Inflation and Exchange Rate Regimes in Mexico

Transcription

1 Review o Developent Econoics, 4(1), , 2000 Inlation and Exchange Rate Regies in Mexico Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis* Abstract The paper presents a version o the exchange-rate-regie odel o inlation. Quarterly data ro Mexico ro 1946 to 1995 are used to estiate and test a siultaneous-equation odel or wage inlation, price inlation and industrial production, taking account o the Lucas critique and the statistical properties o the data. The ain inding is that, ater the all o the ixed-exchange-rate regie in 1976, there was a Barro Gordon type inlation bias owing to the inability o policyakers to coit to low inlation. There is no signiicant evidence o political business cycles in inlation. 1. Introduction Persistent high inlation has been a coon phenoenon in Latin Aerica or decades. One o the possible reasons is the liited ability o governents to coit theselves to low inlation. In a onetary policy gae between wage-setters and policyakers, Barro and Gordon (1983) have shown how this inability ight result in an ineicient equilibriu characterized by high inlation and relatively low eployent. An extension o the Barro Gordon odel is the exchange-rate regie odel o Giavazzi and Giovannini (1987) and Giavazzi and Pagano (1988). 1 In this odel, participation in a regie o ixed exchange rates, in which onetary policy is deterined by an inlation-averse center country, ties the hands o inlation-prone doestic policyakers. This is relected in wage-setters expectations, and so the doestic econoy ends up with the sae average inlation as the center country. 2 This paper presents a version o the exchange-rate-regie odel o inlation, and investigates its applicability to the Mexican econoy since Mexico is particularly suitable or such an investigation because it has had long experience with both ixed and independent anaged loating exchange rates. Hence, it is interesting to exaine whether the institutional constraints o the noinal exchange-rate regie atter or inlation, and possibly eployent. The paper investigates the joint deterination o wage inlation, price inlation, and industrial production by iposing the crossequation restrictions o the Barro Gordon odel and the exchange-rate-regie odel. By doing so, we respect the Lucas critique, and obtain estiates o the structural paraeters o the odel. 3 As ar as we know, this is the irst attept to estiate such a odel or a Latin Aerican econoy. The theoretical odel is as ollows. Under ixed exchange rates, there is no onetary policy independence; hence inlation is exogenously deterined. By contrast, under anaged loating exchange rates, there is roo or policy independence. In *Li: University o Essex, Wivenhoe Park, Colchester CO7 9NL, UK. Tel: ; Fax: ; E-ail: cara@essex.ac.uk. Philippopoulos: Athens University o Econoics and Business, 76 Patission Street, Athens , Greece; and University o Essex. Tel: ; Fax: ; E- ail: aphil@heres.aueb.gr. Tzavalis: University o Exeter, Exeter EX4 4RJ, UK. Tel: ; Fax: ; E-ail: e.tzavalis@exeter.ac.uk. We are grateul to two anonyous reerees or any constructive criticiss, and Gordon Kep or suggestions. We have also beneited ro the coents o Ji Richond, Ji Thoas, and participants at the ESRC Developent Conerence on the Role o the Public Sector (University o Reading, July 1997). This paper is a thoroughly revised version o a previous paper by the irst two authors and Sergio Montaño. All errors are ours., 108 Cowley Road, Oxord OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA

2 88 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis particular, under anaged loating, inlation is endogenously deterined via a Barro Gordon gae between policyakers and wage-setters. The odel leads to structural equations or wage inlation, price inlation, and eployent. We test and estiate the odel by using quarterly data ro Mexico or the period 1946Q1 1995Q1. Our econoetric work ollows three steps. First, we introduce appropriate duy variables to capture policy-induced paraeter changes. Second, we investigate the statistical properties o the data. In particular, by ollowing Perron (1989) and using the Zivot and Andrews (1992) unit-root test, we look or possible structural breaks. Univariate analysis indicates that price inlation displays a break around 1978 (alost two years ater the oicial switch ro ixed to anaged loating exchange rates), while the cointegrating (Phillips-curve type) relationship between price inlation and industrial production displays a break around 1990 (when the governent started to ipleent a series o stabilization policies to cobat inlation). Third, given the statistical properties o the data, we test and estiate the odel by using GMM. The theoretical cross-equation restrictions are not rejected by the data, and ost estiated paraeters are statistically signiicant and have plausible values. The ain result is that the exchange-rate regie atters or wage and price inlation. Ater the switch to anaged loating in 1976, there is a signiicant Barro Gordon type inlation bias owing to the inability o policyakers to coit to low inlation. As a result, wage and price inlation are higher, and signiicantly ore persistent over tie, during anaged loating than during ixed exchange rates. The policy iplication is that ebership o an exchange-rate echanis cannot ake disinlation harder, since it can break inlation persistence (i.e., inertia). We also report that there is no signiicant evidence o electoral cycles in inlation, or dierences in inlation perorance across dierent adinistrations o the ruling political party. 2. Overview o the Mexican Econoy Fro the 1930s until the early 1970s, Mexico experienced a avorable position copared with other developing countries. Land reors, iport substitution industrialization, and investent in basic industries and inrastructure set the basis or econoic growth. Governent policy anaged to reconcile the interests o the heterogeneous elite, to secure social support and a disciplined labor orce, to protect doestic producers, and to ake socioeconoic changes eaturing close governent ties with the industrial elite. As a result, during , there was an average annual GDP growth o 7%, while average annual price inlation was only 3.5%. However, probles in the current account led to contractionary acroeconoic policies that caused a ild recession in This, added to a political crisis (erosion o governent legitiacy and the guerrilla oveent in Latin Aerica), resulted in the ipleentation o populist acroeconoic policies in Mexico aintained a ixed peso dollar exchange rate even ater the collapse o the Bretton Woods syste in 1971 and the world oil price shock in However, the distortions caused by iport substitution policies, the public expenditure-led growth inanced ainly by borrowing ro the central bank (Banco de Mexico), the accuulation o oreign debt, high inlation, the overvaluation o the peso, and a large capital light led inally to the devaluation o the peso in This basically ended the regie o ixed exchange rates. The switch to anaged loating exchange rates in 1976 gave ore lexibility or discretionary econoic policy. It was (wrongly) believed that deand anageent, in cobination with price controls, could be used to cope with rising uneployent (the

3 INFLATION AND EXCHANGE RATE IN MEXICO 89 average annual rate o urban uneployent was 8% in 1977, while undereployent was also strongly widespread). 5 Nevertheless, the econoic situation worsened: inlation (which was 17% on average during ) rose to 24% in the next ive years; the public deicit to GDP ratio (which was 3% in 1977) increased to 6% in 1981; and the balance o payents urther weakened (the current account deicit increased ro 3.2 billion US dollars in 1978 to 16.1 billion US dollars in 1981). In 1982, the public deicit to GDP ratio was 15%, and inlation juped to 59%. The econoic collapse was precipitated by changes in the international environent. The sharp decline in oil prices, the US tight onetary policy, and the increase in international real interest rates pushed Mexico into a oratoriu on repayents o oreign debt. In response to the 1982 crisis, several stabilization and structural adjustent policies were ipleented (there was also an earlier, but not successul, IMF stabilization plan in the id-1970s). However, there were no signs o econoic recovery and the situation was aggravated by an earthquake in 1985 and the collapse o oil prices. In 1986, inlation increased to 86% and continued to rise, the public deicit to GDP ratio rose again to 13%, while both real per capita GDP and real wages ell by 6%.Although GDP growth turned positive in 1987, the run o the peso (ollowing the collapse o the New York stock arket) and the persistency o high inlation orced policyakers to reocus ore seriously on the ight against inlation. In 1988, the governent ipleented heterodox policies to cobat inlation. The Pacto de Solidaridad Econóica was negotiated aong workers, arers, the industry, and the governent. Wage settleents were gradually brought under control, prices o public goods and services reained rozen, and exchange-rate devaluations were reduced. The governent agreed to cut its deicit, and proised tight onetary policy, privatization o public enterprises, and liberalization o the econoy. Mexico negotiated a Brady Plan debt agreeent and re-entered the international credit arket in the early 1990s. Inlation was decreased, the iscal stance was under control, and econoic growth was restored. Nevertheless, current account deicits, negative shocks, inadequate econoic policy, and a inancial panic 6 resulted in the collapse o the peso in the irst quarter o Finally, on the political ront, up until the 1970s Mexico had one o the strongest civilian governents in Latin Aerica. The success o the ruling political party (PRI) can be explained by its wide social representation, its syste o clientilis and cooptation, and various political rewards (usually in the or o subsidies). Nevertheless, the accuulation o econoic and social probles has recently weakened the traditional alliances o the Mexican political syste The Theoretical Model This section will set up a odel consistent with the above stylized acts. The way the price level (or, equivalently, price inlation) is deterined depends crucially on the noinal exchange-rate regie (McKinnon, 1993). Under ixed exchange rates, we assue that inlation is exogenously deterined. By contrast, under anaged loating exchange rates, we assue that policyakers are ree to choose price inlation by playing a Barro Gordon gae with wage-setters. The sequence o events within each tie-period is as ollows: irst, the current exogenous shocks are realized; second, wagesetters sign one-period noinal wage contracts; third, price inlation is deterined; inally, irs set eployent. Given this sequence, we assue (without any loss o generality) that the odel is deterinistic. Following the relevant literature, we use a log linear odel.

4 90 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis The Labour Market Output, y t, is produced by using labour, t, via a Cobb Douglas production unction, so that y t = d t + t, where 0 < d < 1. Productivity, t, ollows the exogenous process t = g + t-1, where g is a constant. Proit axiization by copetitive irs leads to deand or labour: 8 d l t =-b( wt -pt - t), (1) where b 1/(1 - d ) > 0, w t is the noinal wage rate, and p t is the price level at tie t. Noinal wages are set by a group o insiders n t, where n t ollows an exogenous process (deined in section 4). On the other hand, policyakers care about the whole labour orce n t, where n t > n t. Insiders, n t, choose w t to solve: in Et( lt d - nt ) 2, (2) where the iniization is subject to equation (1). Here, E t is the rational expectations operator. Since the odel is deterinistic, and oves are sequential, it is only p t that is not observable by wage-setters when they choose w t. Using the irst-order condition o (2) into (1), eployent, t, is: l t = n t + b( Dp t -E t D p t ), (3) while it is convenient to write wage inlation, Dw t (w t - w t-1 ), as: Dwt = g+ EtDpt -( 1 b) ( nt - l t-1), (4) where Dp t ( p t - p t-1 ) is price inlation and E t Dp t (E t p t - p t-1 ) is expected price inlation. Equation (3) is a standard aggregate supply unction saying that deviations o actual eployent ro its natural level, n t, are due to inlation surprises. Equation (4) is a Phillips-curve type expression saying that wage inlation decreases when eployent has been below its natural level, i.e., t-1 < n t. 9 Solution under Fixed Exchange Rates Under ixed exchange rates (denoted by the superscript ), we assue that price inlation is exogenously deterined. Intuitively, under ixed exchange rates, the doestic authorities do not have the independence o deterining the average doestic inlation rate. This was especially true under the rules o the Bretton Woods syste during which the average OECD inlation rate was deterined by the onetary policy o the Federal Reserve Syste in the USA. Mexico aintained a ixed exchange rate against the US dollar until 1976Q3. Thereore, we assue Dpt = pt, where pt is an exogenous process (deined in section 4). Then, by using (3) and (4), we siply have or price inlation, wage inlation, and eployent, respectively: Dpt = pt, (5a) Dwt = g+ pt -( 1 b) ( nt - l t-1), (5b) t = n t. (5c) Solution under Managed Floating Exchange Rates Under anaged loating exchange rates (denoted by the superscript ), we assue that price inlation is endogenously deterined via a Barro Gordon gae between policyakers and wage-setters.

5 Policyakers choose Dp t to solve: in [ ( Dpt - pt ) 2 + a( lt - nt) 2 ], (6) where the iniization is subject to equation (3). Here, as in Canzoneri (1985), a > 0 is the weight given to eployent relative to inlation, and n t = kn t where k > 1. Coparison o (2) with (6) iplies that the eployent level sought by wage-setters is too sall ro the point o view o policyakers; this is why k > 1. Also, p t is the policyakers exogenous target rate o price inlation under anaged loating (deined in section 4). It is well known that the equilibriu o this one-shot sequential-ove gae is the Nash equilibriu. Then, we have or price inlation, wage inlation, and eployent, respectively: Dpt = pt + ab( k -1) nt, (7a) Dwt = g+ pt + ab( k -1) nt - ( 1 b) ( nt - l t-1 ), (7b) t = n t. (7c) To proceed, we ake the (testable) assuption p t > pt ; i.e., the target o price inlation under anaged loating is higher than the exogenously deterined price inlation under ixed exchange rates. Then, equations (5a) (5c) and (7a) (7c) iply the ollowing: Reark 1: Both price and wage inlation are lower under ixed exchange rates than under anaged loating exchange rates. Reark 2: Eployent is always at its natural level. The irst reark ollows ro the assuption that there is a Barro Gordon gae only under anaged loating, and the assuption p t > pt. The second reark ollows ro the assuption that there is no uncertainty about the exchange-rate regie, and so the odel has classical eatures. Although classical neutrality is a strong result especially or a country like Mexico, we preer to keep the odel siple so as to concentrate on the ain issue; i.e., the role o exchange-rate policy, and hence the role o onetary policy independence, or wage and price inlation. 4. Epirical Speciication and Results INFLATION AND EXCHANGE RATE IN MEXICO 91 This section presents the econoetric speciication o the odel and discusses testing and estiation by using quarterly data ro Mexico over 1946Q1 1995Q1. We will work in three steps. First, we speciy the exogenous targets, and introduce duy variables to capture policy-induced paraeter changes. Second, we investigate the statistical properties o the data, and look or possible structural breaks. Third, we estiate and test the econoetric odel. Exogenous Targets and Policy-Induced Paraeter Changes This subsection speciies the exogenous, unobservable variables (n t, pt, p t ). It also introduces appropriate duies to capture changes in onetary policy across exchangerate regies. To odel the eployent target o wage-setters (n t), we assue that n t is a linear unction o lagged-once eployent ( t-1 ). Intuitively, it is those who are eployed at the tie the wage contract is signed (called insiders) that atter or wage-setting. This

6 92 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis is as in Blanchard and Suers (1986) and Alogoskouis and Manning (1988). Thus, we assue: 10 n t = l t-1, (8) where 0 l 1 easures the power o insiders in wage-setting. To odel the exogenously deterined price inlation under ixed exchange rates (pt ) and the policy target or price inlation under anaged loating (p t ), we assue that pt and p t are linear unctions (with a constant) o lagged-once inlation. Intuitively, the higher the inherited inlation rate, the ore costly the policy adjustent required to reduce it to an arbitrarily low level (in equations (9a) and (9b), these levels are p and p, respectively). In other words, policyakers odiy their targets to take into account these adjustent costs. Thus, we assue: pt = p + q Dp t - 1, (9a) pt = p + q Dpt - 1, (9b) where we ake the (testable) assuptions p < p and 0 q < q 1. These assuptions are consistent with Reark 1. In order to capture policy-induced paraeter changes, we will use duy variables. Deine dt to be a duy or ixed exchange rates that takes the value o 1 during 1946Q1 1976Q3 and during 1988, and zero otherwise. Siilarly, deine d t = 1 - dt ; i.e., d t takes the value o 1 during anaged loating exchange rates, and zero otherwise. By substituting (8), (9a) (9b), and the above duy variables into (5) and (7), the wage, price, and eployent equations during all exchange rate regies can be suarized by: Dwt = gw1dt + gw2dt + gw3dt Dpt-1 + gw4dt Dpt-1 + gw5lt-1 + gw6dt l t-1, (10a) Dpt = gp1dt + gp2dt + gp3dt Dpt-1 + gp4dt Dpt-1 + gp5dt l t-1, (10b) t = g 1 t-1, (10c) where the theoretical restrictions are: gw1 = ( g+ p ), gw 2 = ( g+ p ), gw3 = q, gw 4 = q, gw5 = ( 1- l) b, gw6 = ab( k -1) l, g = p, g = p, g = q, g = q, g = ab( k -1) l, g = l. p1 p2 p3 p4 p5 l1 (10d) Data Sources, Integration, Cointegration, and Structural Breaks Our data source is Estadísticas Históricas de México published by the Instituto Nacional de Estadística, Geograía e Inorática (INEGI, Mexico). The data are quarterly. For t, we will use data on real industrial production (y t ). 11 Concerning Dw t, since there are no consistent tie-series on urban wages or the period under study, we will use the average iniu wage o Baja Caliornia, Caliornia Sur, Chihuahua, Distrito Federal, and urban areas o the States o Sonora, Taaulipas, and Veracruz. 12 Finally, Dp t will be based on the consuption price index (CPI). Augented Dickey Fuller (ADF) t-statistics testing or unit roots in Dw t, Dp t, and y t (allowing or our lags, and a constant or trend when necessary) have values o -4.14, -2.84, and -0.28, respectively. The last two values are higher than the 5% ADF critical value o -2.86, so that the null hypothesis o a unit root cannot be rejected or Dp t and y t. When we test or second-order integration, the null o a unit root is rejected

7 INFLATION AND EXCHANGE RATE IN MEXICO 93 when Dp t and y t are irst-dierenced. Taken together, these results suggest that Dw t is I(0), while Dp t and y t are I(1). However, it is well known that ADF tests tend to avor the null o unit roots when the true process is characterized by structural breaks (Perron, 1989). To circuvent this proble, we carry out the Zivot and Andrews (1992) sequential ADF test, which allows a possible break to be endogenously deterined by the data. Under the null, the process is assued to be structurally stable with a unit root and trend. Under the alternative, the process is assued to be stationary with breaks in its ean and/or trend. The break point is selected to correspond to the iniu value o the relevant, one-sided unit-root t-statistic denoted as In ADF. The Zivot Andrews results are reported in Table 1. The test shows that Dp t and y t are I(1), even i we take account o structural breaks in the deterinistic coponents o the data. In particular, concerning Dp t, there is evidence o a break in intercept where the break point is estiated to be at 1978Q3. In Mexico, this date alost coincides with the switch ro ixed exchange rates to anaged loating exchange rates. Although this is two years ater the oicial regie switch which took place in 1976Q3, the delayed response iplied by the data can be attributed to various adjustent echaniss. Concerning y t, there is weak evidence o a break in intercept at 1974Q1 (based on the 5% critical value o tests or the intercept in unit-root regressions). There is also evidence o a tie-trend without break. Thereore, the Zivot Andrews tests conir the presence o unit roots in both Dp t and y t. Since each o Dp t and y t taken individually is I(1), we now look or a cointegrating (long-run) relationship between the. The theoretical odel, in particular equation (10b), iplies a long-run relationship between Dp t and y t only during the anaged loating-exchange-rate regie. Thereore, we look or a cointegrating relationship between Dp t and d t y t, where recall that d t is a zero-one duy or anaged loating. 13 To investigate whether there is a break in the intercept o the cointegrating regression, we use the Gregory and Hansen (1996) test. The break point is selected in Table 1. Zivot Andrews Unit-Root Tests or Mexico, 1946QI 1995QI k  Dx = a + a d( lt)+ a t+ jx + g Dx + v, where x =( Dp, y ) t t-1 i t-i t t t t i= 1 Dp t y t a (1.56) (0.06) a (2.94) (2.28) a (3.20) (4.12) (3.14) In ADF Date o break 1978Q3 1974Q1 Notes: The date o break is the date o break in the intercept. The tests involved our lags, k = 4. The 5% critical value or the In ADF test is or the regression without the trend, and or the regression with the trend. Absolute values o t-statistics are reported in parentheses.

8 94 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis Table 2. OLS Cointegration Results or Mexico, 1946Q1 1995Q1 Dpt = c0 + c1d( lt)+ bdt yt + et Without break With break c (5.15) (5.21) c (7.28) b (8.27) (11.81) R ADF In ADF Date o break 1990Q1 Notes: Absolute values o t-statistics are reported in parentheses. The 5% critical value or the test without break is -3.49, and the test with break is (Gregory and Hansen, 1996). a siilar way to the Zivot Andrews test; i.e. we choose the sallest value o the ADF test o the residuals o the cointegrating regression over all possible break points. Table 2 reports OLS estiates without, and with, a structural break. The results show that while a cointegrating relationship between Dp t and d t y t can be only arginally accepted in the absence o a structural break, it is easily accepted once we allow or a structural break (Table 2). Further support or the cointegrating regression with break is provided by the increased value o the R 2. Ater allowing or a break, the results iply that the cointegrating vector is (1, ), noralized at Dp. They also iply that the break in intercept happened around 1990Q1. We will thereore include a duy variable (denoted by d t 1990s ) in equation (10b) when we estiate the odel. The duy d t 1990s takes the value o 1 ater 1990Q1, and zero otherwise. Recall ro the overview o the Mexican econoy in section 2 that this break-point coincides with a nuber o iportant events. For instance, the governent has ipleented various stabilization progras to cobat inlation since The Econoetric Model and Estiation Results Having investigated the long-run properties o the data, we now estiate the theoretical odel (10a) (10c) subject to (10d). In the light o the results in the previous subsection, equation (10a) constitutes a structural relationship between Dw t, which is I(0), and the cointegrating relationship between Dp t and y t. Next consider equation (10b). Subtracting Dp t-1 ro both sides o (10b), and taking into account the cointegrating relationship between Dp t and y t, we can rewrite (10b) as an errorcorrection type equation between the change in inlation (Dp t -Dp t-1 ), which is I(0), and the residuals o the cointegrating relationship between Dp t-1 and y t-1. Finally, consider equation (10c). According to the theoretical odel, industrial production depends only on its lagged-once value. Also, the univariate statistical analysis in Table 1 showed that y t has a unit root (with an intercept with break, and a trend). Taken together, these results essentially ean that l = 1 (see the restrictions in (10d)). Hence,

9 INFLATION AND EXCHANGE RATE IN MEXICO 95 to be consistent with the unit-root analysis, we ipose l = 1 upon the whole syste (10a) (10d). 14 Then, we estiate the ollowing econoetric odel: Dwt gw dt gw dt = gw3dt Dpt-1+ gw4dt Dpt-1+ gw5dt yt -1, (11a) ( Dpt - Dpt-1) = gp1dt + gp2dt + gp3dt Dpt-1 + gp4dt Dpt-1 + gp5dt yt s + gp6dt + gp7dt debt + gp8dt oil + gp9dt liber + gp10 dt peso, (11b) Dy t = const + g trend y1 + g y2 d debt t, (11c) where the cross-equation restrictions are now: gw1 = ( g+ p ), gw 2 = ( g+ p ), gw3 = q, gw 4 = q, gw5 = ab( k -1), gp1 = p, gp2 = p, gp3 = ( q -1), gp4 = ( q -1), gp5 = ab( k -1). (11d) Observe that in this econoetric odel, we have also included a nuber o unrestrictive additive duies that inluence the dynaics o (10a) (10c). The inclusion o these duies does not aect our ain results. However, it iproves the it o the regressions, and is also consistent with the ain (exogenous to the theoretical odel) events that have characterized the Mexican econoy (section 2). In particular, in the regression or price inlation (11b), we have included (in addition to d 1990s t which ollows ro the cointegrating regression) a duy or the 1982 debt crisis (called d debt t ), a duy or the oil price shocks (called d oil t ), a duy or various liberalization policy attepts (called d liber t ), and a duy to account or those short tie-periods characterized by peso-type expectations about exchange rate depreciations (called d peso t ). In the regression or industrial production (11c), we have added d debt t to capture the oneshot eect o the debt crisis. 15 The econoetric odel (11a) (11c), subject to the cross-equation restrictions (11d), is estiated by using GMM. This enables us to identiy the structural paraeters g, p, p, q, q, A (notice that since A ab(k - 1), the coeicients a, b, and k cannot be identiied). As instruents, we use the explanatory variables in (11a) (11c). As it is known, GMM estiates are consistent and asyptotically norally distributed. Thus, although the norality test rejects the null o noral errors in all regressions, the test statistics have the right asyptotic properties. The estiation results are reported in Table 3. The LM (4) and ARCH (1) isspeciication tests show that the standard errors o the paraeters have been corrected or serial correlation o order 4 and heteroskedasticity. The results clearly support the theoretical odel. In particular, the data cannot reject the over-identiied restrictions in (11d) at the 9% signiicance level. Note that the nuber o the over-identiying restrictions iplied by (11d) is 22, which equals the nuber o orthogonality conditions between (11a) (11c) and the instruental variables inus the nuber o paraeters to be estiated. Most o the estiated paraeters have signs and agnitudes consistent with the theory and are statistically signiicant. In particular, p = < p = (although the ixed coponent o the quarterly rate o inlation under anaged loating, p,is not signiicant at the 5% level). There is clear evidence that q = < q = 0.818, which eans that price and wage inlation persist ore over tie during anaged loating than during ixed exchange rates. These results are consistent with the theoretical predictions, and are also siilar to the estiates o Alogoskouis et al. (1992) or the UK and Alogoskouis et al. (1998) or Greece. The only crucial paraeter that has sign opposite ro that predicted by the theory is A, which is insigniicant. In par-

10 96 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis Table 3. Restricted GMM Estiates or Mexico, 1946Q1 1995Q1 Paraeter Estiate t-statistic g p p q q A g p g p g p g p g p g y g y J (22) = LM (11a) (4) = LM (11b) (4) = LM (11c) (4) = ARCH (11a) (1) = ARCH (11b) (1) = ARCH (11c) (1) = Notes: The estiated equations were (11a) 11(c) subject to (11d). See text or deinitions o regressors. J (22) is the over-identiied restrictions test-statistic distributed as c 2 (22). LM (11a) (4), LM (11b) (4), and LM (11c) (4) are the LM test-statistics or serial correlation o order our distributed as c 2 (4) or equations (11a), (11b), and (11c) respectively. ARCH (11a) (1), ARCH (11b) (1), and ARCH (11c) (1) are the ARCH test-statistics or conditional heteroskedasticity distributed as c 2 (1) or equations (11a), (11b), and (11c) respectively. ticular, recall that A ab(k - 1) should be positive. The negative sign o A can be due to negative Phillips-curve type eects ro uneployent to current inlation which ore than outweigh the positive Barro Gordon type eects. 16 It is worth noting that the GMM estiate o the long-run elasticity o price inlation with respect to output in (11a) (11d) is consistent with the analogous OLS estiate in the cointegrating regression with break o Table 2.This can be easily seen ro the GMM estiates in Table 3. I we set the let-hand side o (11b) equal to zero and solve or Dp t, then the resulting long-run coeicient on d t y t is equal to 0.049, which is very close to the OLS estiate o b = in the regression with break o Table 2. Notice that the cointegrating regression in Table 2 gives a signiicant b, which in turn iplies a signiicant A. By contrast, the GMM estiates in Table 3 give an insigniicant A at 5% level. However, the insigniicance o A in Table 3 has to be interpreted cautiously because o the sall saple probles o the GMM estiates. By contrast, the estiate o the cointegrating coeicient b is super-consistent. Finally, notice that the unrestricted duy variables have the expected eects. For instance, note the detriental eects o the 1982 debt crisis on price inlation and output, and the inlationary eects o liberalization policies and peso-type expectations. Also note the strong disinlationary eect o recent stabilization policies being captured by the 1990s duy (recall that the inclusion o this duy ollows ro the cointegrating regression with break o Table 2). Beore closing this section, we would like to report soe additional results concerning political business cycles (available upon request). 17 First, there is no

11 INFLATION AND EXCHANGE RATE IN MEXICO 97 statistically signiicant evidence o electoral cycles. In particular, when we tested or dierences in inlation over the electoral cycle, there was only weak evidence that inlation was higher iediately ater elections than in other periods o the electoral cycle. Second, there was no signiicant evidence o dierences in inlation perorance across dierent adinistrations o the ruling political party (PRI). In particular, various possible partisan dierences were tested, but they were not ound to be statistically signiicant. 5. Conclusions, Policy Iplications, and Extensions In this paper we have presented a version o the exchange-rate-regie odel o inlation. When we tested and estiated the odel or the Mexican econoy during 1946Q1 1995Q1, the data could not reject its theoretical restrictions and give plausible estiates or the structural paraeters. Although our results are consistent with the widely accepted view that exchange rate policy aects the inlation process, we want to ephasize that they do not iply that low inlation can be attributed only to exchange rate policy. A country can clearly disinlate on its own. However, the interesting question is not whether a country can disinlate on its own or not, but whether exchange rate discipline can ake the disinlation process less costly. To the degree it can provide a or o incoes policy or an anchor or expectations and so break inlation inertia (which according to the estiate or q sees to be very strong in Mexico), it cannot ake disilation ore costly. I, however, noinal wages are driven without regard or inlation and exchange rate targets, any use o exchange rate coitents will result, sooner or later, in overvaluation and speculative attacks. We close with soe possible extensions. First, it would be interesting to include a public sector, and so exaine how wages and eployent in this sector aect inlation and eployent in the private sector. Second, it would be interesting to introduce uncertainty about the exchange rate regie, and exaine the iplications o expected regie switches or inlation and eployent (Hailton, 1994). We leave these extensions or uture work. Reerences Alesina, Alberto, Macroeconoic Policy in a Two-party Gae with Rational Voters, Quarterly Journal o Econoics 102 (1987): Alesina, Alberto and Jerey D. Sachs, Political Parties and the Business Cycle in the United States, Journal o Money, Credit and Banking 20 (1988): Alogoskouís, George S. and Alan Manning, On the Persistence o Uneployent, Econoic Policy 7 (1988): Alogoskouis, George S., Ben Lockwood, and Apostolis Philippopoulos, Wage Inlation, Electoral Uncertainty and the Exchange Rate Regie: Theory and UK Evidence, Econoic Journal 102 (1992): Alogoskouis, George S., Dong-Ho Lee, and Apostolis Philippopoulos, Exchange-Rate Regies, Political Parties and the Inlation Uneployent Trade-o: Evidence ro Greece, Open Econoies Review 9 (1998): Barro, Robert and David Gordon, A Positive Theory o Monetary Policy in a Natural Rate Model, Journal o Political Econoy 91 (1983): Bazdresch, Carlos and Santiago Levy, Populis and Econoic Policy in Mexico , in Rudiger Dornbusch and Sebastian Edwards (eds.) The Macroeconoics o Populis in Latin Aerica, Chicago: University o Chicago Press (1991).

12 98 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis Blanchard, Olivier J. and Lawrence H. Suers, Hysteresis and the European Uneployent Proble, in Stanley Fischer (ed.) NBER Macroeconoics Annual, Cabridge, MA: MIT Press (1986). Canzoneri, Matthew B., Monetary Policy Gaes and the Role o Private Inoration, Aerican Econoic Review 75 (1985): Cárdenas, Enrique, La Política Econóica en México, , Mexico DF: Fondo de Cultura Econóica (1996). Coles, Melvin and Apostolis Philippopoulos, Are Exchange Rate Bands Better than Fixed Exchange Rates? The Iported Credibility Approach, Journal o International Econoics 43 (1997): Edwards, Sebastian, The Political Econoy o Inlation and Stabilization in Developing Countries, Econoic Developent and Cultural Change 42 (1994): Foweraker, Joe and Todd Landan, The August 1994 Election in Mexico, Electoral Studies 14 (1995): Giavazzi, Francesco and Alberto Giovannini, Models o the EMS: Is Europe a Greater DM Area? in Ralph C. Bryant and Richard Portes (eds.) Global Macroeconoics: Policy Conlict and Cooperation, London: Macillan (1987). Giavazzi, Francesco and Marco Pagano (1988), The Advantage o Tying One s Hands: EMS Discipline and Central Bank Independence, European Econoic Review 32 (1988): Gregory, Allan W. and Bruce E. Hansen, Residual-based Tests or Cointegration in Models with Regie Shits, Journal o Econoetrics 70 (1996): Grindle, Meriless S., Challenging the State: Crisis and Innovation in Latin Aerica and Arica, Cabridge: Cabridge University Press (1996). Horn, Hendrik K. and Torsten Persson, Exchange Rate Policy, Wage Foration and Credibility, European Econoic Review 32 (1988): Ibarra, David and José L. Alberro, Mexico, in Joseph A. Pechan (ed.) The Role o the Econoist in Governent: An International Perspective, Hertordshire: Harvester Wheatshea (1989). Ibarra, Luis A., Credibility o Trade Policy Reor and Investent: The Mexican Experience, Journal o Developent Econoics 47 (1995): Instituto Nacional de Estadística, Geograía e Inorática (INEGI), Series Históricas de México, several issues. Li, Caren, Sergio Montaño, and Apostolis Philippopoulos (1997), Inlation, Exchange-Rate Regies and Electoral Cycles in Mexico, discussion paper 471, University o Essex (1997). McKinnon, Ronald, International Money in Historical Perspective, Journal o Econoic Literature 31 (1993):1 44. Perron, Pierre, The Great Crash, the Oil Price Shock and the Unit Root Hypothesis, Econoetrica 57 (1989): Reer, Karen L., The Political Econoy o Elections in Latin Aerica, , Aerican Political Science Review 87 (1993): Rogo, Kenneth, The Optial Degree o Coitent to Interediate Monetary Target, Quarterly Journal o Econoics 100 (1985a): , Can International Monetary Policy Be Counterproductive? Journal o International Econoics 18 (1985b): Ross, Jaie, Inlación: la Experiencia en la Presente Década, in Nora Lustig (ed.), Panoraa y Perspectivas de la Econoía Mexicana, Mexico DF: El Colegio de México (1980). Sachs J., Aaron Tornell, and Andrés Velasco, The Collapse o the Mexican Peso: What Have We Learnt? Econoic Policy 22 (1996): Svensson, Lars E.O., Optial Inlation Targets, Conservative Central Banks and Linear Inlation Contracts, Aerican Econoic Review 87 (1997): Zivot, Eric and Donald W. K. Andrews, Further Evidence on the Great Crash, the Oil Price Shock and the Unit Root Hypothesis, Journal o Business and Econoic Statistics 10 (1992):

13 INFLATION AND EXCHANGE RATE IN MEXICO 99 Notes 1. Participation in a regie o exchange-rate coitents is only one possible institutional solution to the Barro Gordon outcoe. Appointing an inlation-averse central banker is another institutional solution (Rogo, 1985a). For a recent survey o this literature, see Svenson (1997). 2. Coles and Philippopoulos (1997) have extended this iported credibility arguent to a target-zone odel o exchange rates. The crucial assuption is that exchange rate coitents (e.g., ixed exchange rates and target zones) are ore credible than doestic anti-inlationary policies. 3. Our estiation ethodology is siilar to that in Alesina and Sachs (1988) and Alogoskouis et al. (1998). Speciically, Alesina and Sachs (1988) test and estiate the partisan odel o Alesina (1987) or the USA. Alogoskouis et al. (1998) cobine the exchange-rate-regie odel with the partisan odel, and then test and estiate it or Greece. Here, we ocus on exchangerate regies. 4. See Cárdenas (1996) and Bazdresch and Levy (1991). 5. Ibarra and Alberro (1989) discuss the econoic policy during this period. 6. See Sachs et al. (1996). 7. More details in Grindle (1996) and Foweraker and Landan (1995). 8. For siplicity, the constant ter lnd is oitted. 9. Notice that exchange rates (actual and expected) can be easily introduced. For instance, we can use a sall open econoy odel with purchasing power parity. Then, our solution reains unchanged, i we replace doestic prices with exchange rates (Horn and Persson, 1988). This is especially true in a country like Mexico in which the traded sector is particularly iportant, and hence there is a strong link between price inlation and exchange rate depreciation. Alternatively, we can use a ore general odel with traded and nontraded goods. Again, this would not change our qualitative results (Rogo, 1985b). 10. We could use ore coplicated targets, e.g. n t = l t-1 + (1 - l)n t. This would not change our ain results. 11. We could ind consistent quarterly data on GDP only since Our results do not change uch when we construct real quarterly data on GDP by using real annual GDP with weights provided by real quarterly industrial production. 12. See Ross (1980) or the correlation between the average anuacture wage and the iniu urban wage in Mexico. 13. We can report that our results do not change when we look or a cointegrating relationship between Dp t and y t ; i.e. during the whole saple period. 14. We can report that the restriction l = 1 is not rejected by the data. 15. The debt crisis duy (d t debt ) takes the value o 1 during 1982, and 0 otherwise. The oil price shock duy (d t oil ) takes the value o 1 during and , and 0 otherwise. The trade liberalization duy (d t liber ) takes the value o 1 ro 1985.Q3 onwards (the irst serious attept to reduce trade restrictions took place in July 1985), and 0 otherwise. The peso-type expectations duy (d t peso ) takes the value o 1 in 1987.Q4 and 1994.Q4, and 0 otherwise.we have experiented with various cobinations o duy variables in all three regressions (11c), (11b), (11c), but here we include only those which are signiicant. Also recall ro Table 1 that there was weak evidence o a break in intercept at 1974Q1 in the regression or industrial production (11c). When we estiated the odel (11a) (11d) including a duy that takes the value o 1 ater 1974Q1 and zero otherwise into (11c), this was again ound to be insigniicant. We thereore oit it ro the reported results in Table In the Barro Gordon odel o inlation in which policyakers have direct control over price inlation, and hence use it as a policy instruent, there is always a positive eect ro uneployent to current price inlation. See equation (7a). 17. For details see Li et al. (1997) where we develop and test a richer version o the odel than the one we are using here that includes electoral eects. See also Alogoskouis et al. (1992) or the UK and Alogoskouis et al. (1998) or Greece. Since there is only insigniicant evidence o political business cycles, we have decided just to report the results, so as to keep the odel siple

14 100 Caren A. Li, Apostolis Philippopoulos, and Elias Tzavalis and econoize on space. However, it is worth noting that ost o the epirical evidence on political business cycles involves deocracies in industrial countries. There are ew exceptions. For instance, Edwards (1994) nests the predictions o the naive and rational political business cycles odels in an inlation equation, and tests it or Chile in the period He inds evidence o opportunistic (i.e., electoral) and partisan eects, but no support or any particular odel. Reer (1993) inds liited evidence o electoral eects on a nuber o acroeconoic variables. His results are based on single-equati on regressions or a saple o Latin Aerican countries. By contrast, our results reported here are based on a ully speciied odel with cross-equation restrictions.