The Effect of Budget Deficits

The Effect of Budget Deficits on Inflation Rate

Chapter one

1.1 Introduction

If a government's spending exceeds its revenue, the resulting deficits have to be financed either through borrowing or issuing money. Nonetheless, borrowing is limited by the public's capacity or willingness to hold additional government debt and monetary expansion leads to inflation. Inflation generates uncertainty in economic decisions, may lower investment and output over the long-run and may, therefore, reduce the tax base and increase budget deficits. Inflation may also lead to higher budget deficits by increasing the debt service, by encouraging tax evasion or by means of delays in tax collection. Moreover, inflation lowers the value of money balances, in response to which people hold lower real balances. Hence, real revenues from money creation start to fall above some rate of inflation as inflation continues to rise.

Since World War II, it has been widely accepted that government budgets are a major instrument for regulating the overall general level of the economy, as the government itself is the largest consumer in any economy. Government spending, through fiscal policy, produces the same effect in the economy as does private spending - it raises the total aggregate income in the economy.

Budget deficits are a phenomenon experienced by many countries worldwide. Some countries benefited from them and some are affected adversely. A budget deficit is a situation where government expenditures exceed its receipts during some specified time period, usually one year. It is crucially important to distinguish between what are so called "active" and "passive" deficits.

The passive budget deficit is a deficit that was created by a decline in economic activity (recession). The primary source of revenue for government is from various tax receipts, including income taxes, corporate taxes, etc. As all these tax revenues are functions of the national income, they consequently decrease when national product falls. Hence, government plans or policies are not directly responsible for this kind of deficit.

The active budget deficit is then a deficit which is created by a conscious government policy to pump the economy or to boost growth. This kind of deficit is considered by many economists and politicians to have produced a positive contribution to a country. Yet, in many countries, with the prominent example of the United states, this kind of deficit remains controversial.

Although inflation is socially inefficient and politically unpopular, it exists and is either recurrent or persistent in many economies. Policy mistakes appear to provide an explanation for this. This explanation, however, is inadequate, because as economic agents learn from past mistakes, inflation would not be recurrent or persistent over long periods. Hence, an explanation for inflation is likely to involve governments and special interest groups that benefit from the revenues generated through inflationary monetary expansion.

Generally, there are three schools of thought concerning the economic effects of budget deficits: Neoclassical, Keynesian, and Ricardian. Whether one thinks of deficits as good, bad, or irrelevant depends fundamentally on one's choice of these views.

The Neoclassical view assumes that individuals are farsighted and plan their consumption over their life cycles. It assumes that deficits will raise total lifetime consumption by shifting taxes to the next generation. However, if the economy is at the full employment level, increased consumption necessarily implies decreased saving. Thus, persistent deficits "crowd out" prevent capital accumulation. The Keynesian view, on the other hand, emphasizes the significant impact of a deficit on aggregate demand. If the economy is at a state of underemployment, deficits will stimulate both consumption and national income. Thus, appropriately timed deficits have beneficial consequences. Under the Ricardian view, government budget deficits are a matter of indifference, since there is an inter-generational transfer.

In terms of fiscal policy in developed countries, deficit financing is considered as a means of stimulating the economy by raising aggregate demand in conditions of recession. However, in developing countries, deficit financing is mainly to stimulate growth and development.

Fiscal policy employed in today's developing and in many developed countries has lent itself to financing accelerated programs of public investment, considered to be the essence of efforts to start a cumulative growth process. Often this policy seems grounded on some implicit Keynesian assumptions, which had their ascendancy during the 1930's.

The use of government deficits are considered as the vehicle of economic development for developing countries because of their limited financial resources. But at the same time, the use of deficit financing has side effects on the general price level and the balance of payments of the country. The logic behind this is that the use of deficit financing causes an increase in the money supply, which in turn causes an increase in the price level, as the level of output cannot increase enough at least in the short run to meet the increase in demand. Furthermore, increasing the money supply also contributes to the problem of balance of payments.

There have been many debates about the effectiveness of fiscal and monetary policy. It is difficult to consider the effect of each policy since they are closely related. In considering the effectiveness of fiscal policy, one should also realize that in each fiscal period the government budget has to be balanced. To balance the budget the government will probably need to borrow either from the private sector or from the central bank. Therefore, the mode of deficit financing is an important element in determining the effectiveness of fiscal policy. Certain fiscal operations, such as public borrowings from banks, affect the money supply, while in other cases changes in the money supply may bring about transfers of purchasing power similar to that of taxation, such as when government finances its deficit by an inflationary issue of common money or bank money.

Inflation is the prime result of an increase in the money supply. Thus, a higher rate of inflation depends on whether budget deficits have led to an expansion in the money supply. If a government finances its borrowing requirements when running deficits by the sale of its debt to the central bank rather than the private sector, it is likely that a higher rate of inflation will result. This is so because it involves a higher reserve base, which, according to the traditional theory of credit multiplication by Milton Friedman, leads to creation of deposits in the banking system. This specific approach of monetization of debt is therefore one of the most important and controversial aspects of deficit financing, since an increase in the monetary base by the central bank is the equivalent of printing money.

A phenomenon which has recently been recognized in economic literature is that, in addition to the tradeoff of policy targets, the government may also be faced with a tradeoff in policy instruments. Government also faces resource constraints in the formulation of policies. Revenue available to the government for consumption and investment are limited by its ability to raise income. The government can spend only as much as it earns. If the government plans to spend more than the amount it earns, it will need to borrow. Deficit financing in turn may be counter-productive to expansion in other sectors through the well known "crowding out effect". In recent years, the notion of government budget constraints has become increasingly recognized as an important feature in the analysis of the implications of government finance.

Various studies on different countries show that the method chosen to finance fiscal deficits is an important element in the analysis of fiscal policy effects. The effectiveness of fiscal policy depends not only on the size of government expenditures, but also on the method of financing.

The purpose of this study is to contribute to a greater understanding of the impact of budget deficits and unemployment effects on inflation in Malaysia.

The main hypothesis of this study is that budget deficits lead to inflation. In addition, one of the other hypothesis will investigate the effect of unemployment on inflation rate.

The remainder of the study is organized as follows. First, the importance of this study and research questions are discussed. Then we review both theoretical and empirical studies on the relation between budget deficits and inflation rate through different school of thoughts. Finally, we illustrate the research methodology in the third chapter which followed with data analysis and results on the fourth chapter. Finally the comparison of this study results` with the pat one have been done in the fifth chapter.

1.2 Importance of Study

The current study investigates the relationship between budget deficits and inflation. For doing this, we investigate the effect of budget deficit on unemployment and consequently the effect on unemployment on inflation rate. So, the results of this research could be useful for controlling the inflation rate when governments are faced with budget deficits.

1.3 Research Questions

This research will examine the effects of unemployment and the effect of budget deficits on inflation rate in Malaysia. Therefore, the research questions are as follow:

1. Whether the budget deficits has significant effect on inflation rate in Malaysia.

2. Whether the unemployment has significant effect on inflation rate in Malaysia.

3. Which way of compensating the budget deficit has more effect on inflation rate in Malaysia.

2 Literature Review

In this section, we review the theoretical and empirical literature on the relationship between budget deficits and inflation. On the other hand, we illustrate the economical variables in Malaysia such as budget deficit, inflation rate and unemployment.

Theoretical studies that analyze the relationship between budget deficits and inflation demonstrate in the context of inter-temporal models, that inflation arises when the financing requirement implied by a path of budget deficits is either expected to lead or, in fact, leads to monetary expansion (Sargent and Wallace [1985], Drazen and Helpman [1990)). However, it is mainly the assumption of the endogeneity of monetary policies to fiscal pressures that leads to this outcome.

The first strand of empirical studies typically estimates inflation with its own lags, budget deficits and money growth as the right hand side variables. The following are some of the examples of such studies: Giannaros and Kolluri ( 1985) estimate inflation and money growth, the latter with its own lags and budget deficits as explanatory variables, and by doing this they test for the indirect effects of deficits on inflation; Choudary and Parai (199 I) include lagged inflation rates in the estimation of money growth for a hyperinflationary economy and use the estimated values of money growth to estimate inflation; Darrat (1985) estimates the causal effects of budget deficits and money growth on inflation after testing for exogeneity of government deficits using the Granger test for causality. Another group of studies (for example, Dwyer [1982] and Ahking and Miller [1985]), also provides causality tests by estimating vector autoregression systems for all three variables.

In this research we are looking for the effect of budget deficit and unemployment rate on inflation. So, the main hypothesis of this research is to investigate whether budget deficit and unemployment will affect inflation rate in Malaysia.

2.1 Government Budgeting in Malaysia

Malaysia's budget deficit is among the largest in Southeast Asia in terms of its ratio to the Gross Domestic Product (GDP). The negative budget gap, which started in 1998, occurs as a result of an expansion of government spending (pump-priming) coupled with a reduction in revenue following the recession experienced in 1998. While it was initially seen as a common phenomenon for an economy experiencing a contraction in output, a continuous deficit suddenly became an important consideration, especially among foreign investors in their decision to increase portfolio exposure in the country.

Malaysia has experienced a budget deficit of over 5% of its GDP for the past years and the lack of appetite among foreign investors for the Malaysian equity market could have been, according to some opinion, due to this factor.

A few words need to be said about budget deficits. Firstly, Malaysia is not the only country that has experienced a deficit in the last few years. Thailand, Indonesia and the Philippines also saw their governments' budgets turning negative following the Asian Financial Crisis. In developed countries like the United States, budget deficits are a common phenomenon that Americans have learnt to live with. For instance, the last budget surplus the country saw prior to 1997 was in 1969. The deficit was rolled over for more than two-and-a half decades through foreign financing.

Secondly, the well-known British economist, John Maynard Keynes, only prescribed pump-priming efforts (as a cure for recession) when other things failed. Monetary expansion is the first effort that should be used to get an economy out of recession.

Keynes however realized that there could be a situation where an economy might not respond to such a policy due to consumers' over- pessimistic views (a situation economists refer to as a liquidity trap). Only during such times should pump-priming efforts be undertaken through higher government spending.

An expansionary fiscal policy is therefore akin to a `steroid injection' that should be used only in desperate times. Once economic activities start to normalize, governments should let the private sector drive the economy. This will ultimately reduce government burdens and result in elimination of budget deficits.

Having said that, the key question is: what is the real issue? The most important is the time-frame of the deficit. In the US, the situation is a little different. Foreign money actually poured in continuously through purchases of Treasuries and other forms of capital flows and were being used to finance the deficit.

Asian countries, however, cannot depend on capital inflows (although a large sum actually poured in during the 1990s) especially after the Asian Financial Crisis.

Theoretically, when an economy starts to grow again, the budget deficit should slowly be reduced. A continuing deficit during boom time is disastrous as there could be a structural economic problem in the country.

Another key issue is the method of financing budget deficits. In some Latin American countries, budget deficits were financed through printing of money. This is a real concern among economists as money creation often leads to hyperinflation. Inflation rates of a few thousand per cent were quite common in some of these countries.

Hyperinflation is indeed a scary phenomenon. It is a situation where price tags at supermarkets are changed every 10 or 15 minutes!

Another possible consequence of having large budget deficits is high future interest rates. This happens because in an effort to finance deficits, governments normally increase bond issuance. But to induce financial market players to subscribe to these bonds, high interest rates would need to be offered.

High interest rates would in turn discourage private investment (what economists refer to as a crowding out problem) and eventually destroy growth prospects of an economy.

Fortunately for Malaysia, the budget deficit was not financed by money creation. Inflation has never run out of control. Even during the first oil crisis in the 1970s, inflation never reached 20%. Recent efforts by the Government seem to indicate its commitment to balancing the budget by 2006. This includes the postponement of the double-tracking project worth over RM14 billion.

At the same time, the Government uses a new approach in formulating the latest stimulus package, whereby the financing is shared with the central bank and development financial institutions.

While slashing development expenditure is one of the avenues to achieve the balanced budget target, the Government is also trying to ensure that such a reduction would not severely affect economic growth. Certain expenditures should continue. What is important is to ensure that those expenditures are allocated to productive areas.

With such efforts, and with a little luck from a sharp upturn in global economic activity, particularly the electronic cycle, Malaysia will be able to close up the budget gap as projected by the Government.

Interest rate is another interesting issue. With a brighter prospect of global economic recovery, it is not surprising to see overwhelming expectations of rising interest rates. There is no doubt that global growth momentum is picking up.

The US economy is expected to expand by 4.6% from approximately 3.1% in 2003. The European Central Bank (ECB) is projecting a growth rate of 1.6%, compared with a minuscule expansion of about 0.4%, while the Japanese Government is forecasting a positive growth of 1.8% in the fiscal year.

Past experience indicates that most countries started jacking up interest rates once inflationary pressure re-emerged following rapid economic expansion. This time around, however, things might turn out to be a little different.

In the US, the chief of the Federal Reserve (Fed) has indicated that interest rates can remain at the present low level due to the following reasons: First, a post-bubble economy cannot be treated the same way as other recessions. Labour market remains shaky as evidenced from an average monthly creation of only 86,000 jobs in the past five months. Economists say that 150,000 jobs need to be created every month in order to absorb new entrants to the labour force.

Secondly, capacity utilisation remains low, at around 75% compared with a 10-year average of over 80%.

Thirdly, inflation is definitely not on anyone's mind at this moment as the private consumption expenditure index (PCE), an inflation gauge preferred by the Fed, stood at 0.7% in 4Q 2003. As a matter of fact, disinflation is causing a major headache among policy-makers.

Fourthly, money supply growth is merely at 4%-5%, a rate considered consistent with price stability.

Similarly in the Euro region, growth rates remain mediocre. Having been mired in recession in the first half of 2003, growth is expected to be generated mainly through trade expansion. Germany, for instance, is counting on export growth to keep its economy afloat, following its unsuccessful effort to bring forward the proposed 15.6 billion euros worth of tax cuts.

The amount of tax reduction to be carried forward was recently slashed to half the original amount. With difficulties faced by both Germany and France to expand government expenditures due to the strict rule of the Stability and Growth Pact, the region is struggling to reinvigorate growth through other means.

At the same time, a drastic appreciation of the euro becomes another important reason for the ECB not to raise its key interest rates too soon. Should interest rates rise in the near future, the upward pressure on the euro would become more intense.

As for Malaysia, a similar situation exists. As the Government is committed to balancing its budget, fiscal policy is no longer an option to keep the economy expanding. That leaves monetary policy to play its role in accommodating economic growth.

Secondly, the current positive gap between Malaysia's key interest rate (intervention rate at 4.5%) and rates of other countries would imply that the central bank would not be too impatient to raise interest rates.

Thirdly, even if there was a rise in interest rate in the US, the positive gap that Malaysia has against the US is too wide, meaning that there is less pressure for interest rate to move upward.

With all these arguments, we feel that while Malaysia's rate may have hit the bottom part of the cycle, the probability of having an interest rise is very slim. The Government cannot afford to simply jack up interest rate at a time when it needs to focus on efforts to ensure growth stability amid a volatile global demand.

By this, one of the ways for balancing the budget in Malaysia is to increase tax which in turn may cause more unemployment. It also can affect interest rate in the same way which will investigate in this research proposal.

2.2 Historical Trend of Inflation in Malaysia

Low inflation and sustainable GDP growth has been one of the main features of the Malaysian economy in the last two decades. Despite its robust economic growth in the 1980s and 1990s, Malaysia's inflation rate had been relatively low by international standards. Even after the severe Asian financial crisis (1997 and 1998) and sharp depreciation of the ringgit in 1997-98, Malaysia's inflation rate has been contained at a relatively low level (see Figure 1).

In the early 1970s, Malaysia experienced a single-digit episode of inflation at only 2 per cent while the growth rate of GDP was approximately 7 per cent. The GDP growth rate remained the same during the second half of the 1970s while inflation rate gradually increased to 4 per cent. The sharp oil price increase in 1973 and 1974 was the principal reason for the escalation of world inflation in 1973-74. Consequently, consumer prices in Malaysia began to rise and inflation had reached a double-digit level of 10.56 per cent by the end of 1973. In 1974, the surge in oil price by over 230 per cent added strong fuel to inflation, and the inflation rate in Malaysia increased to its record high of 17.32 per cent. A year later, the Malaysian economy slumped into its great recession, with a GDP growth rate of only 0.8 per cent in 1975, compared with 8.3 per cent and 11.7 per cent in 1973 and 1974 respectively. On the other hand, inflation rate reduced to the level of 4.5 per cent in 1975.

Malaysia experienced a second episode of high prices in 1980 and 1981, which were due mainly to external factors. Oil prices rose by 47 per cent in 1979 and 66 per cent in 1981. As a result, inflation in Malaysia accelerated from 3.6 per cent in 1979 to 6.6 per cent and 9.7 per cent in 1980 and 1981 respectively. Consequently, GDP declined to 7.4 per cent and 6.9 per cent in 1980 and 1981 respectively, compared with 9.3 per cent in 1979. However, since 1982 inflation rate kept decreasing, and it amounted to less than 1 per cent in 1985 and 1986. The development of the Malaysian economy was at an important crossroad in 1985. The economic performance of the country slumped into its greatest recession: -1.1 per cent and 1.1 per cent growth rates were recorded in 1985 and 1986 respectively. The severity of the international economic recession during the early 1980s imposed considerable constraints on the growth and development of the nation in 1985 and 1986.

After registering a significant growth of more than 9 per cent for three consecutive years, with inflation rate as low at 2.6 per cent, the economy in 1990 strengthened further in the country despite some slowing down of growth in the industrial countries. Although inflation rate increased, on average, to 3.9 per cent during the period 1991-96, the growth rate of GDP continued to increase and reached 9.6 per cent. However, with the outburst of the financial crisis in Asia in 1997, interest rates, fuel prices, and prices of goods and services have increased. Robust foreign demand as a result of the depreciation of the Malaysian ringgit (RM) of over 40 per cent placed an extremely powerful inflationary pressure on Malaysia. As a result, inflation rate increased to 5.3 per cent in 1998, compared with 2.7 per cent in 1997. Consequently, in 1998, Malaysian economy experienced a sharp decline in the growth rate of GDP from positive growth rate to negative, at -7.4 per cent, compared with 7.3 per cent in 1997. Between 2000 and 2005, inflation rate stabilized and remained approximately around 1.7 per cent with relatively low growth rate of GDP of only 5.2 per cent.

Generally, Malaysian inflation rate is controlled by the government. Malaysia exhibits an exceptional feature in terms of inflationary experiences; the economy had experienced high (1973-74, 1980-81) and low (1985-87) regimes of inflation, and was able to contain a low and stable inflation during the high economic growth period of 1988-96. The achievement of this relatively low inflation during the high economic growth regime was attributed to the effective and consistent policy mix adopted by the Malaysian government (Cheng and Tan 2003, p. 423). Cheng and Tan (2003, p. 423) indicate that, besides domestic factors, which include private consumption, government expenditure, interest rate and money supply, external factors, such as increased fuel prices, also have a significant influence on Malaysian inflation resulting in a negative impact on growth. In order to test the threshold effect of inflation, Figure 2 provides a more direct view of the inflation-growth association by plotting the average GDP growth rate against average inflation rate.

This analysis is done by reducing the whole sample of observations into six observations, according to the degree of inflation rate; by calculating average inflation rate and corresponding average growth rate of GDP within each range of inflation rate (i.e., inflation rate = 1 per cent, 1 per cent < inflation rate = 2 per cent, and so on). This data-reductioning procedure makes two key features of the data immediately apparent. First, it is clearly evident from Figure 2, that there is a non-linear relationship between inflation rate and growth rate of GDP. Second, this non-linearity shows positive relationship between inflation and growth up to 4 per cent level (approximately); and beyond that level there is negative relationship. The initial conclusion drawn from this analysis is that the threshold value is around 4 per cent.

3.3 Budget Deficit, Unemployment and Inflation Rate

It has been increasingly recognized in re­cent years that expanding government bud­gets may contribute to "cost inflation," that is, inflation that does not require high or rising levels of capacity utilization. A basic idea is that higher taxes, to finance increased government spending, are directly or indi­rectly shifted onto product prices - a phenomenon that has been baptized "tax-shift inflation."

Not only are various types of indirect taxes, such as sales taxes, value-added taxes, payroll taxes, taxes on intermediary inputs, etc., as­sumed to be' shifted onto the prices of final output, it is also assumed that private agents try to compensate themselves, in the form of higher nominal factor prices, for reductions in real after-tax income due to actual or ex­pected tax increases. Indeed, in the case of higher (expected) indirect taxes on consumer goods, this idea is already embedded in the expectations - augmented Phillips curve. Though tax-shift inflation may occur also in the case of increased income taxes, there is an important difference between the two cases. With higher indirect taxes (and possi­bly also taxes on profits, as constructed in reality), firms first experience (or expect) higher production or sales costs, which are shifted onto product prices. These in turn create demands for higher factor prices, wages in particular, in a second round. With higher income taxes for employees, by con­trast, shifting onto higher product prices pre­supposes tax shifting onto higher factor prices (wage rates), at the outset, with second-round effects on product prices.

Regardless of whether a tax shift on factor prices, induced by an expansion of the government budget, comes from the reac­tions of individual employees in some sub­markets (for labor), or from more aggressive bargaining by unions in other submarkets, the phenomenon may be depicted as an up­ward shift of an aggregate supply curve for output in price-output space. Thus, a tax-shift impulse as the government finances its in­creased spending strengthens the depressive effect on output, and moderates the defla­tionary effect on prices.

The likelihood that such events will gener­ate a process of continuing cost inflation, rather than a once-and-for-all increase in the price level, is, of course, greater for recurrent expansion of the government budget than for a once-and-for-all increase in the budget. Moreover, for such a process to lead to sub­stantial price increases without heavily re­duced output, not only monetary accommod­ation and/or higher labor demand by the government sector, but also a depreciation of the currency, is necessary (if other countries do not inflate at about the same rate).

To probe deeper into the relation between budget expansion and cost inflation, it is useful to take a closer look at the results of past study who investigate this area.

Lindbeck (2001) argued that although there are several reasons to expect a positive and causal connection between the size and rate of increase of the government budget on the one hand, and cost inflation on the other, that, of course, does not mean that we should expect a sim­ple statistical correlation between these phe­nomena. Indeed, cross-country regressions from the post-World War II period for highly developed countries do not reveal any posi­tive association between inflation and the size, or rate of expansion of the government budget. Therefore, country dif­ferences in the rate of inflation, at least so far, have been dominated by other dissimi­larities between countries that are relevant for inflation, such as domestic capacity utili­zation, the strength of the full-employment, guarantees, monetary and exchange rate policy, the behavior of labor unions, etc. Moreover, in a world with rather fixed ex­change rates, as before the early 1970's, the long-term inflation trend in individual coun­tries is to a considerable extent tied to the inflation trends of the world economy, rather than to domestic demand and cost- push factors.

Choudhary and parai (1991) used the quarterly macro data of Peru to investigate the effect of budget deficits on the inflation rates. They assert that the country's huge budget deficits as well as high rates of growth of money supply do have significant impact on the high inflation rates during 1973-1988. There are two policy implications that emerge from this study. First, in order to control its high inflation rates (e.g., the annual average rate of 3564% in 1989, Peru needs to cut the size of government deficit perhaps by denationalizing its numerous public sector undertakings and also by cutting the size of its bureaucracy drastically. The policy of cutting Peru's government expenditures to control domestic in­flation is also advocated by Corsepius (1989) (see p. 10 for details).

Second, the Peruvian experience of near-hyper­inflation and massive budget deficits would send a dual signal to the recently democratized countries in South America and Eastern Europe. Democracy by itself could not uplift the economic condition of these countries or their populace until and unless (1) they take concrete and immedi­ate steps to install private initiatives in every sphere of economic life, and (2) they invariably limit the sizes of their respective governments to the minimum. Otherwise, they could end up with the same fate as that of Peru where, in Dornbusch's words, ' ... the end of the story may be written in the streets of Lima' (Dornbusch, 1988).

Smith (1985) explained that in economies where adverse selection problems arise in labor markets, if government expenditures are sufficiently large (in real terms), it may be impossible for the government to balance its budget. Thus, a decision on the part of the government to make large expenditures may, by itself, commit the government to inflationary finance schemes. Moreover this is true even if the government may levy arbitrary lump-sum taxes.

Rahman (1996) described, Whether the budget deficits will be inflationary or not depends on how the deficits are financed. Financing by internal borrowing or taxation is likely to depress private spending along with a rise in government spending. Hence the net effect on the general price level is likely to be ambiguous. The case of financing by external borrowing may, in fact, subdue the inflationary pressure by improving the supply of goods through increased imports. In contrast, any monetization of the budget deficits will intensify the inflationary pressure. The real budget deficits would appear to be a cause of changes in the general price level and hence the real exchange rates. Inflation rates and exchange rates ought to be correlated to each other if the purchasing power parity (PPP) theory holds. But in many cases, it did not empirically hold. The anecdotal empirical evidences on the validity of the purchasing power parity are ambiguous and suggestive (Frenkel, 1981; Dornbusch, 1987; Taylor, 1988; Abuaf and Jouron, 1990; Kim, 1990; Kugler and Lenz, 1993; Dutt and Ghosh, 1995; In and Sugema, 1995; Reinhart, 1995).

Sargent and Wallace (1981) have supported the proposition that the central bank will be obliged to monetize the deficit either now or in later periods. Such a monetization therefore results in an increase in the money supply and in the rate of inflation, at least in the long-run period. The empirical relationship between deficit growth and price level growth has been studied extensively for developed countries, especially the United States (Grossman, 1982;King and Plosser, 1985; Protopapadakis and Siegel, 1987). For developing countries there is relatively less empirical investigation (Dornbusch and Fischer, 1981; Bhalla, 1981; Siddiqui, 1989). Empirical studies have found a weak relationship between budget deficits and inflation in the static or dynamic sense (Grossman,1982; Hamburger and Zwicj, 1981; Hein, 1981). On the other hand, other economists have found evidence to support the proposition that higher deficits increase inflation (Dorbusch and Fischer, 1981; Miller, 1983). For Greece, Dogas (1992) found that public deficit exerts an influence on inflation.

Hondroyiannis and Papapetrou (1994) empirical findings suggested that there is a long-run relationship between PSBR and price level in the Greek economy. In addition, it is observed using Granger-causality test that there is a bidirectional causality between the two variables. The results of the error-correction model suggest that an increase in the public sector net borrowing requirements results in an increase of the inflation rate with a lag of one year. The last result is expected, since typically there is a lag of one year as a result of the enormous amount of additional deficit which typically appears at the end of the year, resulting in additional monetization of fiscal deficits which increases the rate of inflation. A period of time is necessary for the economy to adjust in the new monetary policy; the monetization of fiscal deficit with a one-period lag therefore affects the rate of inflation in the current period. This result indicates that inflation is affected by the rate of growth of the public sector net borrowing requirement.

One extensive study about the relationship between budget deficit and inflation is, 'Budget deficit and the inflationary process in developing countries', written by Aghavali and Khan in 1978. With the help of an application model, it observes that the relationship between budget deficit policies and inflation has been shown in four countries Brazil, Columbia, the Dominican Republic and Thailand. The important point here is that, in their estimation, this group of countries has experienced the in­flationary process.

Chaudhary and Ahmad (1995) studied the issue of monetary supply, deficit and inflation in Pakistan. With the use of an extensive model based on the quantity theory of money, the relationship between budget deficit, monetary supply and inflation was researched. The results showed that financing the budget deficit from internal sources, especially using the banking system, increased inflation in the long run. On the other hand, the results also confirmed the hypothesis of the presence of a positive relation­ship between budget deficit and inflation during the inflationary period seen in Paki­stan in the 1970s.

Ozmucur (1996) studied the relationship between the general level of prices and budget deficit in Turkey. With the use of cointegration tests, he showed that budget deficit growth had a positive effect on increased price levels in Turkey.

Piontkivsky et al (2001) studied the impact of budget deficit on inflation in Ukraine. This research analysed the dynamics of the Ukraine budget deficit and infla­tion, utilizing the class non-structural vector auto regression (VAR) models. Based on monthly data from 1995 to mid-2000, the major finding in the VAR specification was that the fiscal imbalance, apart from other, purely monetary, factors, did play a role in determining inflation.

Over the past two decades, issues concerning the relationship between govern­ment budget deficit and the inflationary process have been among the most important economic concerns in most developing countries. In Iran, years before and after the Islamic Revolution, the government mostly had to contend with budget deficit. It was in this way that inflation became a persistent problem for the Iranian economy. Some­times, in economics, there is a relationship between budget deficit and inflation. This is because dealing with the budget deficit depends on a special manner of financing. In other words, if a government budget deficit requires assistance from the central bank, this can have a knock-on effect for inflation.

Alavirad and Athawale (2005) investigated the relationship between budget deficit and prices in the short and long run, based on the univariate cointegration test and ECM in Iran. In the ARDL approach to the cointegration test, the existence of a positive re­lationship in the long run between the government budget deficit and price levels is verified. In the study from the Phillips-Hansen cointegration test for confirming the mod­el, sensitivity was used in the econometric methods. As it was observed, the results of the Phillips-Hansen approach from both quantitative and qualitative points of view show that to a very large extent for the ARDL approach to cointegration they are symmetri­cal. In analysing the behaviour of variables in the short run, the ECM was used. Their model's results showed that budget deficit and liquidity in the short run, and related to the long run, have less of an effect on price levels. On the other hand, the coefficient of error correction was estimated at -0.2. This value shows that the adjustment speed is relatively slow.

In another research Byung (2002) emphasized the effect of budget deficit. He explained that The Soviet authorities simultaneously increased subsidies and investment by an amount which exceeded monetary resources in the middle and late 1980s. Increases in household money income and the budget deficit suggest that Soviet consumers were more likely to suffer from repressed inflation or shortages during this period.

Levin (2003) showed that When the large deficit of 1945 in USA (caused by World War II) created an imbalance of $39.5 billion, the inflation rate grew by 4.6 points the following year. I The apparent confirmation in this case shows us that it took one year before the budget rise was translated into an inflation rise. Two years later, in 1947, the Consumer Price Index rose 8.4 points. So in this period the duration was two years.

A budget surplus of $13.4 billion was attained in 1947. The rise in the rate of inflation dropped from 8.4 in 1947, to 5.2 in 1948, and all the way down to minus 0.7 in 1949. Again the effect was first felt after one year, and the maximum reached after two years; and again the direction of the change in the rate of inflation followed in the footsteps of the change in the federal budget. The 1950 budget contained a surplus of $9.1 billion and this was translated to a reduction in the inflation rate from 5.7 in 1951, to 1.7 in 1952, again a lag of one year. The drop continued until 1955, five years later, when the maximum was reached-a lag greater than in the two previous instances.

The budget was out of balance again in 1952, but this time the effect on consumer prices took four years to materialize. We must widen the possible span for the first effect from one year to four years.

Nevertheless, a definite pattern seems to be ap­parent with inflation rising or falling about a year after the change in the federal budget, and reaching its maximum from two to five years later. In 1955 the budget was reversed from a $5.9 billion deficit to $4 billion surplus, an improvement of almost $ JO billion. Immediately consumer prices reacted, this time in the same year. So' in some cases the lag may be less than a year.

The budget shortage rose to $10.2 billion in 1958, and the effect was felt two years later when the inflation rate began to rise again. The budget overage of $3.5 billion in 1960 produced a reduc­tion in the rate of inflation of 3.8 points in 1961, peaking in the same year. The years 1962 to 1966 produced no significant change in consumer prices, again following the pattern set by minor changes in budget.

But a sizable deficit of-$12.3 billion in 1967 did bring an increase in the Consumer Price Index the following year, and a peak rise of 6.5 in 197o-three years later. Another surplus-this time $8.1 billion in I 969-was followed by slowing inflation in 1970, after a two year lag, and peak deceleration after three years. From 1970 through 1972, Congress went on a spending spree, with deficits totalling $48.3 billion for the three years. This spree undoubtedly was the principal culprit behind the 9.3 point rise in prices in 1973, (using the 12 month period to September 1973, the latest figures available at this writing). Even without the world shortage of food, and even if the dollar had not been devalued, of itself this budget deficit would have brought on an increased rate of infla­tion in 1973.

The accompanying table makes it clear that the average change in the rate of inflation was a reflec­tion of an earlier deficit change in the same direc­tion. The relationship shows up even better in the graph, where a comparison of the timing of budget deficit points (capital letters) with that of resulting changes in the rate of inflation (small letters to correspond) reveals that the cause and effect were present in every comparison without exception. The calculated averages of both of these two columns in the table show that the effect is usually felt first in one and a half years, on average; and that the maximum effect is felt in about two and a half years, with the duration of the changed trend being at least that long.

To sum up Levin`s findings: Every increase in the federal budget deficit since 1945 (over a quarter of a century) has invariably resulted in a cor­responding increase in the acceleration of in­flation; and every surplus has produced a slow­down in this rate. There have been no ex­ceptions.

TABLE 1. Relative Timing Federal Budget Deficits and Increased Inflation.

Year        Budget Deficits (-)          Resulting             No. of Yrs.           No. of Yrs. 
            and Surpluses   (+)          Change in             Until Change          to Reach Its 
            in billions of $             Rate of               First Felt            Maximum 
1945           $39.5                                               1                    2 
1946          +       3.5                 + 4.6                     2                    2 
1947          +      13.4                 + 8.4                     1                    2 
1948          +       8.4                 + 5.2                     0                    1 
1950          +       9.1                 + 0.7                     2                    5 
1951          +       6.2                 + 5.7                     1                    4 
1952                  3.8                 + 1.7                     4                    5 
1953                  7.0                 + 0.6                     3                    4 
1954                  5.9                 + 0.4                     2                    3
1956          +       5.7                 + 1.2                     2                    3 
1958          .      10.2                 + 2.3                     2                    2 
1960          +       3.5                 + 1.4                     1                    1 
1961                  3.8                 + 0.9                     1                    4 
1967          -      12.3                 + 2.8                     1                    3 
1968                  6.5                 + 4.2                     0                    2 
1969          +       8.1                 + 5.6                     2                    3 
1970          -      12.9                 + 6.5                     0                    3 
1971          -      22.2                 + 5.0                     2                    2 
1972          -      15.9                 + 4.0                     1                    1 
1973 (12 months to Sep.)                  + 9.3            
Average                                                             1.47                 2.6 
                                                                    Years                Years

Darrat (2002) investigated empirically the direct linkage between inflation and other important macro variables in the case of the U.K. and the U.S. using quarterly data from 1960 through 1982. The empirical results consistently suggest the following inferences: For the U.K., among the various potential deter­minants of inflation, wage growth and budget deficits appear to be the significant sources of the British inflation. The results also show that money growth in the U.K. plays no significant role in the inflationary process. Moreover, wage growth substantially dominates budget defi­cits in predicting inflation in the U.K. economy. As to the U.S. infla­tionary experience, the empirical results suggest that budget deficit is not a significant variable for the U.S. inflation. Rather, inflation in the U.S. seems to be significantly linked to wage growth and money growth. Contrary to many previous empirical studies, the empirical evidence presented in his research strongly indicates that, as in the case of the U.K. inflation, excessive wage growth is the prime determinant of the U.S. inflation. In summary, his empirical findings lend strong support to the wage-cost markup theory as a credible explanation of inflation in both the United Kingdom and the United States. Therefore, Reduction in the excessive money growth in the U.S. and reduction in the escalating budget deficits in the U.K. can be important ingredients in any anti-inflation policy. Perhaps more importantly, the empirical evidence presented in his paper also indicates that reduction in the growth of money wages is the most dominant force to moderate inflation in both the United States and the United Kingdom. In the 1980-83 period, such reductions in money wages have been achieved in both countries through deliberate recessionary policies forcing labor unions in key industries to settle for low (or zero) wage increases. Surely, an incomes policy more compati­ble with full employment could be devised to control inflation.

Empirical studies investigating the links between budget deficits, money growth and inflation have yielded conflicting results. King and Plosser (1985) consider 12 countries and conclude that budget deficits do not contribute significantly to money growth or inflation. Similar results are reported by Joines (1985) for the USA, Karras (1994) for 32 countries and Sikken and Haan (1998) for 30 developing countries. In contrast, Edwards and Tabellini (1991) find that inflation rates are determined by deficits in a sample of developing countries. The results of Favero and Spinelli (1999) support the hypothesis that the links between deficits, money, and inflation are not invariant to a policy regime change towards central bank independence in Italy. Metin (1998) considers Turkish annual data (1950-1987) and finds that budget deficits and debt monetization significantly affect inflation. The results by O zatay (2000) suggest that inflation adjusts to a monetary disequilibrium caused by budget deficits in Turkey.

Tekin (2003) investigated the long-run relationships between budget deficits, inflation and monetary growth in Turkey considering two alternative trivariate systems corresponding to the narrowest and the broadest monetary aggregates. While the joint endogeneity of money and inflation rejects the validity of the monetarist view, lack of a direct relationship between inflation and budget deficits makes the pure fiscal theory explanations illegitimate for the Turkish case. Consistent with the policy regime of financing domestic debt through the commercial banking system, budget deficits lead to a growth not of currency seigniorage but of broad money in Turkey. This mode of deficit financing, leading to the creation of near money and restricting the scope for an effective monetary policy, may not be sustainable, as the government securities/broad money ratio cannot grow without limit.

Neyapti (2003) investigates the relationship between budget deficits and inflation with the view that the nature of this relationship depends on the characteristics of monetary and financial institutions. The main hypothesis of his study is that budget deficits lead to inflation primarily when the central bank is not independent and when the financial market is not devel­oped. The current empirical analysis explores the relationship between budget deficits and inflation in a sample of 54 developed and less developed countries, each with 10 to 20 years. This analysis explicitly accounts for the varying degrees of CBI and FMD. In view of the factors that may conceal or eliminate the contemporaneous relationship between budget deficits and inflation, this research investigates their lagged relationship. To overcome possible estimation problems due to the dynamic nature of the relationship and the unbalanced nature of the panel, the estimation is performed in first differences, using a two-stage procedure by which instru­ments are formed by GMM.

Estimation results suggest that budget deficits have a significant positive effect on inflation. The results also suggest, however, that this effect is largely attributable to low degrees of CBI and FMD. This finding is also robust to sample selection; in the absence of CBI and FMD, deficits have a positive effect on inflation in high as well as in low inflation samples. Even though we observe that in sam­ples with relatively low inflation rates (less than 50%) deficits do not, on average, have a positive effect on inflation, this effect recovers when one accounts for the degree of CBI and FMD. The findings remain generally similar in nature in the less developed countries as in the entire sample as well.

Please be aware that the free essay that you were just reading was not written by us. This essay, and all of the others available to view on the website, were provided to us by students in exchange for services that we offer. This relationship helps our students to get an even better deal while also contributing to the biggest free essay resource in the UK!