Inflation Implications of Rising Government Debt
The intertemporal budget constraint of the government implies a relationship between a ratio of current liabilities to the primary deficit with future values of inflation, interest rates, GDP and narrow money growth and changes in the primary deficit. This relationship defines a natural measure of fiscal balance and can be used as an accounting identity to examine the channels through which governments achieve fiscal sustainability. We evaluate the ability of this framework to account for the fiscal behaviour of six industrialised nations since 1960. We show how fiscal imbalances are mainly removed through adjustments in the primary deficit (80-100%), with less substantial roles being played by inflation (0-10%) and GDP growth (0-20%). Focusing on the relation between fiscal imbalances and inflation suggests extremely modest interactions. This post WWII evidence suggests that the widely anticipated future increases in fiscal deficits, need not necessarily have a substantial impact on inflation.
We thank Boris Glass for extensive research assistance and support. We are also grateful to participants at ISOM 2006 and EEA-ESEM 2006. We are particularly grateful to Domenico Giannone, Eric Leeper and Lucrezia Reichlin for their comments and suggestions for improving this paper. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Reichlin, Lucrezia and Kenneth West. NBER International Seminar on Macroeconomics 2006. Chicago and London: University of Chicago Press , 2008.