Price instability in a rational expectations model: The mexican case

Abstract

The purpose of this paper was twofold: (1) to develop an open-economy-rational-expectations model to test the theoretical relationship between the price level and expectations about money and the exchange rate; and (2) based on the empirical results of the model, prescribe policy rules aimed at stabilizing inflationary expectations in Mexico. The major empirical findings were that the price formation in Mexico is positively related to both subjective money and exchange-rate expectations formed at period t. The correction path suggested by the empirical results is the implementation of an “activist” policy aimed at reducing both the ratio of real fiscal deficit and external debt to real gross domestic product from their current levels to the “ideal” levels of 1.6 and 11.3 percent of GDP, respectively.