Modern Economy, 2011, 2, 834-845
doi:10.4236/me.2011.25093 Published Online November 2011 (http://www.SciRP.org/journal/me)
Inflation, Monetary Policy and Economic Growth in
Mexico. An Inverse Causation, 1970-2009
Eduardo Loría1, Jorge Ramírez2
1School of Economics, National Autonomous University of Mexico, Mexico City, Mexico
2School of Economics, State of Mexico Autonomous University, Toluca, Mexico
Received May 25, 2011; revised July 16, 2011; accepted August 3, 2011
Abstract
It is demonstrated through an Structural Vector Auto Regression (SVAR) model which distinguishes short
and long term effects, that the monetary policy implemented in Mexico (1970-2008) has been successful in
reducing inflation at the cost of stagnation, especially after 2002. Inflation Targeting is contradictory in itself
because, while it is efficient in improving transparency and credibility of the monetary policy, it does not
solve the structural causes of inflation and conversely, increases the financial costs of economic agents.
Keywords: Classical Dichotomy, Structural Vector Auto Regression Model, Monetary Policy, Inflation
Targeting
1. Introduction
In the aftermath of important inflationary episodes in
developed countries during the late 70’s and early 80’s,
the mainstream economics concluded that inflation was
one of the major burdens to economic growth. Therefore,
the best policies to follow were to struggle against it at
whatever cost. Consequently, the autonomy of central
banks would become the key factor for economic growth
in the long run. Classical dichotomy claims there are no
real long run effects coming from demand shocks or ex-
pansionary demand policies. Ball [1] & Blanchard and
Quah [2] are among others who uphold this hypothesis.
The above explains why the idea of central bank’s
autonomy [3] was soon to be acknowledged as the best
worldwide policy to steer clear of irresponsibly fiscal
policies and therefore, enhance economic growth1. In
terms of Harry Johnson [7], the proposal was revolution-
ary since it was an original paradigm to alternatively
tackle both inflation and stagnation in an innovative way,
whereas the Keynesian framework was not able to do so.
Needless to say, Inflation Targeting (IT) which has
characterized the monetary policy since the early nineties,
has proven to be efficient in reducing inflation and
keeping it aligned in countries where has been imple-
mented2, and Mexico has not been the exception [8]. In
fact, since 1996—and as a part of the implicit Mexican
NAFTA targets—Mexican inflation has shown a con-
vergent path to that of the United States (Figure 1).
Nevertheless, supply shocks that began in 2008 and
the growing fluency of the transmission mechanisms that
1The idea of central bank independence lies in solving the problem o
f
temporary inconsistency, which refers to the incompatibility among the
central bank’s final goals that result from an interventionist and widely
discretional policy. This independence restricts the authorities when
selecting a priority goal (low and stable inflation) that must be reached
in a certain horizon (Kyndland&Presscott [4]; Barro & Gordon [5] &
Cukierman [6]).
Figure 1. Annual inflation rate (CPI), 1970-2009.
2Among others: Israel, Czech Republic, Poland, Brazil, Chile, Colom-
bia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, The Phil-
ippines, Slovakia, Indonesia, Rumania, New Zealand, Canada, United
Kingdom, Sweden, Iceland, Norway and the European Union.

835 E. LORÍA ET AL.
have encompassed globalization, have proven that this
approach resulted in diminishing returns. This is because
in order to control inflation, the exchange rate (nominal
and real) has to be appreciated, which in turn deteriorates
competitiveness and consequently the balance of pay-
ments. In sum, we claim that reducing inflation in this
manner depresses economic growth both in the short and
in the long run.
Ball [1] states that in 17 out of 20 developed countries,
NAIRU grew during the 1980’s because of a restrictive
monetary policy applied to reduce inflation. In this sense,
Stiglitz [9] argues that the rise in interest rate reduced
inflation but at the cost of restraining the aggregate de-
mand and output. In other words, “the cure proved worse
than the illness”.
In this paper, we show that for 1970-2009, the restric-
tive management of the interest rate in Mexico—even
before the IT existed—depressed growth, although it
may have reduced inflation. This last result is the final
balance of several effects. On one hand, the exchange
appreciation which is inherent to this policy diminishes
production costs (final and intermediate goods) and the
costs of final imported consumption goods; but on the
other hand, the increase in interest rate raises public debt
as well as the financial costs for each individual and
therefore, it restricts aggregate spending. As a result,
even though economic growth has slowed down, trade
deficit has increased, which is not surprising at all. This
can be observed in Figure 2 which shows the coefficient
of imports to aggregate supply.
In order to prove our hypothesis, we estimatean Struc-
tural Vector Auto Regression (SVAR) for the short and
long run.
This paper is divided into five sections. In the second
section, historical (1970-2009) inflation and monetary
policy in Mexico are analyzed; the third section presents
a theoretical framework of the determinants of inflation
and the SVAR methodology. The fourth section dis-
cusses our main results. The final section presents con-
clusions and policy recommendations.
Figure 2. Imports to aggregate supply coefficient, 1970-2009.
2. Inflation and Monetary Policy in Mexico,
1970-2009
IT is characterized as an official announcement of a pro-
jected inflation range to meet preset temporary horizons.
It also claims that the monetary policy is focused on ob-
taining an explicit goal of a low and stable inflation.
Conventionally, Mishkin [10] considers IT as an eco-
nomic policy framework with the following characteris-
tics: transparency of the monetary policy, expressing at
all times the Central Bank’s primary concern regarding
inflation and, rapidly responding (reacting) to inflation-
ary shocks. (Bernanke & Mishkin [11]; Ramos-Francia
& Torres [8]; Kurczyn [12]). IT is built on two founda-
tions: a) the theoretical, which is the real business cycle
approach; and b) the empirical, which relies on the linear
adjustment of a scatter diagram which illustrates a nega-
tive relation of output to inflation3 (see Figure 3). Sch-
wartz [13], Castellanos [14], Díaz de León & Greenham
[15] and Martínez, Sánchez & Werner [16] claim that a
Central Bank’s best contribution to economic growth is
inflation reduction and its stabilization; hence, as of 1994
when the Mexican Central Bank (Banco de Mexico)
autonomy became effective, its sole mandate has been to
fight inflation with IT.
The empirical argument, which is also strictly statisti-
cal, cannot refer causality but a simple correlation that
under an inverse specification has an opposite outcome
(as shown in Figure 4). That is to say, economic growth
through its positive effects on productivity (economies of
scale) reduces inflation.
2.1. Inflation in Mexico. Stylized Facts
Five inflationary phases can be detected which are clearly
related to specific exchange rate regimes (see Figure 5).
The first phase (1970-1975) is of a low and relative
Figure 3. Mexico: inflation vs economic growth, 1970-2009.
3To this respect, see Taylor [3], Bernanke & Mishkin [11] and Mishkin
[10] y [17].

E. LORÍA ET AL.
836
Figure 4. Mexico: inflation vs economic growth, 1970-2009.
123
Figure 5. Mexico: inflation and nominal exchange rate vari-
ation, 1970-2009 (normalized series)*.
inflationary stability even when it shows increases after
1973, mostly as a result of world shocks in the price of
commodities. Afterwards it reduces due to a nominal
exchange rate fixation and its subsequent real apprecia-
tion.
The second phase (1976-1987) is featured by a sys-
tematic depreciation of the exchange rate which implied
an inflationary burst and was reverted by the implemen-
tation of the policy adjustment program on December
1987. The main characteristic of the third phase is the
cuasi fixation of the nominal exchange rate and the con-
trol of several fundamental prices of goods, services and
factors, so a severe and swift inflation reduction was
observed until reaching historical minimums in 1994.
The external and internal financial imbalances, which
were mostly generated by the real exchange rate appre-
ciation and by the internal political instability, provoked
the end of this exchange and monetary regime with the
magni-devaluations that began in December 1994 (Car-
stens & Werner [18] and Elizondo [19]).
In 1995 a completely different phase began which re-
sulted from the monetary policy of accumulated balances
or cero average reserve requirements4 that was used as a
benchmark and as an instrument of transparency of the
Central Bank’s reaction function5. The implementation
of a flexible exchange regime proved that inflation was
not affected as it had been previously. This monetary and
exchange regime, unlike previous experiences, allowed
the stabilization of the nominal exchange rate [20]. As
inflation progressively decreased, a dirty floating ex-
change rate regime was eventually established. Several
analyses (among others Galindo & Ros [21]) stated that
the pass through, that had been fairly high for decades,
noticeably had been reduced.
*In order to directly compare the two variables, we applied the follow-
ing common normalization procedure:
According to the Banco de Mexico, the explicit use
(formal announcement) of IT began in 2001, although
the pragmatism of that approach had been applied most
likely since 1996 [22]. Subsequently, in 2003 the Mexi-
can Central Bank officially established a three percent
annual rate inflationary target allowing one point plus/
minus of variability.
Without affecting the basics mentioned above, some
changes occurred since 2003 with the substitution of the
accumulated balances regime for the daily balances re-
gime (April 10th, 2003), following a similar logic with
the difference that banking accounts needed to be ad-
justed daily, thus reinforcing the contractionary monetary
policy
it t
x
x
SD

t
x
, where SD = standard deviation and = arithmetic
mean. In any case, the active and explicit management of the
interest rates since 1996 has been the disinflationary in-
strument by excellence with the argument that inflation-
ary pressures—regardless of their origin—are in this
manner mitigated.
Upon evaluating the inflationary outcome and its goal
(Table 1), the evidence shows that the Central Bank only
achieved (and even exceeded) it only in 1999-2001, but
at the expense of exchange rate appreciations, growth
reduction and unemployment increases afterwards. (see
able 1 and Figure 6). T
4This regime had the objective of decreasing volatility in interest rates
and prices. It was called cero average reserve requirements because at
the end of the operation, commercial banks could not have positive
balances in their current account with the central bank. Otherwise, it
would be punished with twice the 28 day Cetes interest rate (Schwartz,
1998).
5For Martínez, Sánchez & Werner (2000) the “corto” (money with-
drawn from circulation) was used because the targeted interest rate
could not be used due to high volatility in Mexican government bonds
in foreign currency, which at the time affected the domestic money
market performance and the high pass-through. If the authority at the
time would have used an objective interest rate as its main policy in-
strument, the economy would have gotten through high uncertainty and
therefore macroeconomic instability.

E. LORÍA ET AL.
837
Table 1. Mexico: some macroeconomic variables, 1995-2009.
Inflation CETES Exchange rate1 Unemployment
Year Objective Actual Difference
GDP (%) 28 days
1995 42.0 51.97 9.97 –6.1 48.6 1.35 6.2
1996 20.5 27.70 7.20 5.1 27.6 1.28 5.5
1997 15.0 15.72 0.72 6.8 18.9 1.18 3.7
1998 12.0 18.61 6.61 4.9 33.7 1.17 3.2
1999 13.0 12.32 –0.68 3.9 16.5 1.11 2.5
2000 10.0 8.96 –1.04 6.6 17.1 1.04 2.2
2001 6.5 4.40 –2.10 –0.2 6.3 1.00 2.4
2002 4.5 5.70 1.20 0.8 6.9 1.01 2.7
2003 3.0 3.98 0.98 1.4 6.1 1.10 3.3
2004 3.0 5.19 2.19 4.2 8.5 1.13 3.8
2005 3.0 3.33 0.33 3.0 8.2 1.09 3.6
2006 3.0 4.05 1.05 4.8 7.0 1.07 3.6
2007 3.0 3.76 0.76 3.2 7.4 1.08 3.7
2008 3.0 6.11 3.53 1.5 7.7 1.09 4.0
2009 3.0 3.57 0.57 –6.08 5.4 1.26 5.5
Source: Own calculations with dates from Banxico & INEGI. 1. RER = NER (PUS/PMX). 1993 = 1; PUS, PMX: Consumer Price Index US and Mexico, respec-
tively; NER: Nominal Exchange Rate, pesos per 1 $ US.
Figure 6. Mexico: inflation and unemployment, 1980-2009
(normalized series)
This figure clearly demonstrates how between 1987
and 2000 inflation and unemployment grossly evolved in
the same direction. Afterwards, the social cost (measured
by the unemployment rate) in keeping in check increased,
suggesting diminishing returns in IT.
Our main and alternative argument to this approach
proposes that the relation of interest rate to inflation has
an inverse effect. That is, the interest rate reduction (28
day CETES) decreases inflation by reducing multiple
financial costs of which, based on importance and impact,
are public (domestic debt service) and enterprise costs6.
This improves supply and effective demand and as a re-
sult, scale economies emerge reducing average and mar-
ginal costs which in due course increase economic
growth. This means that the disinflationary effects aris-
ing from the interest rate decrease are doubled through
financial costs and productive efficiency. Thus, our Post-
Keynesian interpretation of the relation between GDP
growth and inflation corresponds to Figure 4.
3. Some Considerations about Inflation
3.1. Theoretical Issues
Our approach starts out from a very traditional specifica-
tion that determines the enterprise equilibrium under
imperfect competition which accepts expectations in
price formation7.
We know—as a benchmark—that in perfect competi-
tion, the equilibrium is attained where the enterprise
maximizes its profit and that is where:
P = MC = MR (1)
also,
MLC = W/P = MLP (2)
The price can be expressed in terms of labor cost:
P = W/MLP (3)
which expressed in variations turns to:
π = w – mlp (4)
6The latter in terms of debt and payment which enterprises usually
incurred to finance their current activities, namely work capital, as well
as innovation and investment. 7What follows is based on Perloff [23] and Carlin & Soskice [24].

E. LORÍA ET AL.
838
where: P = Price; MC = Marginal Cost; MR = Marginal
Revenue; W = Monetary Wages; π = Inflation (∆P/P);
MLC = Marginal Labor Costs; MLP = Marginal Labor
Productivity.
Under imperfect competition, enterprises set prices to
maximize profits. There is an important relation between
their market shares and their marginal revenue. If their
market share decreases, they lose monopolistic power
and therefore, they get closer to competitive equilibrium.
Thus, their elasticity of demand (ε) determines their mo-
nopolistic power:
 = f(  ), 
ε >
 . Under these terms,
their marginal revenue is defined as:
MR = (ΔP/ΔQ) × Q + P (5)
Multiplying the first member on the right hand side by
(P/P) and solving:
MR = P((1 + ε)/ε) = MC (6)
and the price:
P = MC × (ε/(1 + ε)) (7)
Enterprises face several types of costs besides wages
so we can generalize and reach a wider expression of
inflation than Equation (4) by applying variations to
Equation (7) and expressing ε/(1 + ε) = θ.

ˆ
πtMC

 (8)
When incorporating inflationary expectations we fi-
nally get a functional expression. In Equation (9) we
introduce regressive expectations or inflationary inertia.
On the other hand, the marginal costs here also include
those that usually have a greater impact on inflation.


1ˆ
ππ|π
tttt
EMC



t
(9)
This equation is used for our estimation and econo-
metric analysis. Due to lack of information, we were not
able to incorporate θ in the econometric specification.
3.2. Econometric Issues
To prove our main hypothesis, we estimated an SVAR
by selecting variables that are usually accepted as deter-
minants for inflation in our Post-Keynesian approach.
Empirically speaking, the most significant production
costs for the Mexican economy are the following: gaso-
line prices (g) real minimum wages (w), nominal ex-
change rate (n), nominal interest rate (r) and GDP (see
Figure 1A in appendix)8. All the variables are expressed
in the first difference of their logarithm, which not only
avoids unit root problems but also allows a readily eco-
nomic interpretation.
The correct specification of a VAR demands a proper
selection of variables and lags. According to the usual
criteria9, we initially estimated an unrestricted VAR (2).
Our specification did not change with different restric-
tions on short and long run models10. To test the robust-
ness of the relations found in the unrestricted VAR, we
identified the contemporaneous innovations through the
methodology used by Bernanke [25], Sims [26] and
Stock & Watson [27].
The SVAR can evaluate causality, sensitivity and dy-
namic responses by eliminating the undesired distur-
bances as a result of a proper identification which comes
from a correct identification of the stochastic process
behind each variable and from a relevant economic the-
ory. As a result, the sensitivity coming from the con-
temporaneous transmission mechanisms are accurately
detected.
An unrestricted VAR is estimated on the basis of the
lagged endogenous and exogenous variables:
1ttt
ydCy



 (10)
where yt is a vector of endogenous variables dt is a vector
of deterministic components (constant, trend and dummy
variables) and

t is the vector of innovations. In Equation
(10) the contemporaneous effects among the variables
are explained but they are contained in the variance and
covariance matrix generated in vector t. An analysis of
a primitive VAR leads us to a better understanding. Let
us consider the following expression [28]:
Byt = dt + Ayt–1 +

t (11)
The VAR in its reduced form (10) is just a reparame-
trization of the most general specification of (11). In fact,
it is easy to observe since C = B–1A and 
t = B–1

t.
The above implies that the residuals of (10) are linear
combinations of the non-correlated shocks 
t.
To recover the contemporary interactions contained in
matrix B, Cholesky’s [29] triangular procedure is usually
applied. Nevertheless, a proper identification coming
from the economic theory and from the own structure of
the data requires ad hoc restrictions to compute more
accurately the IR functions. Furthermore, it allows the
identification of the system11.
4. Discussion
The SVAR ordering and specification were made in con-
9Final Prediction Error, Akaike, Schwarz, Hannan-Quinn & LR.
10When estimating with 1 or 3 lags, the impulse response (IR) tests did
not register important changes. Regarding the VAR (1), sensitivity
weakened but not in the sense of responses, although the results of the
variance decomposition changed. More lags dramatically reduced the
degrees of freedom to the point that it was not possible to calculate
heteroskedasticity. In all cases, the assumptions of correct specification
were accomplished (see Table 2A in the statistical appendix).
11This states that the number of non-cero elements in the B matrix must
be equal to or less than (n2 – n)/2 [28].
8The latter is only incorporated to contrast the neoclassic hypothesis
that claims that economic growth may turn out to be inflationary.

E. LORÍA ET AL. 839
g










gruence with the theoretical and statistical causal rela-
tions, going from the most exogenous to the endogenous
variables. We obtained a final and correct statistical
specification12 which is over identified (with one degree
of freedom) (Figure 7).
Considering only the equations of interest, we have:
D(pt) = 1.646 × εD(n) + 0.471 × εD(g) + 0.069 × εD(r) + εD(p)
D(yt) = –1.051 × εD(n) + 0.477 × εD(g) + 0.835 × εD(p) + εD(y)
The signs and relations found are consistent with our
theoretical approach and allow us to make the following
statements:
1) Prices are positively influenced by all variables with
the exception of GDP and real wages14. Therefore, the
hypothesis thatclaims that economic growth and wages
are naturally—and by themselves—inflationary is re-
jected. In any case, we should refer to a specification of
the modern Phillips Curve that expresses inflation as a
function of the GDP gap and not of its level and varia-
tions (Galí [30]; Carlin & Soskice [26]).
2) The positive effect of interest rate on inflation is
proven which is in line with the main hypothesis of this
paper.
3) GDP growth is positively affected by gasoline costs
and most remarkably suffers the recessive effect of no-
minal exchange rate devaluations. Gasoline’s positive
effect is remarkable and could be indirectly explained in
the sense that gasoline tax is very important to finance
public budget. This way, we suggest that the VAR may
capture this final effect which is higher than that result-
ing from household income reduction derived from gaso-
line price increases.
Now considering Figure 8 where the short run IR of
the SVAR is depicted, the following analysis can be de-
()
()
21
()
31 323536
()
41 4346
()
51 5254
51 5253()
100000 ()
10000 ()
10 ()
010 ()
010()
001 ()
Dn
t
Dg
t
Dw
t
Dr
t
Dp
t
tDy
Dn
bD
bbbb Dw
bb bDr
bb bDp
bbb Dy














 











Figure 7. Short run identification matrix13.
rived:15
1) In Figure 8 we observe a strong and immediate in-
flationary effect coming from the exchange rate.
2) The positive effect of gasoline prices to inflation is
not very significant and only lasts one period.
3) The effects of interest rate shocks to inflation rate
shocks are not immediate since they start in the second
period and have an easily observed positive effect with
an approximate duration of two periods (years).
The variance decomposition analysis shows useful and
interesting insights in terms of our main hypothesis (see
Table 2). With this purpose, we only analyze the shocks
on inflation and on GDP. Regarding the first variable we
noted that:
1) The greatest effect is generated by the exchange
rate followed by the interest rate. From the beginning
and up to period 20, they altogether represent approxi-
mately 70% of the inflation variation.
2) Unlike other works, there is no great inflation iner-
tia. The opposite would probably occur in series of
greater frequency or for different historical periods (i.e.
the 1980s).
3) It has been previously noted that the price of gaso-
line and wages have insignificant weight on inflation
which would require a deeper analysis and, at the mo-
ment, surpasses the purpose of the present research.
4) The effect of GDP growth is more important on
prices than that of wages, although it was noticed that the
first effect is statistically non-significant.
Table 2. Variance decomposition.
Variance Decomposition of D(p):
PeriodS.E.D(n) D(g)D(w) D(r) D(p)D(y)
1 0.12869.4005.6640.000 0.159 24.7780.000
5 0.27249.6532.0910.790 22.674 11.83412.958
10 0.28946.5622.2010.801 24.633 10.93114.871
15 0.29046.5102.2100.806 24.637 10.93514.903
20 0.29046.5052.2090.806 24.641 10.93414.905
Variance Decomposition of D(y):
PeriodS.E.D(n) D(g)D(w) D(r) D(p)D(y)
1 0.02436.1747.4310.000 0.000 21.68534.710
5 0.03442.8117.4677.332 3.559 18.94919.882
10 0.03541.4648.2867.230 5.517 18.01219.491
15 0.03641.3048.3267.216 5.709 17.92019.525
20 0.03641.3018.3307.217 5.710 17.92119.522
12LR Test: χ2 (1) = 2.647 (0.104). See Tables 1A and 2A in the appen-
dix.
13D(nt) = first difference of logarithm of nominal exchange rate; D(gt)
= first difference of logarithm of gasoline prices; D(wt) = first differ-
ence of logarithm of real minimum wages; D(rt) = first difference o
f
logarithm of nominal interest rate and D(yt) = first difference of loga-
rithm of GDP.
14The non-statistical insignificance of GDP shocks to inflation – evalu-
ated by the confidence bands – and the scarce specific weight in the
variance decomposition of wages are notorious.
15All responses to the shocks disappear before 20 periods which dem-
onstrate the system’s dynamic stability. Only at 95% of confidence IR
might be considered significant according to the range determined by
the confidence bands for ±2 standard errors. In this sense, the validity
of the shocks only cover up when one of the bands reaches zero, which
means that statistically, the response disappears (Valdés [31]; Gulli [32
and Calderón & Méndez [33]).

E. LORÍA ET AL.
840
Figure 8. SVAR impulse-response (short run).
5) Unlike inflation, GDP growth shows a higher auto-
regressive feature.
6) The exchange rate is the most important variable af-
fecting GDP.
To analyze the long run effects, we applied the proce-
dures developed by Blanchard & Watson [34] and
Blanchard & Quah [2] and we imposed the correspond-
ing restrictions now in matrix C. Blanchard & Quah’s [2]
methodology specifically consists in representing the
variables of study through moving averages and then
finding its temporary path with transitory and permanent
components:
Byt = A(L)yt + et (14)
yt = B*(L)yt + 
t (15)
where B* = B–1A;

t = B–1et; L is the lag operator and e
refers to the residuals of the transitory and permanent
effects. The SVAR representation in moving averages
(MA) is described as:
yt = [I – B*(L)]–1

t (16)
yt = C(L)

t (17)
Vector 
t = B–1et represents the independent innova-
tions that have the property of being white noise and the
matrix of coefficients Cij(L) represents the polynomial of
the lag operator L. From the matrix representation (17)
inflation and output paths with permanent effects are
derived, considering that the transitory effects must fol-
low a stochastic process that is strictly stationary, et
 N(0,

2), unlike the permanents. We obtained a correct over-
identified specification—once again—with one degree of
freedom ( 
2(1) = 2.691(0.1009)) (Figure 9).
The results shown in Figure 10 lead to the following
introspective suggestions:
1) In the long run exchange rate and inflation shocks
have positive and permanent effects on inflation which
confirms the existence of the pass through effect and
inflationary inertia.
2) The increase in interest rate affects inflation posi-
tively and permanently, which is coherent with the short
run results previously obtained.
3) Figure 10(d) shows that even though there are posi-
tive contemporary effects (in the short run) of GDP to
inflation, after one period they turn negative and disap-
pear, which again is consistent with our post-Keynesian
framework.
Finally, Figure 11 presents the structural response of
GDP growth in the long run and can be summarized as
follows:
1) Exchange depreciations have a negative impact on
1113 14 15 16
21 2223 242526
33 34 35 36
44 45 46
55
66
0
00
000
0000 0
00000
C CCCC
CCCCCC
CCCC
CCC
C
C




















Figure 9. Long run identification matrix.

841 E. LORÍA ET AL.
Figure 10. SVAR impulse-response (long run).
Figure 11. SVAR impulse-response (long run).
output (for 3 periods-years) due to the foreign depend-
ency (imported components) on production; this also
explains why the authorities have always tried by all
means to anchor the exchange rate-both nominal and
real.
2) Interest rate shocks negatively impact output and
for a much longer time (5 years), compared to those
coming from the exchange rate (3 years).
3) Against what is consistently argued by main stream
economics, inflation has a “positive effect” on output.
Although this result deserves a deeper investigation, we
could say that inflation (at a low and stable level) plays
the role of a system lubricant, and therefore expands
output.
5. Conclusions
Once the evolution of growth and inflation related to the
monetary policy in Mexico (1970-2009) has been studied,
we concluded that—in general terms—the Banco de
Mexico stabilization strategy has followed a restrictive
monetary policy even before IT was implemented. Since
the nineties, Inflation Targeting has been effective in
reducing inflation but at the cost of depressing economic

E. LORÍA ET AL.
842
activity. This is reflecting that inflation in Mexico is not
mainly a monetary phenomenon, but that conversely, it is
responding to production costs where the exchange rate
is very important due to the huge productive dependency
on imports. Therefore, depreciations are highly infla-
tionary and recessive, at least in the short run. That ex-
plains why the monetary authority acts “managing” the
exchange rate through changes in monetary aggregates
and interest rates to anchor nominal and real exchange
rates. Nevertheless, by raising interest rates, there are
huge costs for businesses and families along with raising
the public debt (payment) and consequently, depresses
economic growth and increases unemployment. This
outcome is very clear after 2000.
This is why it is essential for the monetary authority to
search for new mechanisms to provide the Banco de
Mexico with multiple targets, not only with the objective
of restraining inflation but also dealing with unemploy-
ment as well as assigning growth objectives for the
monetary policy and the exchange rate. This additional
mandate must be based on the “success” of IT. That is, to
continue in terms of transparency, reputation and credi-
bility that have been achieved. There is no doubt that
economic growth must be the most important goal to
reach since inflation (high and unstable rate, like those of
the 1980s) has been defeated.
6. Acknowledgements
This article received financial support from the research
project Determinants of Output and Employment in
Mexico, 1985.1-2006.4: A Multivariate Econometric
Approach, IN305208 DGAPA, UNAM. Javier Galan’s
participation was crucial in the elaboration of the paper.
We thank the comments of Guadalupe Mántey and Nora
Ampudia which improved the initial version, and also,
the assistance of Ariadna Díaz. The usual disclaimer
applies.
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Modern Economy, 2011, 2, 834-845
doi:10.4236/me.2011.25093 Published Online November 2011 (http://www.SciRP.org/journal/me)
Statistical Appendix
Figure 1A. Mexico: production costs, inflation & GDP, 1970-2009.
Table 1A. Unit root test variance decomposition.
ADF1 DF–GLS2 PP3 KPSS2
r 1.0544 –0.332 1.1344 44.788
∆r –2.3484 –2.889 –2.208 0.1489
p –2.090 –0.676 –2.0384 35.010
∆p –1.5526 –2.153 –1.372 0.149
y 5.392 –0.421 5.3924 0.149
∆y –2.667 –4.296 –2.515 0.1019
n –0.554 –1.330 –0.5547 3.242
∆n –4.481 –4.4927 –4.470 0.244
g 1.8895 –1.1115 –1.623 22.2195
∆g –5.7836 –5.4157 –4.396 0.3938
w –0.049 –1.5387 –0.0497 4.4817
∆w –4.766 –4.7657 –4.763 0.1008

E. LORÍA ET AL.
845
1 without trend, intercept and zero lags; 2 whit intercept and one lag; 3 without trend, intercept and three lags; 4 with one lag; 5 with six lags; 6 with intercept; 7
zero lags; 8 with two lags; 9 with trend, intercept and zero lags. Bold numbers reject the existence of unit root at 99% of confidence. The integration order of all
variables are I(1).
Table 2A. Joint test of the unrestricted VAR.
Normality Autocorrelation Heteroskedasticity
Jarque-Bera LM (6) No cross terms
Joint 122.074
(0.999)
29.372
(0.774)
541.664
(0.298)