported good is not consumed. The effect of exchange rate movements on the inflation rate would only be aggravated in the same direction if this assumption were dropped.

6. Lima and Setterfield (2010) provides an elaborate overview of the cost push channel of monetary policy that discusses a variety of pricing specifications that lead to a direct relation between the interest rate and the rate of inflation.

7. Lima and Setterfield (2008) elaborate the many facets of workers’ power to push up prices and the significance of how the policy makers deal with this class conflict.

8. Presumably, new funds brought in by foreigners will be sensitive to the rate of depreciation of the domestic currency since depreciations will create a loss when foreigners ultimately close their domestic currency positions. This requires a different formulation of equation (16), for example, . Such a formulation is not pursued because it further complicates the expressions for the long-run impact multipliers without much contribution to the argument.

9. In the literature, the role of inflation in the long run law of motion of the debt-capital ratio is usually assumed away by referring to a situation of zero inflation where the mark-up may change but the price level remains constant. This is possible if, in the long run, in equation (1), the nominal wage and exchange rate components of the price behave in a way to counteract the effects of an increased mark-up. In this setting such behavior is quite unrealistic. It has already been mentioned that the wage inflation in equation (12) is conflict driven so there is no obvious reason for nominal wages to fall in case of a higher mark-up. It has also been assumed that there is a positive association between the mark-up and the exchange rate. Thus, the conventional justification for zero long-run inflation does not hold water in this context.

10. When the long-run stability condition holds, it is safe to assume holds as well since in all likelihood.