Inflation Volatility, Financial Institutions, and Sovereign Debt Rating : The Welfare Implications

This study analyzes the impact of reducing inflation volatility and the impact of enhancing financial institutions on economic welfare. First, an empirical analysis of the impact of inflation, inflation volatility, and financial institutions on a country’s sovereign debt rating is undertaken. Using a sample of 37 developed and developing countries over the period 1989-2006, the study estimates a non-linear rating regression that interacts inflation volatility with an index for financial institutions developed in this paper using principal component analysis. The results suggest that reducing inflation volatility can have a statistically and economically significant positive effect on a country’s sovereign debt rating. The results also show that improving financial institutions has a statistically and economically significant positive direct and indirect effect on a country’s sovereign debt rating. These empirical results are then used to calibrate the neoclassical one-sector growth model of Barro and Sala-i-Martin (1995) in order to quantify the welfare implications under two policy scenarios; 1) a one standard deviation decrease in inflation volatility and 2) a one standard deviation increase in the level of financial institutions. The growth model is calibrated using data from Mexico; a country that, by the measure used in this paper has poor financial institutions and moderately high inflation volatility. The results show that a one percent decrease in the standard deviation of inflation volatility will lead to an increase in a country’s sovereign debt rating of about two classifications. This increase in sovereign debt rating leads to a reduction in the average long-term bond yield by about 4 …