The real effects of inflation in a developing economy with external debt and sovereign risk

• We examine the real effects of inflation in a small open developing economy.
• The economy faces an upward sloping supply curve of debt due to risk premium
• Higher inflation leads to lower consumption, employment, capital and foreign debt.
• Non-monotonic adjustment of the current account explains the Feldstein–Horioka puzzle.

In this paper we develop an intertemporal optimizing model to examine the real effects of inflation induced by monetary policy in an open developing economy with external debt and sovereign risk. The economy faces an upward sloping supply curve of debt. In our model, households require real balances in advance for consumption expenditures, and monetary policy involves targeting the inflation rate. We show that an increase in the inflation rate leads to a decrease in the stock of foreign debt. It also leads to a decrease in consumption, employment, capital accumulation and output in the long run. Our results show that the accumulation of foreign debt exhibits non-monotonic adjustment. Particularly, an increase in the inflation rate leads to a current account surplus followed by a deficit. Along with this non-monotonicity, our model also explains the positive correlation between savings and investment during the transitional periods (Feldstein–Horioka puzzle).