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Fiscal sources of inflation risk in EMDEs: the role of the external channel

Author

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  • Ryan Niladri Banerjee
  • Valerie Boctor
  • Aaron Mehrotra
  • Fabrizio Zampolli

Abstract

We examine how changes in fiscal deficits affect near-term future inflation in a panel of emerging market and developing economies (EMDEs). Using a novel method for quantile panel regressions with fixed effects, we find that an increase in the fiscal deficit has highly non-linear effects on inflation - that is, a larger impact on upside tail risks than on average inflation. These effects are substantially larger in EMDEs than in advanced economies. We then show that an increase in the fiscal deficit raises the risk of future currency depreciation which magnifies the initial inflation response. This external channel is closely related to sovereign risk, being greater when the share of sovereign debt in foreign currency is large or when a sizeable share of sovereign debt is held by foreign residents. Finally, we find that the effects of fiscal deficits on future inflation are strongly attenuated in inflation targeting regimes and also influenced by constraints on monetary policy.

Suggested Citation

  • Ryan Niladri Banerjee & Valerie Boctor & Aaron Mehrotra & Fabrizio Zampolli, 2023. "Fiscal sources of inflation risk in EMDEs: the role of the external channel," BIS Working Papers 1110, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1110
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    1. Brandao-Marques, Luis & Casiraghi, Marco & Gelos, Gaston & Harrison, Olamide & Kamber, Gunes, 2024. "Is high debt Constraining monetary policy? evidence from inflation expectations," Journal of International Money and Finance, Elsevier, vol. 149(C).

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    More about this item

    Keywords

    fiscal deficit; inflation; exchange rate depreciation; sovereign risk; emerging market and developing economies; original sin; inflation targeting;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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