The justification for inflation targeting rests on three core propositions. The first is called ‘lean against the wind,’ which refers to fact that the monetary authority contracts (expands) aggregate demand below capacity when the actual rate of inflation is above (below) target. The second is ‘the divine coincidence,’ which means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The third proposition is that of stability. This means that the inflation target is part of an equilibrium configuration which generates convergence following any small disturbance to its initial conditions. These propositions are derived from a closed economy setting which is not representative of the countries that have actually adopted inflation targeting frameworks. Currently there are 27 countries, 9 of which are classified as industrialized and 18 as developing countries that have explicitly implemented a fully fledged inflation targeting regime (FFIT). These countries are open economies and are concerned by the evolution of the external sector and the exchange rate as proven by their interventions in the foreign exchange markets. We show that these three core propositions and the practice of inflation targeting are inoperative in an open economy context.

Conventional wisdom about the business cycle in Latin America assumes that monetary shocks cause deviations from the optimal path, and that the triggering factor in the cycle is excess credit and liquidity. Furthermore, in this view the origin of the contraction is ultimately related to the excesses during the expansion. For that reason it follows that avoiding the worst conditions during the bust entails applying restrictive economic policies during the expansion (that is, the boom) in the business cycle including reining in government expenditures and reducing liquidity to private agents. In this paper we develop an alternative approach that suggests that fiscal restraint may not have a significant impact in reducing the risks of a crisis, and that excessive fiscal conservatism might actually exacerbate problems. In the case of Central America, the efforts to reduce fiscal imbalances, in conjunction with the persistent current-account deficits, implied that financial inflows, with remittances being particularly important in some cases, allowed for an expansion of a private spending boom that proved unsustainable once the Great Recession led to a sharp fall in external funds. In the case of South America, the commodity boom created conditions for growth without hitting the external constraint. Fiscal restraint in the South American context has resulted, in some cases, in lower rates of growth than what otherwise would have been possible as a result of the absence of an external constraint. Yet the lower reliance on external funds has made South American countries less vulnerable to the external shock waves of the Great Recession than Central American economies.

We argue that a fundamental difference between the various post-Keynesian approaches to economic growth lies in their treatment of investment. Neo-Kaleckian models, which are more appropriately Robinsonian models, postulate an investment function dependent on profitability, and that is partly autonomous from income. Some of these models rely on the importance of profitability, captured by the profit share, to make the case for profit-led growth. For their part, Kaldorian models, which are in our view compatible with Sraffian models, place the emphasis on the accelerator in the determination of investment. More importantly, since investment is a derived demand, that is, ruled by the adjustment of capacity to autonomous demand, there is a tendency to a normal level of capacity utilization. These are supermultiplier models. In our view the Kaldorian approach is better equipped to deal with some of the issues relating income distribution to accumulation with effective demand in an open economy in the long run. We develop an open economy model to examine the conditions under which an increase in real wages can produce wage-led growth, showing that the limit to wage-led expansion is a binding external constraint. The model is unique in emphasizing the role of income distribution in affecting real exchange rates, and it is through this channel that the ambiguous effects of income distribution on growth arise. We also provide some evidence indicating that real wages are positively related to growth, investment, and capacity utilization, and we highlight the role of finance in sustaining expansions suggesting that debt-led growth should not be identified with profit-led growth.

Hyman Minsky's financial instability hypothesis (FIH) argues that as part of the normal functioning of capitalist economies robust financial structures tend to evolve into highly leveraged fragile financial structures. The paradox of debt challenges the very foundation of Minsky's FIH as it maintains that the upward and downward phases of business cycles need not be characterized by processes of respective leveraging and deleveraging. Using a panel of firm-level data and seemingly unrelated regressions we analyse the relationship between debt and investment for 12 Latin American countries for the years 2005 (expansion) and 2009 (contraction). We reject the paradox of debt in favor of the FIH, regardless of our model specification or the choice of external financing. The FIH seems to intensify in expansions with respect to recessions, and its intensification during expansions is explained by a larger fraction of firms acquiring debt and new investment projects, rather than from further leveraging for those firms already engaged in fixed investment.