Inflation and Exchange Rate Targeting Challenges Under Fiscal Dominance

Countries have increased significantly their public-sector borrowing since the Global Financial Crisis. In this context, we document several potential fiscal dominance effects during 2000-2017 under Inflation Targeting (IT), and non-IT regimes. Higher ratios of public debt-to-GDP are associated with lower policy interest rates in Advanced Economies. In Emerging Market economies under non-IT regimes, composed mostly of exchange rate targeters, the interest rate effect of higher public debt is non-linear and depends both on the ratio of foreign-currency to total public debt, and on the ratio of hard-currency debt to GDP. For these Emerging Market economies under non-IT regimes, real exchange rate depreciation and international reserves accumulation are significantly associated with higher interest rates. Sorting countries into low, medium and high nominal exchange rate volatility bins, we find that the high nominal exchange rate volatility group of Emerging Market economies, specifically those with high commodity exposure, show the most persuasive evidence of debt levels influencing policy interest rates