This Selected Issues paper analyzes Jamaica’s experience of low growth despite consistently high investment rates. It suggests that the link between public debt and productivity is part of the answer to the puzzle. The paper considers Jamaica’s debt management strategy and its optimal debt structure. It also reviews the institutional framework for debt management in Jamaica, and presents a newly constructed dataset that documents Jamaica’s notable market access to long-maturity, fixed interest rate, and domestic currency bond placements.

Abstract

This Selected Issues paper analyzes Jamaica’s experience of low growth despite consistently high investment rates. It suggests that the link between public debt and productivity is part of the answer to the puzzle. The paper considers Jamaica’s debt management strategy and its optimal debt structure. It also reviews the institutional framework for debt management in Jamaica, and presents a newly constructed dataset that documents Jamaica’s notable market access to long-maturity, fixed interest rate, and domestic currency bond placements.

II. Public Debt, Money Supply, and Inflation: A Cross-Country Study and Its Application to Jamaica1

A. Introduction

1. Jamaica is one of the most heavily indebted countries in the world. The public debt sharply increased from an already high level of 80 percent of GDP to nearly 140 percent of GDP over the past decade. The sharp increase was due mainly to the assumption of off-budget liabilities, notably the bailout of financial institutions in the late 1990s—budget deficits accounted for only a quarter of the surge. Debt service costs have hovered around 15 percent of GDP in recent years and to help meet these payments, primary surpluses in excess of 10 percent of GDP have been generated over the past several years. The public debt is broadly evenly spilt between foreign and local currency denominated issuances, with the bulk of the latter in short durations. This structure has rendered the debt very sensitive to exchange rate as well as domestic interest rate changes.

2. Motivated by the need to reduce the large public debt, the Jamaican authorities started in 2004 an ambitious program that includes as its objective the goal of reducing inflation to single digits. The ultimate goal of the government’s comprehensive program is to reduce public debt to 100 percent of GDP by 2008 through fiscal consolidation. This consolidation effort, in turn, is expected to lead to a virtuous circle of higher economic growth, lower inflation and lower interest rates, and hence lower debt. The key role of inflation in the program raises, however, important analytical and policy questions about what its main determinants are in highly-indebted countries like Jamaica and what policies would be need to sustain price stability.

3. The most widely accepted school of thought on inflation is that it is a monetary phenomenon and as such the reduction of inflation is largely the purview of monetary policy, particularly in the initial stages of disinflation. This school of thought, based on the quantity theory of money, posits that inflation is determined solely by the change in the relative supply of money and goods. Against this background disinflation policy in many countries is framed with the objective of constraining monetary growth to be in line with the expansion in nominal income. Hence, an increasing number of countries have granted their central banks autonomy in the hope that it will insulate them from having to accommodate imprudent fiscal policies and hence supply more money than there is demand for.

4. However, given that current money demand should depend on expectations about future inflation, a purely monetary effort at reducing inflation may not be successful. Theoretically, once account is taken of forward-looking expectations, multiple 29 equilibrium paths for inflation can co-exist. Under such circumstances, money supply alone may not be sufficient to pin down the time path of inflation.

5. Against this background, attention has increasingly been given to the fiscal role in determining inflation. The main result of the seminal paper by Sargent and Wallace (1981) is that the effectiveness of monetary policy in controlling inflation depends critically on its coordination with fiscal policy. In their model, tighter monetary policy could lead to higher inflation under certain circumstances, even when the traditional relation between money and the price level holds. The rationale is that, with the demand for government bonds given and in the absence of changes in future fiscal policy, a part of government obligations has to be covered by seignorage at some point in the future. This idea of fiscal dominance in price determination has spawned an extensive literature on fiscal policy and inflation (Aiyagari and Gertler 1985; Leeper 1991; Castro et. al. 2003).

6. A similar line of reasoning lies behind the fiscal theory of the price level (FTPL). Apart from seignorage financing, traditional analysis of the fiscal impact on inflation focus mostly on Keynesian aggregate demand considerations, public wage spillovers to private sector wages, and taxes affecting marginal costs and private consumption (Elmendorf and Mankiw 1999). The FTPL identifies the wealth effect of government debt as an additional channel of fiscal influence on inflation (Woodford 1994; Sims, 1994; Loyo, 1999; Christiano and Fitzgerald, 2000; Canzoneri, Cumby, and Diba 2001; Woodford 2001; Gordon and Leeper 2002; Cochrane 2005). This theory posits that increased government debt adds to household wealth, and hence to demand for goods and services, leading to price pressures.

7. This paper provides a comprehensive empirical examination of the link between fiscal policy and inflation identified by the various forward looking fiscal-monetary models of inflation. We draw on an extensive cross-country dataset for 71 countries spanning up to 43 years in order to overcome potential biases arising from the selection of sample countries and sample periods. Given the importance of policy regimes on inflation expectations, we rely on flexible econometric techniques allowing for cross-country heterogeneity. Our approach also differs from much of the existing empirical literature (Evans 1987a and 1987b; Elmendorf 1993; Ardagna et. al. 2004; Catao and Terrones 2005) in that we focus on the role of public debt (instead of the budget deficit) in determining inflation. This will better ensure that we capture the nontraditional channels of fiscal influence on inflation, namely monetization expectations and wealth effects of debt, which can arise independently of the budget deficit. The focus on the stock variable is also important empirically since budget deficits often diverge substantially from changes in public debt on account of the use of non-debt financing, debt-indexation, exchange rate movements and the government’s assumption of quasi-fiscal liabilities (IMF 2003; Singh et. al. 2005).

8. The rest of the paper is organized as follows. Section B describes a simple forward-looking macroeconomic model that we use for the empirical estimation. Section C presents basic stylized facts on public debt and inflation, discusses empirical modeling strategies, and presents our empirical findings. Section D applies the empirical model to Jamaica. Section E discusses budgetary and policy implications of the findings and Section F summarizes and concludes.

B. Conceptual Framework

9. We draw on a simple fiscal-monetary model of inflation. A number of authors have developed theoretical models of fiscal dominance and FTPL2. Our model is a simplified version of Castro et. al. (2003). In our model, a representative household is endowed with resources, y, for each period, and allocates its wealth between consumption (c), real domestic money (m/p), and non-indexed real government bonds (b/p) in order to maximize the following utility function:

Σt=0βt(ln(ct)+γln(mt/pt))(1)

subject to a resource constraint:

ct+mtpt+btpt=ytτt+mt1pt+it1bt1pt(2)

where τ is the lump-sum tax and it-1 is a nominal gross return of a government bond between periods t-1 and t.

10. The government is faced with the following intertemporal budget constraint:

Gt+(it11)Bt1pt=τt+(MtMt1)pt+(BtBt1)pt(3)

where G is government expenditure, and B and M are the aggregate stocks of outstanding bonds and money, respectively (i.e. the sum of b and m across all households). Iterating (2)-(3) and using no arbitrage and market-clearing conditions, it can be shown (see Appendix, Section I) that:

pt=(1β)(M+δBt)γct,whereptistheequillibriumpricelevel.(4)

Equation (4) is log-linearized to obtain a more easily estimable specification as follows:

p^t=λ1M^t+λ2B^tc^t,whereλ1=M*M*+δB*,andλ2=δB*M*+δB*(5)

where hats above terms represent deviations from equilibrium values in logarithms (denoted with asterisks). This establishes a linear relationship between inflation and growth in money and public debt, which can be tested empirically through a variety of specifications allowing for dynamics and heterogeneity among countries.

11. The precise nature of the fiscal policy determines the reduced form of the equation (5) relating prices to money and debt. This derives from the critical implicit assumption in this model that monetary policy accommodates fiscal policy. Consider for a moment the monetization factor δ. Suppose the government does not monetize its debt at all and runs a balanced budget over the long term. The monetization factor δ then reduces to zero and equation (4) simplifies into the conventional quantity theory of money. Similarly, if the implied fiscal rule is full monetization of all public debt, δ becomes 1 and, hence, debt heavily influences inflation. In reality, the parameter is likely to vary between 0 and 1, with the exact amount depending on the capacity and willingness to service public debt, as often reflected in the debt size, credibility of policy commitment, and institutional and political constraints. In our log-linearized form in equation (5), the larger the monetization factor 8, the higher the coefficient for debt growth.

C. Empirical Findings of the Cross-Country Study

Data and basic stylized facts

12. The attached table provides some interesting descriptive statistics of long-term cross country data derived from the main dataset. During the sample period, the average annual growth of money exceeded average inflation by a wide margin (see Appendix, Section II for data sources and definitions). The differential between average money growth and average inflation is average real money growth, which is about equivalent to real GDP growth in the dataset. This empirical relationship between real money and real GDP implies that the velocity of money in the 71 sample countries remained, on average, virtually unchanged during the sample period. Average public debt, however, rose faster than money by about 0.5 percentage point per annum—a small but significant difference if extended over the long term. This could reflect financial deepening, which tends to increase the money multiplier.

Descriptive statistics of long-term average cross country data

(In average percentage changes per annum, unless otherwise noted)

article image

13. There is considerable variation across countries in the dataset, indicating potentially large gains from using panel data. The table below shows a summary of regional variations of selected macroeconomic indicators averaged over the sample period. Among developing countries, average annual inflation (geometric) in Latin America is only second to Europe, much of which suffered hyperinflation during the transition to market in the 1990s of the eastern European countries. It is also notable that the average debt-to-GDP ratio of Caribbean countries is the highest, their growth rate the lowest, and their exchange regime the least flexible, compared with other regions.3 As regards public debt and inflation the data set appears to indicate that debt tends to rise nearly twice faster than inflation in low inflation regions but not as fast in high inflation regions. This suggests that there might be a natural limit to real debt growth. A similar observation could be made with respect to money growth and inflation.

Table.

Selected Macro Economic Indicators (up to 1963-2004) 1/

(Average annual percentage changes, unless indicated otherwise)

article image
Sources: IFS, WEO, OECD, and WHD databases and Reinhart and Rogoff (2004)

Country groupings are based on IMF’s WEO (2005).

Narrowest definitions of money available from IFS, WEO and OECD databases.

Based on Reinhart and Rogoff (2004). The higher the indices are, the more flexible the exchange regimes are.

Adjusted for the shortest time periods for which data are available.

14. Our finally preferred econometric framework is indeed panel estimation on first differences, notwithstanding some evidence of co-integration (see below on limitations of long-term average data). Most macro variables in the dataset are non-stationary in their levels but all become stationary in their first differences. Our panel co-integration tests are not conclusive, as is often the case with medium-sized panels. The tests for stationarity, based on Pedroni (1999), reject the null of co-integration of the 4 main variables (CPI, money, public debt and real output) in both the pooled and group mean t tests at a 5 percent level but not always in the panel and group ρ tests. In light of these mixed outcomes, we proceed mainly with their first difference terms. Figure 1 show the means of cross-country data in the first difference logarithmic terms over the full sample period. Similar patterns are observed in their median values.

Figure 1.
Figure 1.

Jamaica: Mean of Cross-Country Data for Each Year

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

Limitations of long-term average data

15. A simple long-term cross-country regression confirms the findings of other empirical studies that long-term average inflation is strongly positively associated with long-term money growth and negatively with long-term output growth but at best weakly with debt. This is in line with the quantity theory of money and consistent with many empirical studies on this subject (Schwartz 1973; Vogel 1974; Lucas 1980; Duck 1993; Favero and Spinelli 1999). In addition, the regression shows that more flexible exchange regimes tend to be associated with higher inflation although the causality is by no means established in this simple regression. As regards the role of public debt, there is evidence of a positive linear relationship between inflation and public debt growth and a weak association between inflation and the size of public debt (see table below and Figure 2). However, both fiscal variables lose their explanatory power for inflation completely when money growth is controlled for.

Figure 2.
Figure 2.

Jamaica: Scatter Plots of Selected Macroeconomic Indicators and Public Debt Growth

(Mean of time-series data for each country)

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

Cross-country OLS regression results*

article image
Coefficients significant at the 5 percent level are in bold.

16. It is however difficult to make direct inferences about the link between public debt and inflation from these long-term average data. While these results appear to reconfirm the dominant influence of money supply on long-term inflation, they do not necessarily reject the possibility that large public debt could push up inflation over the long term. Nor do they simply the absence of debt monetization (i.e., δ = 0 in our model). The reason for the lack of a statistical relationship between debt and inflation in these regressions becomes clear when one considers the fact that essentially, public debt is transitory over the long term. In other words, a change in debt is an intermediate manifestation of the fiscal stance and eventually gets repaid with either a real primary surplus or, if not sustainable, gets deflated by monetization over the long term. The ultimate link between debt and inflation therefore depends critically on the policy regimes in place (Sargent 1982), which are likely to change over time. To really bring out the relationship, one thus needs to conduct panel regressions, the results of which are described below.

Basic results of panel data regressions

17. Given the limitations of long-term average data, our main empirical modeling strategy is to use panel data, which provide variability of individual countries and yet preserves the dynamics of adjustment within countries. Our basic specification is an autoregressive version of equation (5) with unobserved country-specific fixed effects. This is designed to capture the potentially complex dynamics of public debt, inflation and other macroeconomic variables within the constraints of a medium-sized panel (see Appendix, Section II for details). The existence of the fixed effects is supported by the results of the Breusch-Pagan test (1980). Regressions are run separately for different groups of countries in order to address the potential problem of slope heterogeneity without sacrificing efficiency gains from panel data. In line with the conceptual framework, the grouping of countries is made on the basis of economic development levels and, among subgroups, sovereign indebtedness—both as classified by the most recent IMF WEO (2005).4 The possible existence of serially correlated errors is handled through the use of a robust estimator. Table 1 in the Appendix presents one-step dynamic GMM estimates. Pooled OLS estimates and dynamic fixed effect estimates are also presented for comparison.5

18. Below is a summary of the main findings.

  • Our panel regressions show a strong and stable positive effect of debt growth on inflation in developing and non-major advanced economies. The coefficient for public debt is nearly 0.2 for the short term and 0.25 for the long term (Appendix Table 1). This implies that a 1 percent increase in public debt leads to a 0.2 percentage point increase in inflation. The debt coefficients are lower than those of money growth but are sufficiently significant and rise to 0.3 and 0.5, respectively, for a subset of 25 indebted developing countries for whom the main financing source is borrowing from the non-official sector. Arellano-Bond’s second-order serial correlation test for the residuals is rejected in support of the GMM specification. The existence of the strong debt-inflation linkage, after controlling for money growth, stands in strong contrast to the results of the long-term cross-country regression above and does not square well with the static monetarist model of inflation.

  • None of the explanatory variables, except lagged inflation in 13 major advanced economies, show significant short-term associations with inflation. This result is consistent with other empirical studies on inflation, which find virtually no short-term relationships between money and inflation in developed countries (Christiano and Fitzgerald 2003; Dwyer 1982). The result is also consistent with other studies that report the existence of a significant relationship between budget deficits and inflation only in high inflation episodes and mostly in developing countries (Catao and Terrones 2005; Fischer, Sahay, and Vegh 2002). It should be noted, however, that the fact that we define money primarily as reserve money may have further weakened the linkage between money and inflation, since a host of financial instruments are used as money substitutes as countries increasingly become financially developed.

  • Public debt growth is more inflationary in high debt countries. The simple scatter plot below suggests that inflation is more sensitive to debt growth in high debt countries than in low debt countries. For a formal test, we first derive the sensitivity coefficients from a modified dynamic fixed effect model allowing for heterogeneous slopes. Then, the estimated coefficients—taken as a proxy for the expectation of debt monetization—are regressed on average debt ratios and other institutional or economic factors that might affect the expectation of debt monetization—central bank independence, exchange rate regimes, average long-term depreciation, and average long-term money and output growth. The results show that a 10 percentage point difference in the debt-GDP ratio is associated with a 1 percentage point higher elasticity of inflation to debt growth (Appendix Table 7). The tests also indicate that statutory independence of the central bank, as measured by Cukierman (1992), does not play an important role.6

  • Exchange rate regimes matter in the link between debt growth and inflation. The fixed rate regime dummy in our regressions distinguishes between exchange rate regimes with a peg, those with limited flexibility, and managed floats (as defined by Reinhart and Rogoff, 2004). The regression outcomes show that the sensitivity of inflation to debt is higher and significant under a floating rate regime while it is low and often insignificant under a fixed rate regime (Appendix Table 3).

Robustness of the results

19. Our results are robust to corrections for possible endogeneity biases, changes in the regression periods, and relaxation of common slope restrictions. The results presented above are robust to corrections for possible endogeneity of explanatory variables (Appendix Table 2). The coefficients for lagged debt growth remain significant and positive in pooled OLS, fixed effect, and GMM estimators for a small subset of 25 indebted developing countries. The results remain broadly unchanged for a large subset of 58 widely-defined developing countries. The main results are also largely maintained in regressions over each rolling 20-year period (Appendix Table 4). In absolute terms, the sensitivity coefficients are larger in 1983-2003 than in 1963-1983, possibly reflecting the adoption of flexible exchange rate regimes after the breakdown of the Breton Woods system. The relaxation of common slope coefficients does not change the main result either. Mean group estimates (Pesaran and Smith 1995) show that debt growth (both contemporaneous and lagged) affects inflation positively and its degree is stronger in indebted developing countries (Appendix Table 5). Similar patterns are observed in fully modified OLS estimates (Pedroni 2000) although the coefficients are not directly comparable to those from other regressions (Appendix Table 6).7

Transmission channels

20. We undertook a simple vector autoregression (VAR) to trace out the transmission channels of the fiscal influence on inflation. Our panel VAR. show a weak or no response of inflation to fiscal shocks in major advanced economies8 (Figure 3a). A similar pattern is observed in the monetary response to fiscal shocks. It is also notable that public debt declines in response to positive output shocks, a possible indication of the existence of counter-cyclical fiscal policy. The results are robust to changes in the shock ordering and the lag length.

Figure 3a.
Figure 3a.

Jamaica: Impulse Responses in Major Advanced Economies

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

21. The panel VAR outcomes render additional support to the prediction of the fiscal-monetary model of inflation—that the debt-inflation link is affected by institutional and structural factors. Impulse responses for advanced economies are starkly different from those for other countries (Figures 3a and 3b). The latter show a strong and positive response of money supply and inflation to fiscal shocks whereas the impulse responses for major advanced economies do not. This suggests that in countries that are not advanced economies, an increase in public debt is mostly accommodated by monetary easing, contemporaneously and with lags—a phenomenon of fiscal dominance. The VARs for developing countries also exhibit little fiscal and monetary response to output shocks, implying that macroeconomic policies in such countries are typically acyclical—a finding that is consistent with many empirical studies of macroeconomic shocks and policy responses (Mélitz 1997; Akitoby et. Al. 2004; Kaminsky, Reinhart and Vegh 2004).

Figure 3b.
Figure 3b.

Jamaica: Impulse Responses in Countries Other than Major Advanced Economies

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

D. Application to Jamaica

22. In Jamaica, monetary policy is constrained severely by fiscal considerations due to the large public debt. Unlike many other countries in similar circumstances, the central bank (BOJ) has traditionally adopted a conservative monetary policy stance, with seignorage financing of the budget deficit rarely exceeding 1 percent of GDP. This policy stance was possible thanks to its strong operational autonomy, notwithstanding little statutory independence compared with other countries in the region (Jácome and Vázquez 2005). Inflation nonetheless has remained high historically, rising to double digits since 2003, in contrast to most neighboring countries that have much lower inflation. The BOJ’s main policy instrument is its stock of short-term bills (OMOs)—used to sterilize the accumulation of international reserves (NIR) and credit to the public sector—but room for their utilization has been limited due to the large volume of OMOs outstanding (amounting to about one-fourth of GDP) and already high sterilization costs 1½–2½ percent of GDP per year in recent years).

uA02fig02

Jamaica: OMO, NIR and Base money

(US$bn)

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

23. A VAR is applied to Jamaica to test whether the cross-country debt-inflation relationship identified from the panel regressions holds for Jamaica. The estimation uses annual data between 1980 and 2004 for CPI, real GDP, reserve money, and enlarged government debt including OMO debt. The exchange rates are also included in the robustness test to control for possible biases from exchange rate volatility on the debt dynamics. Data for GDP and CPI are from the Statistical Institute, and government debt from the Finance Ministry. All other data are from the Bank of Jamaica. All the variables are non stationary and, as such, we test whether any stationary long-run relation exists among the variables. Both the trace and maximum eigen value tests based on the full information maximum likelihood method reject the null hypothesis of no co-integration but the number of co-integration vectors depend on the specification of the co-integration equations, most probably in reflection of the short time span. Hence, we run VARs both with and without the error correction terms.

24. The VAR outcomes confirm the significance of public debt dynamics in determining inflation in Jamaica. The impulse response functions show that the price level is positively affected by money supply and public debt but the latter has more lasting effects on inflation. Also, positive fiscal shocks have positive and persistent effects on money supply while the opposite does not hold (see the charts below for the impulse responses). These results are similar to those from the panel VAR estimates for developing countries and robust to changes in the ordering of the shocks. The directions of the impulse responses remain unchanged in an alternative VAR including the exchange rate as an endogenous variable and alternative regressions based on the vector error correction model.

25. Caution is, however, needed in interpreting these outcomes as the results are applicable for annual data, but not necessarily for higher frequency data, and it is not clear which precise fiscal channel is driving inflation in Jamaica. The main drivers in our conceptual framework are expectations, which take time to form and influence behaviors. In fact, our simple VAR of monthly data for Jamaica between 1996 and 2005—consisting of prices, money, exchange rates and open market instruments—shows that monthly inflation is explained mostly by lagged inflation, money supply and the exchange rate although open market instruments also positively affect inflation with about a half-year lag. More importantly, the regression results do not separate the wealth effects of public debt from its effects on monetization expectations. It could well be that the wealth effects are important in Jamaica, given the high primary surpluses and the strong commitments of the authorities for fiscal consolidation. It should, therefore, be stressed that our results for Jamaica do not necessarily mean that an upswing in inflation in recent years signals concerns about monetization of debt in future. Notwithstanding this caveat, our regression results confirm that the movements of public debt do matter for inflation dynamics in Jamaica.

uA02fig03

Jamaica: Impulse Responce of Inflation to Money and Debt*

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

* Based on a one-year lag VAR, covering annual data for 1980-2004.
uA02fig04

Jamaica: Impulse Responces between Debt and Money*

Citation: IMF Staff Country Reports 2006, 157; 10.5089/9781451820171.002.A002

* Based on a one-year lag VAR, covering annual data for 1980-2004.

E. Budgetary and Policy Implications

26. Our regression results point to a number of budgetary and policy implications applicable to countries with high debt.

  • There is a significant risk of a debt-inflation trap in highly indebted countries. A rise in inflation expectations will eventually push up nominal interest rates, elevating public debt unless fully countered by a primary surplus. The debt increase will in turn raise inflation expectations further. This vicious feedback effect implies that rising inflation expectations could increase budgetary costs more than proportionally.9 This also means that rising inflation expectations could be destabilizing the debt dynamics more than an adverse real output shock does—possibly by as much as one third to one half (see Appendix, Section III for details).

  • The budgetary costs of noncredible disinflation policy are potentially large in highly indebted countries. In Jamaica, for example, the central bank has medium-term inflation forecasts of 5 percent, which are considerably lower than current inflation. Suppose that bond holders believe that inflation would indeed fall but only to 10 percent over the medium term. The nominal interest that they demand for holding debt would then be correspondingly higher. In the event that inflation actually falls to 5 percent, the ex post budgetary real interest payments would be higher (by about 3 percent of GDP, given Jamaica’s debt profile) than in the case of 10 percent inflation. Conversely, unanticipated inflation would help reduce borrowing costs in the short term but only exacerbate the credibility problem and ratchet up borrowing costs over the medium term. This points to the merits of managing inflation and inflation expectations so that there are minimal surprises.

  • The evidence of cross-country heterogeneity in the debt-inflation link indicates that institutional and structural factors are critically important. Fiscal rules that limit the size of budget deficits or public debt could, under appropriate circumstances, be an important institutional means of safeguarding price stability to the extent that the commitment is credible. Independence of the central bank could also help reduce monetization concerns although our regressions do not indicate a significant effect of the central bank’s statutory independence on the debt-inflation relationship (see Appendix Table 7). The development of the financial sector could help promote price stability as the financial sector tends to support the central bank’s policy autonomy (Posen 1995). It could also reinforce fiscal discipline by providing immediate and clear signals about perceived risks of debt monetization (Rubin and Weisberg, 2003).

  • More broadly, the conduct of monetary policy is extremely challenging in highly indebted developing countries. In principle, flexibility in monetary policy would be severely constrained by considerations about implications of interest and exchange rate movements on debt dynamics. Operationally, monetary data alone might not provide reliable indications of emerging inflationary pressures, as growth in government debt in lieu of money printing could also affect inflation expectations. In this regard, sustained sterilized intervention could backfire since such interventions would limit growth in money supply but raise public debt. In sum, in countries with significant debt overhangs, purely money-based stabilization is unlikely to be effective without the support of fiscal consolidation.

F. Summary and Conclusions

27. Our study provides comprehensive and robust evidence that an increase in government debt is typically inflationary in countries with large public debt. Our regression results (see Appendix Table 1) show that an increase in public debt is significantly associated with high inflation in developing countries, after controlling for money growth, real output growth, currency depreciation, and output gap. This pattern however does not hold in major advanced economies, consistent with the thesis of a forward-looking model of inflation that—unlike the implications of a static aggregate demand model—policy regimes matter in the debt-inflation nexus. These results are invariant over sub-sample periods (see Appendix Table 4) and robust to corrections for possible endogeneity biases (see Appendix Table 2) and relaxation of common-slope restrictions (see Appendix Tables 5 and 6). Our regressions also show that public debt growth is more inflationary in high debt countries than in low debt countries (see Appendix Table 7) and that the debt-inflation linkage is weak in inflexible exchange rate regimes (see Appendix Table 3). A panel VAR traces out the transmission mechanism that a positive innovation to debt has a positive and persistent effect both on the price level and money supply. The significance of public debt dynamics on inflation is confirmed in Jamaica.

28. Our findings highlight challenges for price stabilization in highly indebted countries such as Jamaica. They point to a significant risk of a debt-inflation trap, potentially large budgetary costs of noncredible disinflation policy, and limitations of sustained sterilized interventions designed for stability in prices and exchange rates. They also stress the importance of institutional and structural factors in the debt-inflation link, such as fiscal rules, inflation targeting, and the depth and breadth of the financial sector. They also indicate that, notwithstanding an important role of monetary policy in managing and meeting short-term inflation expectations, fiscal policy would likely be the dominant factor for trend inflation in highly indebted developing countries. This implies that price stability achieved mainly through the issuance of central bank open market instruments (i.e., accumulation of public debt) in lieu of deficit monetization could be sustained only if supported by fiscal consolidation and other reforms to address fiscal dominance.

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APPENDIX I

I. Derivation of the Estimated Equation

Our model is a simplified version of Castro et. al. (2003). In our model, a representative household is endowed with resources, y, for each period, and allocates its wealth between consumption (c), real domestic money (m/p), and non-indexed real government bonds (b/p) in order to maximize the following utility function:

Σt=0βt(ln(ct)+γln(mt/pt))(1)

In the utility maximization, the household is subject to a resource constraint of

ct+mtpt+btpt=ytτt+mt1pt+it1bt1pt(2)

where τ is the lump-sum tax and it-1 is a nominal gross return of a government bond between periods t-1 and t. This yields the following standard first order conditions for consumption and money demand, respectively:

ct+1ct=βitπt+1(3)
mtpt=γctitit1(4)

where πt=pt+1/pt. These two first order conditions nest a Cagan-type money demand function, which is inversely related to inflation expectations.

The government is faced with the following intertemporal budget constraint:

Gt+(it11)Bt1pt=τt+(MtMt1)pt+(BtBt1)pt(5)

Forward iteration on (5) and no-Ponzi game conditions on the government imply the following intertemporal budget constraint of the government:

it1Bt1pt=Σj=0τt+jRt,jΣj=0Gt+jRt,j+Σj=0Mt+jMt+j1pt+jRt,j(6)

where G is government spending and Rt, j is the compounded real discount rate as expressed as Rt,j=Πh=1jrt+h where rt+h is the exogenous real interest rate between periods t+h-1 and t+h. In the case of a fiscal policy rule of backing a part, (1-δ), of the debt service by future primary surpluses and monetizing the remainder (δ), we obtain Equation (7) shows that the path of money supply is determined by the extent of debt monetization (the first variable in the right hand side) and savings in the future interest payments brought about by current monetary financing of the budget deficit (the third variable).

MtPt=it1it[δit1Bt1pt+Mt1ptΣj=1Mt+jpt+jRt,jit+j1it+j](7)

Using the conditions for money market equilibrium in (4) and (7) and exploiting the recursive nature of the Euler equation in (3), we obtain the equilibrium price as following:

pt=(1β)(Mt1+δit1Bt1)γct(8)

Given the recursive nature of the equilibrium and no arbitrage between bond and real asset returns (rt+1=it/(pt+1/pt)), this can be rearranged to:

pt=(1β)(Mt+δBt)γct(9)

Equation (9) is log-linearized to obtain a more easily estimable specification as following:

p^t=λ1M^t+λ2B^tc^t,whereλ1=M*M*+δB*,andλ2=δB*M*+δB*(10)

In a dynamic setting which allows restoration to the equilibrium over time, equation (10) could be expressed as the following general unrestricted form:

p^t=αp^t1+β1M^t+β2B^tβ3c^t(11)

II. Data sources, Definitions, and Specifications

Our main dataset is a panel data spanning 71 countries over up to 43 years. The main dataset includes annual data for CPI, money, public debt and real GDP of each country for the maximum period of 1962-2004. Country selections were based primarily on the availability of the data and hence excludes many African countries and some small Caribbean countries.

Data for inflation and real GDP—a proxy for real consumption—are mostly from the International Financial Statistics (IFS) but, in some cases, the WEO dataset of the IMF. Public debt data are from a variety of sources, including the IFS, WEO, OECD databases, and, in some cases, the authorities’ websites. Monetary data are mainly from the IFS and the WEO, and, in the case of the Euro-zone countries, the OECD. The definition of money is reserve money, or the narrowest definition available in the databases.

In addition to the four main variables, several other data were used for alternative specifications and various robustness tests. These include exchange rate regimes (Reinhart and Rogoff 2004), exchange rates (IFS), central bank independence (Cukierman 1992), and output gap estimates (derived from de-trended real GDP using the Hodrick-Prescott filter).

Theestimatedmodelis:Yit=αYit1+βXit+ηi+νit

for i=1,..., N, and t=2,..., T, where ηi + νit has the standard error component structure

E[ηi]=E[νit]=E[ηiνit]=0.

We assume that the transient errors are serially uncorrelated

E[νitνis]=0forstfori=1,,N,andt=2,,T

and, for now, that variables in X are predetermined

E[Xitsνit]=0fors0.

Y refers to inflation (dlogcpi) and X represents a set of explanatory variables in the model including changes in public debt (dlogpdebt), money (dlogmoney) and real GDP (dlogrgdp), all in first-difference logarithms. The equilibrium condition in equation (9) suggests that the coefficients for debt and money should be positive and one for output negative. Also, equation (10) suggests that the coefficient for debt would be higher if the debt monetization factor, δ, is larger. In most specifications, we assume that coefficients in vector β are constant for each group but we relax this slope-homogeneity assumption in robustness tests. No other restrictions are imposed on the coefficients of the explanatory variables.

III. Debt-Inflation Trap and Debt Sustainability

A rise in inflation will eventually push up nominal interest rates, which will in turn increase public debt unless countered by a higher primary surplus. This feedback effect implies that budgetary costs of rising inflation expectations rise more than proportionally to the increase in inflation expectations. This point can be illustrated by simple debt dynamic accounting as follows:

ΔDDt=RtStDt, where D is public debt, R is an interest rate, and S is primary surplus.

If the interest rate is set in line with inflation expectations (πte) and the primary surplus in percent of GDP is predetermined,26 the debt dynamics can be simplified as follows:

ΔDtDt=(πte+r)StYt/DtYt=(πte+r)C,whereC=StYt/DtYt

In a steady state of no change in the debt-to-GDP ratio, C is constant. If inflation expectations (πte) rise in α proportion to debt growth (ΔDtDt) in line with our empirical finding, πte=α(ΔDtDt)+βX+ɛ,thenΔDtDt=βX+ɛ+rC1α.

Hence, an increase in inflation expectations raises debt not only directly (through an immediate increase in the borrowing cost) but also indirectly (through a multiplier effect (1/(1-α)) resulting from the debt-inflation nexus).

An alternative way of looking at this is to see the implications on the debt-stabilizing levels of the primary surplus (St*). The levels can be represented as follows:

St*Yt=[RtDtYtDtYtΔYtYt]=DtYt(RtΔYtYt)=DtYt((1+πte)(1+r)(1+πt)(1+gt))DtYt((πteπt)+(rgt))

Given that inflation expectations (πte) could rewritten as:

πte=βX+ɛ+r1ααC1α,

it follows that the debt-stabilizing primary surplus could be rearranged to the following simplified form:

St*Yt(1α)DtYt[βX+ɛ+r1απt+rgt]

This means that rising inflation expectations (as embodied in a jump in s) would elevate the debt-stabilizing level of the primary surplus more than the same percentage decline in real GDP growth would. Our regression results for the debt-inflation link place a at the range of ¼ (mean group estimator) to ½ (GMM estimator). This implies that the effect of rising inflation expectations could be larger than the effect of a decline in real GDP by as much as one third to one half.

Main Findings from Panel Regressions

Summary Table 1.

Panel regression outcomes

(Dependent Variable: Inflation 1963-2004)*

article image

Coefficients significant at the 5 percent level are in bold. Standard errors are below the estimated coefficients.

Indebted developing countries, whose main source of financing is non-official financing.

Pooled panel OLS.

Dynamic fixed effects.

GMM based on the 1-st difference transformation, assuming that explanatory variables are predetermined. Standard errors are adjusted for intracountry serial correlations and heteroscadasticity.

Summary Table 2.

Panel regression outcomes

(Dependent Variable: Inflation 1963-2004)*

article image

Coefficients significant at the 5 percent level are in bold. Standard errors are below the estimated coefficients.

Indebted developing countries, whose main source of financing is non-official financing.

Pooled panel OLS.

Dynamic fixed effects.

GMM based on the 1st difference transformation, assuming contemporaneous correlations between shocks and explanatory variables. Standard errors are adjusted for intracountry serial correlations and heteroscadasticity.

Summary Table 3.

Panel regression outcomes

(Dependent Variable: Inflation 1963-2004)*

article image

Coefficients significant at the 5 percent level are in bold. Standard errors are below the estimated coefficients.

Indebted developing countries, whose main source of financing is non-official financing.

Pooled panel OLS.

Dynamic fixed effects.

GMM based on the 1-st difference transformation, assuming that explanatory variables are predetermined. Standard errors are adjusted for intracountry serial correlations and heteroscadasticity.

Summary Table 4.

Panel Regression outcomes

(Dependent Variable: Inflation 1963-2003)*

article image

Coefficients significant at the 5 percent level are in bold. Based on a dynamic fixed effects model.

Indebted developing countries, whose main source of financing is non-official financing.

Summary Table 5.

Mean Group Estimates*

article image

Coefficients significant at the 5 percent level are in bold. Based on country-by-country dynamic OLS regressions.

Indebted developing countries, whose main source of financing is non-official financing.

Mean of OLS regression coefficients for each country (over contemporaneous explanatory variables).

Mean of OLS regression coefficients for each country (over one-year lag explanatory variables).

Summary Table 6.

Fully Modified OLS Estimates*

article image

Coefficients significant at the 5 percent level are in bold. Based on FMOLS regressions over level variables (Pedroni 2000).

Indebted developing countries, whose main source of financing is non-official financing.

Common time dummies included.

Common time dummies not included.