Expectations decoupled: inflation and exchange rate dynamics in Argentina and Venezuela

Abstract

This paper delves into the complex relationship between high exchange rate depreciation and high inflation expectations in Emerging Market Economies, explicitly focusing on the cases of Venezuela and Argentina. Employing a Bayesian-modeled Dynamic Stochastic General Equilibrium (DSGE) framework, we challenge the conventional Rational Expectations assumption by embracing Adaptive Learning. Our research uncovers that exchange rate expectations are pivotal in driving short-term deviations in exchange rates, leading to ”bubbles” in inflation dynamics significantly contributing to hyperinflation episodes. This unconventional approach emphasizes the need to incorporate learning expectation dynamics into macroeconomic models. Our study provides insights into the consequences and implications of countries like Venezuela and Argentina lacking an inflation-targeting regime and, therefore, having difficulties in not achieving a stable nominal anchor in the economy.