Debt Crisis and Inflation

Abstract

This paper develops and tests a model that predicts a negative link between the degree of openness of an economy and its equilibrium inflation rate. The effect arises in an economy going through a debt crisis, and in which inflation tax constitutes an important source of the government's revenue. The predictions of the analysis are compared to those in Romer (1993), which uses a Barro-Gordon type model to argue that openness puts a check on a government's incentive to engage in unanticipated inflation, because of induced exchange rate depreciation. Romer's tests are reevaluated, and it is shown that the degree of openness is only a significant determinant of inflation among highly indebted countries, during the debt crisis period. The empirical results indicate that the model of openness and inflation' presented here explains the data better than Romer.