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Abstract:
Considerable research has focused on explaining why currencies appreciate in
real terms after the nominal exchange rate is stabilized, but this research
generally has taken a theoretical approach, and rarely has tested its
hypotheses empirically. In this paper I estimate a simple error-correction
model for Mexico, based on the Salter-Swan framework, in which inflation is
determined by (1) the gap between the actual real exchange rate and the
exchange rate that clears the market for non-traded goods, and (2) persistence
effects of past inflation. Using this model, I decompose the excess of Mexican
inflation in 1988-94 over peso-adjusted international inflation rates--that is,
the real appreciation of the peso--into that part attributable to the initial
undervaluation of the peso, that part explained by the subsequent expansion of
domestic demand, and that part attributable to inertial inflation. The results
indicate that the effects of inertial inflation in appreciating the real
exchange rate were quite temporary, lasting only about a year after the
stabilization of the peso in 1988. Of the real appreciation that took place
between 1988 and 1994, about half was attributable to the expansion of domestic
demand-which appreciated the equilibrium real exchange rate in the
non-tradeables sector--and about half reflected the correction of the initial
undervaluation of the real exchange rate relative to its equilibrium level in
the non-tradeables sector. Finally, the paper uses the model to illustrate the
impact of various prospective exchange rate policies on inflation and the real
exchange rate in Mexico.
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