Inflation Dynamics in a Small Open Economy: An SVAR Approach

Abstract

This article proposes a structural vector autoregression (SVAR) to study the forces driving inflation in Costa Rica, a small open economy. We estimate the model using Bayesian methods and combine several identification strategies. The resulting historical decomposition attributes inflation dynamics to structural drivers, including supply, demand, exchange-rate, and monetary-policy shocks, classified according to their global or domestic origin. The historical decomposition attributes the inflation surge from 2021Q4 to 2023Q1 primarily to global factors. The subsequent disinflation from 2023Q2 to 2024Q1 reflected both a decline in global inflationary pressures and additional downward pressure from domestic factors. Domestic monetary-policy shocks contributed little to realized inflation, averaging about +0.07 percentage points per quarter. Long-run expectations remained considerably more stable than headline inflation, while the model implied inflation target displayed a gradual downward drift and its associated shock contributed to the initial disinflation. Taken together, these results identify relative resilience, but not perfect alignment, of the perceived nominal anchor and highlight the implicit inflation target as a useful indicator for evaluating Costa Rica's inflation-targeting regime.