A test of the credibility-enhancing role of the IMF: The case of Mexico

The International Monetary Fund (IMF) might have an impact on a member country's economy in two ways: through the financing it provides (the direct or the financing effect) and through enhancing the agents' confidence in government policies and/or the sustainability of these policies (the indirect or the credibility effect). The effectiveness of IMF supported programs in developing country crises has been discussed and studied frequently since the early 1980s. The evidence from the existing literature, comprising mostly cross-section analysis of a group of IMF-program countries, is mixed, with no consensus on the methodology best-suited to study the effects of IMF programs. With the exception of a few studies, the impact on the inflation rates of IMF-supported programs is found to be insignificant. This paper studies the effect of “the IMF” and “IMF programs” on the inflation rate in Mexico during 1980–1999, focusing more on the credibility effect rather than the financing effect. The credibility effect is allowed to work through the inflationary expectations of the agents in the economy. The use of a Markov switching model with time-varying transition probabilities makes it possible to capture the time-varying nature of agents' perceptions of the state of the economy (a high inflation state vs. a low inflation state). The empirical estimation of the model suggests a significant “direct” effect of IMF programs, but provides no evidence for a pure “credibility” effect. While the presence of an IMF program helps to reduce inflation, favorable news regarding the IMF, preceding or during a program period, is not sufficient to convince the agents to change their perceptions of the state of the economy.