Revisiting the fiscal deficit-inflation puzzle

• Pages: 153-158

Page 153

Governments that run persistent budget deficits must sooner or later finance those deficits through money creation, thus producing inflation. So says a wellestablished macroeconomic theory, but empirical work has had little success proving this. A recent IMF Working Paper by Luis Catão and Marco E. Terrones of the IMF's Research Department reexamines this issue and finds evidence to support the theory. The authors talk with the IMF Survey about their findings.

IMF SURVEY: Macroeconomic theory tends to associate fiscal deficits with inflation.Why have most empirical studies been unable to uncover a strong connection between the two?

CATÃO: Most of your readers will probably find this as puzzling as we did when we started working on this topic. The inflation literature seems to suffer from a kind of split personality.Wellestablished theories postulate that fiscal deficits eventually lead to inflation. But living side by side with these well-established theories are empirical studies that show that therePage 156 is no statistically significant relationship between fiscal deficits and inflation across a panel of countries. At most, these studies have found a very weak relationship. Since we work for an institution that preaches the virtues of fiscal rectitude, we were rather unsettled by this dichotomy.

We took it upon ourselves to take a more in-depth look at the issue, building on earlier research we did for a WEO [World Economic Outlook] chapter.

Do fiscal deficits lead to inflation?

One question we sought to address is why, if there really is a significant and reasonably strong relationship between fiscal deficits and inflation, other studies have not been able to uncover it.We were certainly aware that it was no mean task to pin down this relationship, and one of our main suspects was the econometric methodology.

Fiscal deficits and inflation should not necessarily be related in the short run because governments that run fiscal deficits can, at least temporarily, finance the deficit through borrowing. So, for a while, you may see no relationship at all. But it is bound to show up in the long run, because governments cannot accumulate debt indefinitely.We applied a state-of-the-art technique that allowed us to look at this long-term relationship in a large panel of countries, and that technique is one reason our results differ from others in the literature.

In our mind, the second culprit was that other studies did not allow for the fact that fiscal dominance- when the need to finance government deficits outweighs other policy concerns-varies widely across countries. For instance, fiscal dominance has been very weak in the United States over the past couple of decades or so, and this has also been so in several other advanced countries. In contrast, the fiscal authorities clearly call the shots in several developing countries, although it is important to acknowledge that new institutional arrangements in some of them have managed to tame fiscal dominance quite a bit in recent years. So we separated countries into...