APPENDIX A: Inflation Expectations: The Model and its Empirical Results
The model of inflation expectations, which was assumed to be the base for public behavior, is a short-run or disequilibrium model. This model recognizes that, while overall inflation depends on changes in the prices of both tradable goods and nontradable goods, the forces that affect the former differ from the forces that affect the latter in the short and medium run. 28/ Therefore, in the short and medium run, there may be disequilibrium of relative prices between tradables and nontradable goods. 29/
The domestic prices of tradable goods are assumed to be determined by inflation in the rest of the world and by the exchange rate. Thus, if we denote the external inflation by p* and the change in the exchange rate by e, the inflation rate in tradable goods is [(1+p*) (1+e) – 1], which will be denoted as w.
The domestic prices of nontradable goods depend on the excess demand of the economy. Given that annual changes in aggregate supply are relatively small to changes in domestic demand and relatively constant, the expansion of domestic demand is used as a proxy for the excess demand of the economy. In turn, the expansion of domestic demand may be approximated by the expansion in the money supply. However, because of the relatively high transaction and information costs in developing countries, which are reflected in a slow adjustment of the money market, the relevant changes in the money supply may not be the contemporary changes but those of past periods. Thus, if we represent the changes in the money supply in current and past periods by m-i. (i=0,1..), the determinants of the overall inflation, p, can be represented by the following function:
Pt = a0 + a1 wt + a2 mt + a3 mt-1 + .-.-.
The results from the application of the model to the cases of Mexico and Chile, appear in Table 6 (below):
The results for both countries suggest that, while contemporary changes in the money supply have no influence on the annual inflation rate, changes in the other 2 variables, the money supply of previous periods and the external inflation, have marked influence on the domestic inflation rate. The R2 values are relatively high, in particular when we recall that the dependent variable is a rate of change in percent.
Given the assumption that public behavior would be as if their inflation expectations were based on the best model available, the “predicted” values from the first two regressions were assumed to measure the public’s inflationary expectations. Accordingly, these predicted values were used to adjust the nominal interest rate to obtain the (expected) real interest rate.
APPENDIX B: Description and Sources of the Data
Blanco H. and P. M. Garber, “Recurrent Devaluation and Speculative Attacks on the Mexican Peso.” Unpublished paper, Rice University and The University of Rochester, December 1983.
Chenery, H. and P. Eckstein, “Development Alternatives for Latin America,” Journal of Political Economy, Vol. 76, No. 4 (Supplement), July 1970.
Corbo V, M. Goldstein and M. Khan (Editors), Growth-Oriented Adjustment Programs, International Monetary Fund and The World Bank, Washington, D.C., 1987.
Cuddington, J. T., “Macroeconomic Determinant of Capital Flight: An Econometric Investigation”, in Leonard D. and Williamson J. (Edit.), Capital Flight and Third World Debt, Institute for International Economics, Washington, D.C., 1987.
Flavin, M.A., “The Adjustment of Consumption to Changing Expectations About Future Income,” Journal of Political Economy, Vol. 89, No. 5, September 1981.
Gylfason T., “Interest Rates, Inflation and the Aggregate Consumption Function,” Review of Economics and Statistics, Vol. 63, No. 6, 1981.
Hall R.E., “Stochastic Implications of the Life Cycle - Permanent Income Hypothesis: Theory and Evidence.” Journal of Political Economy, Vol. 86, No. 6, November 1978.
Landau L., “Differences in Saving Ratios Among Latin American Countries” in Chenery H. (Editor), Studies in Development Planning, Harvard University Press, Cambridge, Massachusetts, 1969.
Leff N. H. and K. Sato, “A Simultaneous-Equation Model of Savings in Developing Countries,” Journal of Political Economy, vol.83, no.6, November 1975.
Mikesell R. F. and Zinser J. E., La naturaleza de la función ahorro en los países en desarrollo. CEMLA. Mexico City, Mexico, 1974.
Molho L. E., “Interest Rates, Saving and Investment in Developing Countries: A Re-examination of the McKinnon-Shaw Hypothesis,” International Monetary Fund, Washington D.C., DM/85/63.
Sargent T. J., “Rational Expectations, Econometric Exogeneity, and Consumption,” Journal of Political Economy, vol.86, no.4, July 1978.
Secretaría de Hacienda y Crídito Público, Estadísticas Hacendarias del Sector Público. Cifras Anuales 1965–1982, Mexico City, Mexico.
I would like to thank Jeffrey M. Davis, Robert Franco, Anthony Lanyi, Pedro Radó and Chorng-huey Wong for their helpful comments. Of course I retain responsibility for all errors.
IMF “Growth-Oriented Adjustment. Themes from the World Bank-IMF Symposium”, SM/87/269. Also see Corbo V., M. Goldstein and M. Khan (editors) (1987), pp.7–8.
Recent studies for the U.S. have combined the permanent income theory with the life cycle theory. The combined theory assumes that the individual will select the consumption path so as to maximize lifetime utility subject to his intertemporal budget constraint and to the variables affecting the relative price (cost) of present consumption relative to future consumption. See, for instance Hall (1978), Sargent (1978), Blinder (1981) and Flavin (1981). However, the combined theory assumes that the individual only cares for consumption during his life time horizon. This assumption seems too restrictive for Latin American countries, where relying on the extended family, instead of on individual resources exclusively, appears to be the norm.
Ibid, p. 986.
This theory assumes the Ricardian Equivalence Theorem away or, equivalently, that the tax increase is seen by economic agents as implicating a permanent change in the present value of aggregage real taxes.
However, if the increase in domestic real interest rates reflects a similar increase in international real rates, because this increase also raises net factor payments, the aggregate income effect might be negative and thus it will reinforce the substitution effect.
Of course, to the extent that investment would be financed by credit, the other side of the tax would be the corresponding subsidy to borrowers that have access to cheap credit. L. Mohlo (1985), p.25. However, negative real interest rates will cause saving and therefore investment to be lower than otherwise, for two reasons: one the effect of the tax on saving; the other, the fact that sub-optimal investment allocation will result in lower income and, therefore, in lower saving.
The only difference between the two alternative definitions is that taxes in RDI1 are net of all transfers from the government to the private sector, while in RDI2 they are only net of subsidies. A detailed explanation of the two empirical definitions of real disposable income for the case of Mexico appear in Appendix B. Their annual values appear in Table 3, in Appendix B.
In contrast to the case of Mexico, only one definition of real disposable income was used in the case of Chile; it corresponds to the RDI1 definition for Mexico. The relevant Chilean data appears in Table 4 in Appendix B.
Banco Central de Chile, Boletín Mensual.
The appreciation of the real exchange rate was also possible because of sizable capital inflows.
The annual real rate in short term deposits reached about 28 percent in 1981.
This difference was less marked for Chile than for Mexico, given the sharp changes in the income and consumption ratios of the former country during the 1970s.
Natural logs were used whenever possible. It was not possible to use the logs of the real net capital inflows per capita, PEND, or of the real interest rates, r and r (E), because at least one of the empirical values of these series was negative.
Several empirical studies support this conclusion. For instance, J. Cuddington (1987) found that overvaluation of the exchange rate was an important cause of capital flight in Mexico. In addition, H. Blanco and P. Garver (1983) developed an empirical model in which the overvaluation of the Mexican peso and the devaluation expectations, at the same point, triggered accelerated capital outflows, that forced the devaluation of the currency.
Differing from the case of Mexico, there is no evidence of sizeable capital flight from Chile during the second half of the 1970s and beginning of the 1980s.
For a more detailed explanation of the way the two variables EXDV and OVL were constructed, see Appendix B.
The value of this semi-elasticity is somewhat lower than the value of elasticity of real private consumption per capita with respect to the real interest rate for Chile reported by McDonald (1983): -0.153 for the short term and -0.232 for the long term. The analysis period covered the period 1961–1975.
This model is a simplification of a more complete model that uses excess demand for money instead of the money supply. See, for instance, Blejer (1977) and Gómez-Oliver (1978).
In the long run, the equilibrium of relative prices is ensured by changes in the net exports (of goods, services and assets) of the country, which will in turn change the domestic money supply or the exchange rate. However, these long-run reactions were not explicitly considered in the model.
The publications of the Central Bank that have most of the relevant data were, from the Banco de Mexico, Indicadores Económicos, and Informes Anuales and, from the Banco Central de Chile, Cuentas Nacionales de Chile 1960–1983 and Boletín Mensual. The Central Banks were also the source of the data on real (private and government) consumption.
The sources of the nominal values were the official publication, Estadísticas Hacendaria del Sector Público, which covers the years 1965 and after, and Griffiths (1972), for the years 1960–64. Total taxes less transfers are net of intergovernment operations involving public and departmental enterprises; however, they differ from taxes less subsidies (as recorded in the national accounts) because of differences in timing (the former are recorded on a cash basis) and in coverage (for instance, in the case of Mexico, the former do not include revenues--quotas--and payments--transfers--of the Housing Fund--INFONAVIT).
The implicit rate was computed as the ratio of yearly interest flow on government securities to the stock of government securities held by the private sector at the end of the year. The source of both series was the Central Bank.
The real rate used was 5 percent, which represents the more common rate.