Inflation targeting in an import dependent indebted economy

Abstract

This paper develops a one-sector Kaleckian model of an import dependent indebted small open economy, where the mark-up rate is sensitive to both changes in the interest rate and the exchange rate and foreigners provide part of the long-term finance. The short-run consequences of an inflation targeting policy in the form of high interest rates and strong domestic currency are explored. Among the possible short-run scenarios the one most relevant for developing countries involves a decline in the profit rate the capacity utilization rate and the rate of accumulation as well as the employment rate and the real wage. Leverage ratio of the firms and the extent of external indebtedness play an important role in bringing about this result. Long-run analysis reveals that this scenario is associated with instability in the long run and that also in the long run the extent of foreign indebtedness and the responsiveness of capital inflows to the return on existing portfolios are important in determining the direction of the effects of inflation targeting on the equilibrium debt-capital ratio.