Inflation Adjustment, Endogenous Risk Premium and Exchange Rate: A Theoretical Analysis
| Published date | 01 May 2024 |
| DOI | http://doi.org/10.1177/00157325221145398 |
| Author | Moumita Basu,Rilina Basu,Ranjanendra Narayan Nag |
| Date | 01 May 2024 |
| Subject Matter | Original Articles |
Inflation Adjustment,
Endogenous Risk
Premium and
Exchange Rate: A
Theoretical Analysis
Moumita Basu1, Rilina Basu2 and
Ranjanendra Narayan Nag3
Abstract
This article develops a full employment monetary framework that deals with the
interaction between exchange rate and inflation rate dynamics, emphasising the
existence of risk premium. The economy consists of internal and foreign bonds.
These are close substitutes since there exists a risk premium that depends on
inflation rate, budget deficit and net exports. According to the monetary policy
rule, both inflation rate and exchange rate negatively influence money supply.
Overtime, changes in inflation rate are proportional to the excess supply in the
money market. The dynamic adjustment of exchange rate arises due to discrep-
ancy between home interest rate and world rate of interest and risk premium.
Based on this framework, we investigate the implications of increase in exports,
technological innovation and policy mix for the interaction between exchange
rate and inflation rate.
JEL Codes: E31, E63, F32, F41
Keywords
Inflation rate, exchange rate, risk premium, macroeconomic policies
Original Article
1 Department of Economics, Krishnagar Government College, Krishnagar, Nadia, West Bengal,
India
2 Department of Economics, Jadavpur University, Kolkata, West Bengal, India
3 Department of Economics, St. Xavier’s College (Autonomous), Kolkata, West Bengal, India
Corresponding author:
Moumita Basu, Department of Economics, Krishnagar Government College, Krishnagar, Nadia,
West Bengal 741101, India.
E-mail: 3.moumita@gmail.com
Foreign Trade Review
59(2) 225–251, 2024
© 2023 Indian Institute of
Foreign Trade
Article reuse guidelines:
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DOI: 10.1177/00157325221145398
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226 Foreign Trade Review 59(2)
Introduction
The long-standing debate on the impact of ination on growth has been far from
conclusive. While one set of economists has observed a positive relationship be-
tween ination and economic growth,1 one can associate high ination with a low-
er tendency to save and deteriorating corporate and public sector balance sheets
and hence can dampen growth and initiate nancial crisis (IMF, 2001, Mishkin,
2008).2 Given the association between ination and real economy, it becomes im-
perative to look into the factors that initiate ination, alternative channels through
which ination can operate as well as dierent ination management policies.
However, the article abstracts from the nexus between growth and ination rate.
There have been alternative schools of thought in explaining the factors causing
inflation. The two major views have been those of the monetarists and the structur-
alists. The monetarists believe that ‘money is a veil’ and that a rise in quantity of
money relative to output level generates inflationary pressure. So inflation is an
outcome of increasing money supply. In contrast, structuralists attribute inflation to
non-monetary factors and say it can arise from rapid economic growth process.
Economists such as Noyola (1956), Sunkel (1960), Olivera (1964) and Arndt (1985)
among others, suggested that with rapid economic growth, excess aggregate demand
over supply constrained by bottlenecks generated inflationary tendencies.
In absence of strong monetary policy regime in many of the emerging market
economies, along with a rising burden of public debt, these economies may
be increasingly vulnerable to shifts in market sentiments domestically and glob-
ally. With increasing integration into world economy, global inflation cycle3
has become an important feature in determining domestic inflation level.4
In context of hyperinflation, García (2018) shows that hyperinflation cycles origi-
nate whenever economic freedoms are depressed, socio-economic conditions
deteriorate, political instability and high levels of domestic conflicts. This neces-
sitates an inquiry into the possible factors leading to inflation in developing
countries.
One of the key factors behind inflation in developing economies, as identified
by macroeconomic theory, is seigniorage used for debt financing and thereby gen-
erating inflationary pressures.5 The ‘fiscal view of inflation’ has been most rele-
vant in the context of emerging economies, which have weak revenue functions
along with limited access to external borrowings.6 There has been no dearth of
empirical research exploring the causality between fiscal deficit and inflation.
Aghevli and Khan (1978) and Sarma (1982) show the bi-directional causality
between fiscal deficit and inflation. While inflation leads to a widening fiscal defi-
cit, financing this gap leads to mounting inflationary pressure through a rise in
supply of money. In this article, we intend to analyse the effect of a deteriorating
fiscal position on inflation through seigniorage from a theoretical perspective.
An interesting finding in recent literature has been the effect of technological
innovation on inflation. With more emphasis on technology, firms can now
achieve a lower production cost and hence a lower market price for finished goods
and services. It has been observed that technological innovation categorically
reduces the prices of information and communication technology along with that
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