Abstract

CUEVAS AHUMADA, Víctor M.. Inflation, Output and Economic Policy in Mexico. Inv. Econ [online]. 2008, vol.67, n.265, pp.85-120. ISSN 0185-1667.

This paper investigates the leading sources of inflationary pressure and output variations in the Mexican economy. To this end, we make use of a multivariate error-correction model, which is consistent with a small open economy with a floating exchange rate system. As our object is to let the data expose the key determinants of prices and output, we resort to a broad aggregate demand-aggregate supply model consisting of three markets: goods, money, and labor. Taken as a whole, the empirical evidence suggests that monetary expansions are basically accommodated through a higher price level, rather than a higher economic activity. In the short run, real exchange rate depreciations produce a moderate effect on inflation and an insignificant effect on output. In the long run, however, an undervalued currency results in production losses. In addition, we find that i) both inertial inflation and inflationary expectations are among the driving forces of price instability, and ii) shocks to nominal wages are recessionary at impact and this negative effect is persistent over time. Lastly, nominal wages are a positive function of capacity utilization and the expected rate of inflation, thereby suggesting a forward-looking wage adjustment process. As we shall see, these findings have some relevant implications not only for the monetary and the exchange rate policies, but also for the so-called central bank's credibility.

Keywords : inflation; output; monetary policy; error-correction model.

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