Working Paper: NBER ID: w4661
Authors: Sebastian Edwards; Fernando J. Losada
Abstract: We use data from Guatemala and Honduras to investigate some implications of the Purchasing Power Parity theory over the long run. In particular, we address two questions. First, to what extent did the fixed exchange rate regime impose macroeconomic discipline on these countries. Second, what was the impact of terms of trade shocks and growth differentials on inflation rate differentials between those countries and the United States. We found that the fixed parities regime worked properly until the mid-1970s, providing some constraint on central bank behavior. However, the evidence suggests that the fixed exchange rate system was not sufficient to avoid inflation outbursts and balance of payments crises. Specifically, it was unable to accommodate large negative terms of trade shocks in the late 1970s and early 1980s.
Keywords: fixed exchange rates; inflation; macroeconomic discipline; purchasing power parity; terms of trade
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fixed exchange rate (F31) | inflation stability (E31) |
| fixed exchange rate (F31) | central bank behavior (E58) |
| negative terms of trade shocks (F14) | inflation outbursts (E31) |
| fixed exchange rate (F31) | adverse inflationary outcomes (E31) |
| external economic factors (F69) | inflation outcomes (E31) |