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We thank Tam Bayoumi, Ken Kletzer, Ayhan Kose, Jonathan Ostry, Ken Rogoff, and participants in an IMF Research Department seminar for comments on an earlier draft. Emily Conover and Ben Sutton provided excellent research assistance.
An extensive survey of ARDL models is provided in Banerjee, Dolado, Galbraith, and Hendry (1993). The time-series properties of ARDL models in the estimation of long-run cointegrating relationships are discussed in Pesaran and Shin (1998).
If the variables are I(1), the superconsistent property of OLS estimates holds and reverse causality becomes a non-issue (Stock, 1988). If the variables are I(0), the fact that left-hand side variable enter the regression in lagged form helps mitigate endogeneity biases. Moveover, reverse causality in fiscal deficit-inflation relationship seems to be more of an issue only in very high inflation episodes or during hyperinflations (Sargent, 1982; Franco, 1990; Dornbusch, Sturzenegger, and Wolf, 1990).
While the change in high-powered money is also a widely used measure of seigniorage, it is less germane to theoretical concept of demand for transactions money in the model. Moreover, high powered money as a measure of the inflation tax base is not unproblematic: it overestimates the inflation tax base when reserve requirements held at the central bank are remunerated (as is the case in some countries in our panel, and underestimates it when the government finds a way of extracting from banks the gains yielded by negative real interest rates paid on sight deposits.
To allow for reasonably rich dynamics without wasting too many degrees of freedom, we impose the condition that p,q ≤ 3. A shorter lag structure (p, q ≤ 2) does not change qualitatively the results but lowers the t-ratios in several cases.
The same conclusion holds if other standard model selection criterion—the Akaike Information Criterion—is used.
See the Appendix for the list of countries comprising each group. The developed v. developing country breakdown is based on the IMF’s World Economic Outlook classification, whereas the definition of “emerging markets” follows IMF (2001). High inflation countries comprise those in the upper quartile of the inflation distribution (averaged over the 1960–2001 period) and low inflation countries comprise the bottom 25 percent. Using a breakdown by quintiles rather than by quartiles does not change the thrust of the results. Period averages of the inflation rate and of other relevant variables for those various groups are provided in Table 1.
Another distinctive feature of the advanced country estimates is the substantially lower coefficient on the error correction term, suggesting that the dynamics of the inflation-deficit relationship takes much longer to unravel.
Specifically, the PMG estimator yields a coefficient of 0.1 with a t-ratio of 3.05 and a h-statistic of 0.29, which clearly does not reject the cross-country slope homogeneity assumption. Full details of these estimates are not reported to conserve on space but are available from the authors upon request.
We have also estimated (9) using pooled OLS without country-specific fixed effects but standard hausman tests clearly favored the fixed-effect specification relative to pooled OLS at any conventional level of statistical significance.
Standard errors of individual country regressions vary from as low as 1 (Austria) to as high as over 300 as in high inflation economies such as Argentina, Brazil, and Turkey. Such a dispersion of error variances is reflected in the disparate R2,s between the distinct groups as shown in Table 3.
The way the log approximation accomodates non-linearities in the data can be readily seen by taking the derivative of inflation with respect to the deficit in In(l + π) = μ + Ψy (G − T)/GDP + ε. This yields:
The average fit of individual country regressions also improves significantly with the inclusion of oil prices. The full panel country averages of the adjusted R2 for the model with oil is 0.38, as opposed to 0.27 without oil. The full panel average unadjusted R2 with oil is 0.45.
The other widely studied hypothesis derived from the time inconsistency theory of monetary policy is that inflation should be lower in countries with more independent central banks or with central banks which are credibly committed to a low inflation mandate (Cuckierman and others, 1992; de Haan and Kooi, 2000). For evidence that central bank behavior helps explain historical swings in inflation rates in the United States, see Goodfriend (1997) and Ireland (1999). Lack of long time series on central bank independence measures for most countries in our panel unfortunately prevents us from evaluating this hypothesis on a broad cross-country basis.
As the index is not available for all countries in the data set, the panel size drops to 78 countries.