Monetary policy in a developing economy with external debt: Theory and empirics

Using annual data from four open economies (Thailand, Indonesia, Mexico, and Chile), and estimating correlations and generalized impulse responses within the traditional vector autoregressive (VAR) analysis, we find that inflation, both in the short and long run, is negatively correlated with consumption, investment, and the stock of foreign debt. We propose an optimizing model of an open economy with outstanding foreign debt and borrowing constraint that could explain these empirics. In this economy, risk premium depends on creditworthiness measured by debt–income ratio. Firms operate under costly investment, and all transactions involving consumption and investment are subject to cash-in-advance (CIA) constraints.