BUDGET DEFICITS AND INFLATION

i) Closed Economy: Unpleasant Monetarist Arithmetic

Consider the following GNP (Y) identities: Y = C + I + G + CA S = I + CA . (SPt - IPt) + (SGt - IGt) = CAt. where Y = GNP, C = Private consumption, I = Investment, G = Government consumption, CA = Current account of the balance of payments, S = Savings (private sector savings S P plus public sector savings SG), I = Investments (private sector investments IP plus public sector investments IG). In a closed economy, CAt = 0, thus (SPt - IPt) -(SGt - IGt) = 0 meaning that, public deficit must be matched by private surplus, or vice versa. Consider the following closed economy government budget constraint: (SGt - IGt) = Dtg = Dt + rtBt = (Bt - Bt-1) + (Mt - Mt-1) = Bt + Mt (1) where Dg is the total public sector deficit to be financed, D is the primary deficit (i.e., excluding interest payments), B is the outstanding stock of government bonds and treasury bills, M is the stock of base money, and r is the relevant interest rate. This identity can be referred to as the government budget constraint if we consider that there is an upper limit to the size of the real stock of publicly held interest bearing government debt (government bonds) relative to the size of the economy. It is often argued that monetization of budget deficits is the basic cause of inflation especially in developing countries. Budget deficits are inflationary in the monetarist framework only to the extend that they are monetized. According to Sargent and Wallace1 (1981), on the other hand, the monetarist arithmetic may be misleading as it ignores the fact that governments are constrained by their intertemporal budget. According to Sargent and Wallace (SW), tight money may lead to an unsustainable debt finance process and thus higher inflation in the long-run. A tight monetary policy (for example Mt = 0) implies that the deficit must be financed solely through newly issued bonds Bt. By definition, if the (real) interest rate exceeds growth rate of real GNP, then the debt/GNP ratio must rise under a tight monetary policy. Rising debt, increases the deficit and hence leads to ever increasing debt and debt ratios. SW notes that, there is a limit to the ratio, therefore the tight monetary policy must be loosened at a time not later than the ratio exceeds the critical level. SW also shows that the increased interest expense by tight monetary policy forces government to print money at a faster rate than would have been necessary had it been chosen at the outset to finance the deficit by printing money. Consequently, a bond financed deficit could ultimately be more inflationary than a money financed deficit. In this framework, inflation is a fiscaldriven monetary phenomenon, and nominal monetary growth is endogenously determined by the need to finance exogenously given deficit to satisfy the budget constraint. In the fiscal theory of the price level (FTPL), on the other hand, there is virtually no role for money in the determination of prices in a non-Ricardian world. According to the FTPL prices adjust to nominal private sector wealth increases resulting from bond financed deficits. In this non-Ricardian world, inflation is a symptom of too much nominal wealth chasing too few goods. The existence of the government budget constraint simply indicates that monetary and fiscal policies cannot be independent of each other as often noted by standard undergraduate textbooks. That is, under the budget constraint, it may not be, for example,
Sargent, T. and N. Wallace (1981). Some Unpleasant Monetarist Arithmetic, Federal Reserve Bank of Minneapolis Quarterly Review, 1-17.
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meaningful to discuss the relative effect of fiscal and monetary polices (recall the textbook section on the Monetarist/Keynasian debate). This is simply because, monetary policy actions have repercussions for fiscal policy settings and vice versa. Sargent and Wallace (1981) also argue that, if money demand is also a function of "rationally" formed expectations of the inflation rate (in the sense that, "the current price level depends on current and all anticipated future levels of the money supply" (p. 166)), then "tighter money today might fail to bring about a lower inflation rate and price level even today" (p. 167). Thus Sargent and Wallace, (1986, p. 159) commenting on the dilemma of the FED in the early 1980s note:
"With the budget persistently in deficit and real interest rates exceeding the economy's growth rate, the FED must choose between fighting present inflation with "tight" monetary policy now or fighting future inflation with 'easy' monetary policy now. Put differently, without help from the fiscal authorities, fighting current inflation with tight monetary policy must eventually lead to higher future inflation".

Sargent and Wallace (1981) and the government budget constraint remind us the fact that monetary and fiscal policies are not independent of each other. The degree of interdependence is not mechanical, and depends critically upon the policy regime, institutional structure, the degree of the financial development of an economy, and the existence of international capital mobility.

ii) Closed Economy: Domestic Debt Dynamics

The budget constraint given by equation (1) can be expressed as a share of nominal income PX: D/PX + rB/PX = B/PX+ M/PX The Debt/GNP growth rate (B/PX) is: (B/PX) = (PXB - B PX)/P2X2 = B/PX + (B/PX)(PX/PX) (2) Nominal income growth PX/PX is the sum of inflation () and real income growth (Xg). Thus, (B/PX) = B/PX + (B/PX)( + Xg) (B/PX) = D/PX + rB/PX - M/PX + (B/PX)( + Xg) (3) (4) From (1), B/PX = D/PX + rB/PX - M/PX. Inserting B/PX into (3) gives: As PX = Y (nominal income), M/PX = (seigniorage as a share of GNP), (4) can be written as: (B/Y) = D/Y + (r - Xg - )B/Y - Or, using, r - = i (real interest rate): (B/Y) = D/Y + (i - Xg)B/Y - (6) (5) (1)

iii) Debt, Deficits and External Constraint in an Open Economy

For an open economy, the budget constraint given by (1) can be written as: (SGt - IGt) = Dtg = Dt + rtBt + rftB*t Et = Mt + Bt + B*t Et, (7) where B* is the foreign exchange value of the outstanding stock of external debt, r f is nominal foreign interest rate on the external debt, and E is the nominal exchange rate (domestic currency per foreign currency). The identity given by (7) states that the deficit D tg must be financed either through monetary expansion (M), domestic (B) or/and foreign (B* E) borrowing. From the national income identity, we know that (SPt - IPt) + (SGt - IGt) = CAt. If there is capital mobility, (7) indicates a possibility of substitution between foreign and domestic financing, where the rate of substitution is determined by (ceteris paribus) relative costs of borrowing. Capital mobility allows governments to get advances against future income to meet current debt obligations at an exogenously determined interest rate. However, this is not without a limit. Analogous to the closed economy domestic bond finance case, the supply of foreign bonds are eventually constrained by the solvency requirement that the value of the external debt should not exceed the present discounted value of future non-interest current account surpluses. A binding constraint on the availability of the external finance, therefore, can make the current account deficit unsustainable. Consider an imperfect capital mobility regime where the capital flow depends on expected risk-adjusted returns subject to the long-run solvency constraint and degree of openness of an economy. We can assume that a borrowing small open economy is faced with an upward sloping supply curve, or at least with a supply curve that, at some point, turns steeply upward. The risk-inclusive flow supply curve can be defined as rft = rwt + S*t(.) + t,
w

(8)

where r is the exogenous world interest rate (usually proxied by the London Interbank Offered Rate, LIBOR), S*(.) is the risk premium, rf is the risk adjusted interest rate, and is a shift variable to represent shifts in the foreign supply as a consequence of political factors. The risk premium S*(.) can be taken as a function of the external debt-GNP ratio, B* E/Y which is closely related with the expected probability of an insolvency and/or the "creditworthiness" of a debtor country. The interest rate rf increases with the perceived default risk by lenders, and at some point of indebtedness, the supply curve may turn steeply upward, or it may even slope backwards, due to credit rationing. The cost of the debt in terms of the domestic currency is r*t = rft + (E/E)et (9) For the domestic debt finance, a risk-inclusive demand curve for the domestic bond can be defined as: rt = rrealt + (P/P)et (10) The capacity of the financial system relative to the amount of the debt to be financed is not without a limit, and as the domestic debt-GNP ratio rtBt/Y increases, potential bond buyers are more likely to attach an higher default risk to the bonds. In the Fisher identity (10) we assume that the expected inflation rate embodies the domestic risk. Considering the external debt supply equation (8), the asset market flow equilibrium condition can be written as rrealt = rflt + (e/e)et (11) where (e/e)e is the expected real exchange rate depreciation. Although capital mobility can allow a wider option for debt finance, it at the same time may imply severe restrictions on the scope of a government policy if asset markets are linked

internationally in terms of risk adjusted returns. Equation (11) sets the rules of the game for the domestic debt finance: as long as the domestic interest rate is lower than the alternative return there will be capital outflow. The increase in the debt stock is eventually constrained by the solvency requirement. The necessary condition for the long run external debt stock equilibrium is that the country runs a non-interest current account (NICA) surplus which is just enough to service the net external debt (namely the long run current account balance is zero). Under the assumption that all external debt is public, the external balance condition must be matched with the internal balance condition that the PSBR is zero. This implies that the primary deficit plus the money finance equal to the debt (external and internal) service in the long run. The adjustment process is closely related with the transfer problem. By definition, a binding constraint on external borrowing increases the government's reliance on domestic resources to finance the deficit. That is, the solvency constraint rules out everlasting "Ponzi games": The country cannot forever pay the interest on the debt simply by borrowing more. Sooner or later, the country may be cut off from new borrowing, and it may have to make an external transfer (that is, it may have to pay for its debt servicing from domestic sources). Since most of the debt is public (or de facto publicly guaranteed), to make the net external transfer, it is necessary to make a net positive transfer from the private sector to the public sector (internal transfer).

DOMESTIC DEBT FINANCE AND THE MONEY SUPPLY PROCESS

EMPIRICAL MONEY MEASURES (CBRT): CC M1 = CC + DD M2= M1 + TD M0 = CC + BR BALANCE SHEETS (Simplified): Central Bank DCGCB DCPCB NFACB NFADMB Deposit Money Banks DCGDMB DCPDMB BR Banking System

M2Y = M2 + FXD

Assets

Liabilities
CC BR TD

Assets

Liabilities
DD TD FXD

Assets
DC NFA

Liabilities
CC DD TD FXD

DCG = DCGCB + DCGDMB , DCP = DCPCB + DCPDMB , DC = DCG + DCP; NFA = NFACB + NFADMB

Note that:
M0 = DCGCB + DCPCB + NFACB DMBA = BR + DCGDMB + DCPDMB + NFACB M2Y = (DCGCB + DCGDMB )+ (DCPCB + DCPDMB) + (NFACB + NFACB ) where, DMBA is deposit money bank assets. The Public Sector Borrowing Requirement (PSBR) must be financed by borrowing from or selling securities to the central bank, the deposit money banks, the non-bank private sector and/or the rest of the world. Central Bank Finance: When the PSBR is financed through the CB then both M0 and M2Y increase by the same amount. With BR constant, the increase in the DCGCB needs to be financed via issuing currency. This can have a further expansionary impact on the broader monetary aggregates as the CC/DEPOSIT increases (via the multiplier mechanism). The CB finance is often called debt monetization as it increases the money supply. This had been the main domestic debt finance method in Turkey until mid-1980s.

Non-bank private sector finance: The sale of government debt to the non-bank private sector provides, in the first instance, non-monetary finance of the PSBR. The sale of government securities to the public implies a shift of money from the private sector to the government and back to the private sector when the money is spent. The items in the money balance sheets are not affected by these transactions, therefore, the financing of the PSBR by issuing debt to nonbank private sector has no effect on money supply. However, this financing method may lead to an upward pressure on interest rates in the credit markets. The ultimate effect on the money supply depends on CB's response with regard to interest rates. Deposit money bank finance: The first-round effect of financing the PSBR through the deposit money banking system is to increase the assets of DMBs via DCGDMB . The asset shock can lead to higher loan interest rates so that the DMBs can offer higher rates on deposits for the adjustment of the liability side. If there is no effective control on the deposit creation, then there will be a simultaneous increase in both sides of the balance sheets, and M2Y will increase by an equivalent amount. The increase in the reserve money will be determined by the RRR and the change in the deposit liabilities. Effective controls on money/deposit creation, on the other hand, can lead to a substitution amongst the items of the asset side. In such a case, the expansionary impact of this mode of financing will be determined by the degree of substitution between the assets. In the literature, the substitution between DCGDMB and DCPDMB is often called financial crowding out. In the extreme case, the total quantity of bank loans is assumed to be constant, and thus an increase in DCGDMB is argued to cause the same amount of decrease in the credits available for the private sector (DCPDMB). Note that, policies to control the creation of credit/deposit money can lead to increase the magnitude of the interest rate adjustment, and thus can increase the cost of government borrowing. This implies that, the attempt to control monetary aggregates can be compromised by a substantial PSBR. Foreign finance: If there is a flexible exchange rate regime and no official currency substitution, the foreign currency proceeds of the external debt finance must be used to purchase domestic currency on the exchange rate market to be spent by the government. This implies a shift of money from the private sector to the government and back to the private sector when the money is spent. The items in the money balance sheets are not affected by these transactions, therefore, neither the broad money supply nor the monetary base are affected by foreign debt finance. In the case of an imperfectly flexible exchange rates, on the other hand, the supply of money can be effected through changes in the reserves.

SEIGNIORAGE, INFLATION TAX AND DEMAND FOR MONEY

There are different measures for seigniorage and inflation tax in the literature. The most commonly used definition of seigniorage is the government revenue from money creation in the economy; hence seigniorage is identified with the change in the monetary base M0. As M0 = CI + BR, seigniorage is the sum of the revenue from the CB's creation of non-interest bearing fiat money (Currency Issued, CI) and the revenue obtained by imposing reserve requirements on the deposit money created by DMBs (BR excluding vault cash of the banks). The real seigniorage revenue (SR) can be expressed as SR = M/P = (M/M)(M/P) = gM(M/P), (1) where gM = M/M is the money growth rate. Since gM = gMi + gX, where gMi is the money growth excess of real income growth gx, (1) can be expressed as SR = gMi (M/P) + gX(M/P). (2)

Inflation tax (IT), on the other hand, refers to the loss in the value of desired real balances (M/P)d in the face of inflation (). In this context, inflation tax can be defined as the increase in the quantity of money that the public have to accumulate in order to stay "on" their real money demand function in the face of inflation. The real revenue from the inflation tax can be defined as the product of the tax rate and the tax base (M/P)d, Formally, ITR = (M/P)d. (3) Since ITR that a government can raise by M depends not only the nominal increase in the supply, but also on the "terms" on which the public desire to hold the money, specification of the money demand function (M/P)d is crucially important for an inflation tax analysis. The long-run demand for real cash balances can be taken as a function of real income X and the

opportunity cost of holding currency. Following Cagan (1956) and many studies on inflation tax we consider expected inflation rate e as the opportunity cost variable. Formally, (M/P)d = f(X,e). (4) In the long-run (M/P)d = (M/P), and - e is stationary around zero mean, i.e. agents do not make systematic expectational errors. If - gMi (hence the income velocity growth gv) is a zero drift stationary process, then the long-run seigniorage revenue can be expressed as: SR = (M/P)d + gX(M/P)d = ITR + gX(M/P)d This result is consistent with Friedman (1971, p.487): (5)

"[For a growing economy], the issuer of money obtains a yield from two sources: a tax on existing real cash balances [ITR]; and provision of the additional real balances that are demanded as income rises [gX(M/P)d]".

The conventional inflation tax literature, following the quantity theory framework, postulates that inflation is determined in the money demand variable space with money (and real income) determined outside the system. This corresponds to a case that the tax rate is deliberately chosen by monetary authorities by setting gMi so as to maximize the real seigniorage revenue. Rejection of the long-run endogeneity of inflation in the money demand variable space is consistent with a Keynesian argument which states that the system can be postulated to explain money conditioned upon the demand arguments including inflation rate. In the Keynesian endogenous money / exogenous inflation tax rate case, the government receives seigniorage and inflation tax revenues simply by accommodating nominal income growth ( + gX). Thus, the inflation tax and seigniorage expressions given by (3) and (5) are consistent both with the exogenous and endogenous money postulates. Inflation Tax Laffer Curve From (3) and (4): ITR = (M/P)d = f(X,e), where is the inflation tax rate and (M/P)d = f(X,e) is the inflation tax base. Note that, dITR /d = (M/P)d + [d(M/P)d /d = f(X,e) + [df(X,e)/d]. (7) The first term of the equation, [(M/P)d = f(X,e)], is positive. The second term, [[d(M/P)d /d = [df(X,e)/d], is negative since the demand for real balances decreases with inflation. The second term approaches to zero as inflation rate approaches to zero. Since (M/P) d is strictly positive, it follows that dITR /d is positive for sufficiently low values of . That is, at low tax (inflation) rates, the real revenue is increasing in the tax rate. However, as becomes large, it is possible that the second term eventually dominates; that is, further increases in the inflation (tax) rate decrease the real revenue. The interrelationship between the "tax rate" and the "tax base" leads to the possibility of an inflation tax Laffer curve: When is high enough, a further increase in the tax rate can lead to a decrease in the tax revenues. Currency Substitution and Inflation Tax The presence of currency substitution implies that the real seigniorage revenue corresponding to a given level of income is shared by the issuers of domestic and foreign currencies. Hence, the part of the real seigniorage taken by the issuers of foreign currencies increases with the degree of currency substitution. The effect of a currency substitution on the inflation tax may be straightforward as its existence simply means a decrease in the tax base. The more the tax base shrinks, the less the real seigniorage revenue will be obtained for a given level of the tax (inflation) rate. (6)