1. Academy of Economic Studies Doctoral School of Finance and Banking DISSERTATION PAPER BUDGET DEFICIT AND INFLATION MSc. Student : Marius Serban Supervisor : Prof. Moisa Altar

2. Contents I. Objective II. The Model III. Theoretical Considerations IV. Econometric Results V. Conclusion

3. I. OBJECTIVE the influence of budget deficit on inflation rate in Romania inflation has fiscal roots how large are the effects of deficit cuts upon inflation

4. II. THE MODEL a simple version of Woodford (2001) model households maximize with the private budget constraint

5. first order condition on c t, m t and b t market clearing condition c t + g t =y t

6. real interest rate (r) is assumed constant EQUILIBRIUM CONDITIONS

7. II. THEORETICAL CONSIDERATIONS on how fiscal deficit affects inflation MONETARISTIC THEORY FISCAL THEORY OF THE PRICE LEVEL

8. MONETARISTIC THEORY fiscal dominance regime seigniorage pull inflation money demand equation determines the price level

9. FISCAL THEORY OF THE PRICE LEVEL developed by Sargent and Wallace (1981), Leeper (1991), Dupor (1999), Woodford(1994,1995,1996,1998), Cochrane (2001) gouvernment budget constraint is the evaluation equation of the public debt and not a constraint

10. comparison with a stock B t,g t and τ t exogenous and have to meet certain restrictions gouvernment budget constraint determines the price level

11. IV. ECONOMETRIC RESULTS estimation of the gouvernment budget constraint which is accepted by both theories special case : no new debt is issued

12. starting from 1996 the public debt is relatively stable due to - Asia’s crisis 1997 - Russia’s default in 1998 -debt payments due in 1999 were 1.9 mil. $ -reduced demand on the domestic market

13. imposing the restriction on the public debt results : the left term is real budget deficit (D t /P t ) the right term seigniorage (S)

14. estimated equation nonlinear effect of budget deficit on inflation rate the lower the monetary base the higher the effect of budget deficit

15. DATA period 1991-2001 π - quarterly inflation rate (consumer price index) D - quarterly budget deficit (mil.ROL) M - end of quarter monetary aggregate M1 (mil. ROL) BM - end of quarter money issuance from the balance sheet of the central bank (mil. ROL)

16. testing series stationarity cannot reject the null hypothesis

17. testing cointegration - Johansen Test series are cointegrated starting from the last quarter of 1993 PARAMETER ESTIMATION with M1

18. vector error correction model

19. residuals testing -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15 9495969798990001 INF Residuals period 1994-2001 -0.10 -0.05 0.00 0.05 0.10 0.15 199619971998199920002001 INF Residuals period 1996-2001

20. monetary aggregate M1 is 6% of GDP 1procentual point reduction of the share of budget deficit in GDP results in 8.2 - 8.7 procentual points reduction in annual inflation rate the share of monetary aggregates in GDP is assumed constant

21. ESTIMATION WITH MONETARY BASE testing cointegration - Johansen test series are cointegrated starting from the last quarter of 1993

22. vector error correction model

23. residuals testing -0.15 -0.10 -0.05 0.00 0.05 0.10 0.15 9495969798990001 INF Residuals period 1994-2001 -0.10 -0.05 0.00 0.05 0.10 0.15 199619971998199920002001 INF Residuals period 1996-2001

24. monetary base is 4% of GDP 1 procentual point reduction of the share of budget deficit in GDP results in 7.7 - 8.5 procentual points reduction of the annual inflation rate

25. the adjustment term in VEC is 0.85 and 0.88 quick impact of the deficit upon inflation the transmission channel is 2 quarters MONETARIST THEORY deficit => excess money supply => inflation monetary policy cannot stimulate economy through this channel FISCAL THEORY OF THE PRICE LEVEL deficit =>  aggregate demand => inflation expectations of future deficits fiscal authority must commit to definitly cut deficits

26. GRANGER TEST

27. COMPARISON WITH OTHER STUDIES Catao and Terrones (2001) estimate for 23 emerging countries for period 1970-2000 with annual data they found a mean estimator  equal to 1/3 using M1 for money supply 5.5 procentual points cut in inflation when the deficit in GDP is reduced with 1 procentual point The difference is explained :  is 0.52 because is obtained with quarterly data including quasi-fiscal deficit could reduce the effect of deficit upon inflation

28. V. CONCLUSION the budget deficit explains is the main cause of inflation the low level of monetary base makes the deficit effect very powerful (an increase with 1 procentuial point of the budget deficit in GDP raises annual inflation rate with 7.7- 8.7 procentual points the adjustments of inflation to a fiscal shock takes place in 2 quarters in the future a stricter fiscal discipline is required to reduce and maintain a low inflation