Inflation and the Measurement of Fiscal Deficits

The presence of high inflation raises questions about the usefulness of the conventional measure of the fiscal deficit as a gauge of necessary fiscal adjustment. Economists are divided on this issue: those who believe that regardless of inflation the conventional measure is the relevant one; and those who maintain that a measure that excludes from the deficit the part of interest payments that compensates bondholders for inflation is the correct one. This paper analyzes these issues, concluding that neither measure gives the right signal, and that consequently both measures should be calculated when inflation is high.


The presence of high inflation raises questions about the usefulness of the conventional measure of the fiscal deficit as a gauge of necessary fiscal adjustment. Economists are divided on this issue: those who believe that regardless of inflation the conventional measure is the relevant one; and those who maintain that a measure that excludes from the deficit the part of interest payments that compensates bondholders for inflation is the correct one. This paper analyzes these issues, concluding that neither measure gives the right signal, and that consequently both measures should be calculated when inflation is high.

INFLATION AFFECTS government revenue and expenditure in different ways; as a consequence, in general it changes the size of the fiscal deficit. Although a sizable literature addresses the relationship between tax revenue and inflation, few writings consider the impact of inflation on the level of public expenditure.1 A priori, it would seem realistic to assume that different parts of the budget would respond differently to inflationary pressures. These reactions, however, often depend on political considerations, union power, indexation rules for wages and pensions, and so forth. It is thus difficult to generalize on the automatic relationship between the level of public expenditure and the rate of inflation, with one major exception: the behavior of nominal interest payments related to the servicing of the public debt. For this category of expenditure, it is now generally recognized that an increase in expected inflation almost always brings about a fairly automatic increase in nominal interest payments.

The growth of interest payments in an inflationary situation is often explained by the Fisher effect, which indicates that in an inflationary situation the nominal rate of interest tends to approximate the real rate that would have prevailed in the absence of inflation plus the expected rate of inflation. Although in actual situations nominal interest rates may increase by more or less than the level hypothesized by Fisher, there should be no question that, when the expected rate of inflation rises, the nominal rate of interest also rises unless it is artificially constrained by governmental action.

An increase in the rate of expected inflation can lead to quick and dramatic increases in nominal interest expenditure when the domestic public debt is a substantial proportion of gross domestic product (GDP). Let us consider an example. Assume for the sake of simplicity that all government debt is in the hands of just one individual. This individual derives all his income from the interest payments that he gets from the government and bases his behavior as a consumer on that income. Assume also that the debt is in instruments of very short maturity. Assume that the size of the debt is US$1 million. With expected price stability and a 5 percent nominal (and real) rate of interest, the income of the individual, and the interest expenditure of the government, would be $50,000. With an expected inflation rate of 10 percent, and under the assumption that the Fisher effect holds, the nominal rate of interest would become 15 percent. Thus, the nominal interest income received by the individual would rise from $50,000 to $150,000, and, of course, the interest expenditure by the government would also increase by the same amount.2 Thus, an increase in the rate of inflation from zero to 10 percent has increased interest expenditures by the government by 200 percent. This example allows us to focus on the main question to be analyzed in this paper: How would an individual who sees his nominal interest income increase by 200 percent react to this increase? Three alternative reactions can be hypothesized.3

The first assumes a perfectly rational individual. He realizes that, although his nominal interest income has increased by 200 percent, his real income has not changed at all, since $100,000 of the $150,000 of nominal interest income is just compensation for the erosion of the real value of his financial capital. We shall call this compensation the monetary correction. This is a return of capital rather than a return on capital, since a 10 percent inflation rate reduces the real value of his financial capital by $100,000 after one year. The proponents of this school would argue that the individual would treat this $100,000 in exactly the same way as he would have treated an amortization payment equal to $100,000, since in a real economic sense, though not in an accounting or a legal sense, it is amortization. His behavior as a consumer will continue to be determined by the real value of his permanent income, which presumably has not changed.4 In other words, he will save all the monetary correction. Thus, one should treat this monetary correction exactly as one would a normal amortization payment. Because amortization payments are not part of the fiscal deficit, the monetary correction should also not be part of the deficit. This is the argument made by Eisner in his recent book. (See Eisner (1986).)

The second alternative assumes that the individual does not distinguish at all between real interest payments and monetary corrections regardless of how high the expected rate of inflation is. Therefore, as a consumer, he would treat the full $150,000 interest payments received when the rate of inflation was 10 percent in the same way he would treat the $50,000 interest payments received when the rate of inflation was expected to be zero. He would thus behave as if his real income had, in fact, increased from $50,000 to $150,000. Under this assumption, which is implicit in the conventional way in which the fiscal deficit is measured, whereas amortization payments are not considered income for those who receive them or ordinary expenditure by the government, and are thus not assumed to increase the deficit and to affect aggregate demand, monetary corrections are treated as income. The conventional measure of the deficit is thus highly sensitive to the rate of inflation whenever the size of the domestic debt is significant.

Finally, one can assume that both of the two alternatives mentioned above are unrealistic. As the rate of expected inflation rises, the conventional measure provides a progressively more distorted measure of the size of the fiscal adjustment needed by the country to achieve economic stability.5 By the same token, the “perfect rationality” approach is equally likely, for reasons to be elaborated later on, to underestimate the size of the needed fiscal adjustment. Unfortunately, although it is easy to criticize these two polar versions of the measure of the fiscal deficit on the grounds that neither will provide the correct gauge of the needed fiscal adjustment, it is very difficult or, perhaps, impossible to propose an alternative measure that does not suffer from the shortcomings ascribed to those versions.

I. Effects of Inflation on Fiscal Deficits

Fiscal deficits, as conventionally defined on a cash basis,6 measure the difference between total government cash outlays, including interest outlays but excluding amortization payments on the outstanding stock of public debt, and total cash receipts, including tax and nontax revenue and grants but excluding borrowing proceeds.7 Therefore, not all outlays related to public debt servicing are included in the measure of the deficit: on the one hand, interest payments are added to non-debt-related expenditures but amortization payments are excluded. On the other hand, current revenues are accounted as government income while proceeds from borrowing are excluded. In this manner, fiscal deficits reflect the gap to be covered by net government borrowing, including direct borrowing from the central bank. Fiscal deficits so defined do not provide, therefore, a direct measure of monetary expansion8 nor a measure of gross government pressure on credit markets, as borrowings required to finance amortization payments are not included as part of the deficit.9

Under this definition, there are two kinds of financial government operations, both involving domestically held debt, that do not affect the current fiscal deficit: first, any operation that only involves changes in the composition of government debt—for example, when long-term bonds are replaced by short-term Treasury bills, and vice versa; and second, any operation that involves the monetization of existing government debt. The first type of operation reflects debt management policy designed to obtain a particular maturity structure of the government debt. The second type of operation reflects open-market operations by the central bank; that is, pure monetary policy. Thus, in the conventional definition, the fiscal deficit is independent of the maturity structure of the outstanding domestic government debt and of the degree of debt monetization that the central bank may pursue for purely monetary policy purposes. This conclusion is not valid for the longer run, because both debt-management policy and open-market operations will eventually affect the size of the deficit.

Effects of Inflation on Interest Payments

When incorporated into expectations and, thus, reflected in nominal interest rates, inflation has a direct impact on the nominal interest service of the public debt. In order to isolate this effect from the other consequences of inflation on the government budget, it is assumed that noninterest expenditures grow pari passu with inflation, and that policymakers adjust the tax system through discretionary actions to a new inflationary environment so as to maintain constant the ratio of tax revenue to GDP.10 Clearly, however, a similar assumption cannot be adopted for interest payments on government debt. The growth of nominal interest payments on existing domestic debt is generally beyond the control of the fiscal authorities, since it is tied to the evolution of market interest rates and to indexation clauses.11 Often, however, as discussed earlier, the increase in nominal interest payments does not represent a real transfer of purchasing power from the government to the debt holders. Rather, as long as the real rate of interest does not change, that increase tends to compensate the latter for the erosion in the value of their principal caused by the higher inflation rate. Debt holders are, therefore, no richer in real terms because of the higher level of nominal interest rates, although, in relative terms, they might be if inflation has reduced the real incomes of other groups.

In Appendix I, the effect that an increase in the rate of inflation produces on conventional fiscal deficits in the presence of a floating interest debt instrument is formally illustrated. The exercise assumes that government revenues and non-debt-related expenditures follow the evolution of the price level. In other words, it assumes that the primary deficit is not affected by the rate of inflation.12 The presence of a full Fisher effect is assumed, such that nominal interest rates adjust completely to the expected rate of inflation to yield a constant expected real rate of return. Moreover, actual and expected inflation are assumed to be equal and all the debt is domestically held.13 Under these assumptions, it is shown that when inflation accelerates, the nominal interest bill rises more than proportionally to the price level, leading to an increase in the fiscal deficit in terms of GDP. A deceleration in the rate of inflation would result in a contrary effect.14 The explanation for this result is that whereas inflation, by assumption, does not affect the real value of revenues and noninterest expenditure and therefore does not affect the primary deficit, it does increase the real value of interest payments in order to compensate holders of government bonds for the reduction in the real value of the stock of the outstanding debt. The magnitude of this effect depends on both the rate of inflation and the size of the stock of floating interest domestic debt.

Effects of Inflation on Conventional Fiscal Deficits

A similar demonstration provided in Appendix I indicates that conventional deficits are not affected by inflation when the public debt is either index-linked (and the monetary correction is then considered as amortization) or when it is denominated in foreign currency.15 To show this result, the exchange rate is assumed to follow the evolution of domestic prices.16 When inflation accelerates, the depreciation of the currency leads to an increase in the domestic value of the external debt that is proportional to the change in the country’s price level. Because the real value of the stock of debt remains, therefore, unchanged, interest payments will increase at the same rate as domestic prices, thus maintaining constant their share of GDP.

Therefore, in the presence of inflation, and provided that the domestic debt is in short-term instruments, the share of the conventional fiscal deficit relative to GDP becomes a function of (1) the rate of inflation, (2) the size of the domestic public debt, and (3) the composition, domestic versus external, of total public debt. For countries with all their public debt in foreign currencies, their fiscal deficit as a share of GDP will not be affected by their inflation rate, irrespective of the magnitude of such debt. On the contrary, for countries whose debt is held in the form of floating-interest domestic debt, this fiscal deficit will depend on the rate of inflation and on the magnitude of their public debt. This asymmetry results only from the convention that, whereas all nominal interest payments (including the inflation premium contained in the nominal interest rate) are considered expenditures and thus contribute to the fiscal deficit, amortization payments are not considered expenditure and thus do not contribute to the increase in the deficit. During high inflation, the rate at which a country is implicitly forced to amortize its debt increases, but the de facto amortization is not recognized as such. The higher is the rate of inflation, the faster is the implicit amortization.

The consequences of inflation on the deficit in the presence of some other types of debt instruments also deserve some comment. When long-term fixed interest bonds have been the main instrument of government financing, the nominal interest bill will not be affected by a burst of inflation that had not been anticipated at the time the bonds were sold. This means that, initially, the interest bill and, thus, the fiscal deficit will tend to fall as a share of GDP.17 However, when those long-term instruments become due, their amortization will have to be financed by the issuance of new bonds. These will bear a higher interest rate that will reflect the increased expected inflation rate.18

As mentioned above, the case of domestic index-linked debt is almost identical to the case of foreign debt, provided that the adjustment of the principal for inflation (the monetary correction) is treated as amortization and is thus not considered an interest expenditure.19 Index clauses, be they tied to domestic prices or to the value of foreign exchange, adjust the value of the principal, which affects the nominal magnitude of present or future amortization payments. Interest payments are also affected, up to the extent that the (fixed) interest rate has to be applied on a principal adjusted for inflation (or the exchange rate). This effect, however, tends to increase interest payments only in proportion to the domestic rate of inflation, leaving the interest bill and the deficit unaltered in terms of GDP.20 The magnitude of the adjustments produced by index-linked debt is, in principle, similar to that produced by foreign debt. A potential source of difference may be related to changes in the real exchange rate—a distinct possibility in many countries, particularly when those changes take place for macroeconomic reasons or for purposes of stabilization.21

II. Macroeconomic Implications of Conventionally Defined Fiscal Deficits

An important conclusion arising from the preceding analysis is that countries with (1) identical rates of inflation, (2) the same total public debt in terms of GDP, and (3) identical ratios of tax revenue and non-interest expenditure to GDP may, nevertheless, show very different conventional fiscal deficits, depending solely on the composition of their debt. The question then arises about the economic implications of the fiscal deficit as conventionally defined and about the merits and the shortcomings of such a definition.

The measurement of the fiscal deficit in a noninflationary context is supposed to provide policymakers with an indication of the net effects of government budgetary activity on aggregate demand and on financial markets. It is intended to indicate the magnitude of additional resources over the ordinary government revenue that the government must attract from the private sector, or from external sources, to finance its own operations. The conventional definition is, thus, designed to be a measure of government contribution to aggregate demand and, through this, to the external current account disequilibrium; or, alternatively, it may measure the crowding-out of the private sector in financial markets.22

Under this definition, amortization payments are not added to other government outlays in the computation of the deficit because of the implicit assumption that those amortization payments will not be regarded as income by those who receive them. Thus, one basic assumption is that the behavior of the bondholders as consumers will not be changed by the amortization payments. Furthermore, and this is another important assumption, bondholders are expected to reinvest willingly those receipts in new government bonds issued at current market conditions. In other words, their behavior as financial investors will also not be affected. Amortization services are, therefore, not expected to create additional pressures on financial or goods markets. However, in a noninflationary context, government interest payments should be treated differently from amortization payments. Those who receive interest payments are assumed to regard them as they would any other type of income to be consumed or saved, depending on their propensity to consume. Such payments are a return on wealth rather than a return of wealth. Thus, they can be consumed without reducing the bondholder’s accumulated net wealth. Therefore, interest payments would be similar in their macroeconomic effects to any other type of expenditure.23

The Bondholder as Consumer

In the presence of inflation, however, the situation becomes more complicated. As already argued, in an inflationary environment, interest payments reflect—at least partially—compensation for the erosion in the real value of the invested capital. The part of interest payments that simply reflects the erosion of the principal as a consequence of inflation constitutes, therefore, an implicit repayment of the principal.24 One can argue that, in a true economic sense, this part is similar to the amortization payment and that a rational bondholder would treat it in the same way. The relevant question, then, is whether this inflation-induced portion of interest payments should be treated as other deficit-determining government expenditures, or whether it should be treated in the same way as amortization payments.

The answer to the above question rests in large part in the use that individuals are expected to make of the monetary correction. If individuals do not consider these interest payments as income (that is, if they do not suffer from money illusion), they should treat these interest payments in the same way as they would treat explicit amortization payments. As a consequence, these payments might have monetary, current account, or crowding-out implications similar to those of explicit amortization payments.25 Bondholders might reinvest these proceeds in additional government bonds, at existing market conditions, provided that these bonds retain their relative attractiveness. In such a case, the conventional measure of the deficit is likely to overstate the aggregate demand effect of the deficit on the economy, and an argument could be made for correcting that deficit for the effect of inflation. Notice that these considerations apply equally to nominal interest payments and to payments arising from the formal indexation of the principal.

To analyze the potential different effects on the economy of the inclusion or exclusion of the inflationary debt service, a useful starting point is the national income identity, from which the influence of government deficits on the current account is frequently derived:26


where CA is the current account deficit, DG is the government fiscal deficit, and DP is the private sector net balance, all in nominal terms.27 The government deficit could be defined as


where G is nominal government expenditure, including the real component of interest payments, I stands for the monetary correction,28 and T is current tax and nontax revenue.

It is observed from equation (1) that when the private sector is in balance (DP = 0), the current account deficit equals the fiscal deficit. Under noninflationary conditions, the private sector balance may be expected to remain more or less stable, at least in the short run; the relationship between changes in the government fiscal deficit and changes in the current account then becomes obvious.

With inflation, however, correlation between the government deficit and the private sector surplus could weaken the link between the fiscal deficit and the current account. An increase in the public sector deficit caused by an increase in interest payments that simply compensates for inflation would raise by an equivalent magnitude the private sector surplus if those payments are fully reinvested in public bonds by the private sector. In that case, the current account would remain unaltered, and, since there is no need for other financing, the increase in the public sector deficit is unlikely to result in further demand pressures.

This point can be better illustrated if the public and private sector balances are defined in terms of their financing:


where FG is foreign financing to the public sector, ΔBS is the net increase in domestic government borrowing, and ΔMS is the (nominal) increase in the supply of base money. The left-hand side of equation (3) represents the fiscal deficit as conventionally measured,29 whereas the right-hand side summarizes the financing alternatives for the fiscal deficit. FP in equation (4) is foreign financing to the private sector, ΔMD is the increase in private sector money holdings, and ΔBD is the increase in holdings of government bonds. Equation (4) indicates that the deficit or surplus of the private sector must show up in changes in its net financial asset position.

Assuming, for simplicity, zero net foreign financing to both private and public sector (that is, FG = FP= 0) and substituting equation (4) into equation (1), we obtain


It is clear from equation (5) that changes in the conventionally defined deficit will affect the current account only if those changes are not matched by changes in the same direction in the nominal demand for either money or government bonds. A more specific result could be obtained by assuming ΔMD = 0 and substituting equation (2) into equation (5), as follows:


which implies that if the total increase in the deficit arises from higher inflation-induced interest payments on the outstanding debt, I, and if this increase is fully matched by an equivalent increase in the nominal holdings of bonds (in order to maintain the real value of the stock constant), then I = ΔBD; therefore, the higher deficit does not have current account implications. Thus, it could be said that inflation, by creating the possibility of a significant correlation between increases in government deficits as conventionally defined and increases in private sector nominal savings represented by an increase in the nominal demand for bonds, eliminates, or at least weakens, the link between changes in conventionally defined budget deficits and changes in the current account.30 That this argument has some empirical validity is demonstrated by the fact that in countries with very high rates of inflation and very high (conventional) fiscal deficits, little correlation is often observed between the size of the fiscal deficit (as a share of GDP) and the size of the current account deficit. Such correlation is obvious, however, for countries with low rates of inflation.

The Bondholder as Investor

The relevant question then becomes whether the interest payment that represents the monetary correction, I, should be included in the deficit concept in order to provide an accurate estimate of the latter’s potential impact on the economy. The answer is not as straightforward as the above discussion may have led one to believe. It depends in large part, though not completely, on whether the monetary correction can indeed be refinanced under the same conditions as assumed above.31 In this regard, the factors affecting the determination of private sector demand for government bonds become crucial.

One way of dealing with the question is to consider the behavior of a typical bondholder as a consumer and as an investor. For his behavior as a consumer not to be affected by the monetary correction, it is sufficient to assume that he does not suffer from money illusion. In the absence of money illusion, the inflationary component of interest payments will not affect aggregate consumption and, thus, the current account of the balance of payments. However, when the rate of inflation is not high, or when it is changing, or when inflation is a new phenomenon, or when it is being repressed by various government policies so that there are doubts about the underlying rate of inflation, money illusions are likely to occur for at least some bondholders. The complete absence of money illusion, therefore, can be accepted only when the rate of inflation has stabilized for some time and is relatively high.

However, although it might be reasonably argued that a high conventional deficit that results mainly from the effect of inflation on nominal interest payments may not have any direct effect on the bondholder as a consumer, it is very likely to influence him as an investor. A high conventional deficit will increase the nominal payments the government makes to bondholders (that is, it will accelerate the pace at which the debt is being implicitly amortized) exactly at the time when their perceptions of expected rates of returns on different assets and of the risks associated with those returns are changing rapidly. Thus, it is unlikely that, under such circumstances, the government will be able to refinance the inflation-induced component of interest expenditure under the same real conditions (that is, equal real rate for identical maturity) as it would have in the absence of inflation.

Full bond refinanceability of inflation-induced interest service would require, first, that there is a stable demand for bonds in real terms and, second, that the rate of inflation is not an argument in that function. These two conditions would imply that the private sector is willing to hold in its portfolio the same real amount of government bonds, denominated in domestic currency, without changes in conditions with respect to other domestic or foreign financial assets, regardless of the magnitude of the inflationary process. If such a behavioral assumption does hold, the government would be able to issue and place, without changing rates of returns and liquidity conditions, new nominal bonds to finance the part of the debt service that compensates bondholders for inflation. This issue of new bonds would not change the real stock of bonds outstanding and, since it would be willingly held, would not change spending patterns or create pressures on interest rates.

How plausible is the argument that the demand function for government bonds does not include inflation? Although this is essentially an empirical question, most of the theoretical arguments based on portfolio theory support the existence of such a function.32 These arguments were developed for large industrial countries without high rates of inflation. There are, however, some channels through which inflation may reduce the real demand for bonds. These include money illusion effects, which would induce bondholders to increase their consumption; or, much more likely, the possible perception of increased default risk, which would accompany a higher nominal stock of debt and a high rate of inflation. Tax considerations are a third possibility.

If, indeed, inflation reduced the real demand for bonds, inflation-induced interest payments (as well as indexation payments) would not be fully refinanceable under the existing conditions. The sale of these bonds would require either higher real interest rates or bonds of higher liquidity, which would result in higher demand pressures throughout the economy. Therefore, in this case, inflation-induced interest payments should not be excluded from deficit calculations. Whether they should be completely included in these calculations is a different issue.

It is difficult to rationalize money illusion on a significant scale or beyond a short period of time when the rate of inflation is high and stable. But it is likely to emerge when inflation is a new phenomenon, or when the rate of inflation is changing rapidly. In these cases, some individuals will very likely be unable to distinguish between real and nominal interest payments, and their consumption will be affected.

The notion of default risk associated with the level of the nominal debt is, however, more plausible and needs some elaboration. An increase in risk perception related to growth in the stock of real debt does not need explanation. With respect to nominal debt, it could be rationalized mainly on the basis of the relative increase in the weight of public debt compared with other sources of revenue and financing, in particular, the growth of public debt in relation to (1) government tax revenues, which in actual situations are likely to lag the inflationary process; (2) the monetary base, which falls in real terms, given the reduction in money demand, as inflation accelerates; and (3) the capacity to borrow abroad, which is affected by the tendency of inflation to reduce foreign confidence.

If inflation brings about a fall in the capacity to raise taxes, to collect the inflation tax on the monetary base, and to borrow abroad, it will also increase the risk of default on the public debt or, at least, the public’s perception of such a risk. As such, it may reduce the willingness of individuals to lend to the government. This attitude on the part of the public will be reinforced by the fact that the deterioration of the inflationary situation will increase the probability that adjustment programs will be adopted that might include capital levies on bondholders, higher income taxes on interest incomes, and restriction on capital movements.

It could be argued that, under certain circumstances, the demand for government bonds may actually rise in real terms as inflation increases. This may happen, first, because individuals may attempt to get out of non-interest-bearing money and may thus increase their demand for interest-bearing assets. More important, demand may rise when government bonds are fully indexed or bear returns closely related to the rate of inflation. There might then be little risk in holding government bonds as long as bondholders continue to have confidence in the government’s ability and willingness to continue meeting its financial obligations. In such a case, government bonds may come to be seen as more desirable investments than other available alternatives, because the risk associated with the return on specific real assets (like stocks or real estate) as well as nonindexed financial assets is expected to increase due to the higher variability of relative prices in inflationary situations.33

The strength of this argument is, however, weakened when the rate of inflation becomes high and when the alternative of financial investments abroad is feasible; it is further weakened by the possibility that the government might change its treatment of indexed bonds or that it might default. In that case, indexed government bonds may be seen, at least by some investors, as less attractive investments than the foreign alternatives, so that financial savings may be channeled abroad. The “dol-larization” of the economy may be one of the results of this shift. Capital flight might be another.

The tax system introduces another important factor that leads to a reduction of the real demand for government bonds in a period of high inflation. Income taxes are in general, though not always, levied on nominal incomes. Thus, when individuals receive nominal interest payments, they are taxed on the total of these payments without an adjustment for the effect of inflation. This fact in itself would induce a shift away from financial assets (including government bonds) toward real assets or foreign investments, since unrealized capital gains on real assets are tax free and foreign investments are often totally tax free. Furthermore, since it is difficult, if not impossible, to evade taxes on incomes derived from government bonds, whereas it is much easier to evade taxes on incomes derived from private sources, the demand for government bonds will fall unless they are made tax exempt. In fact, to induce bondholders to continue holding these bonds, governments have at times increased their real return by making them tax free.

Two additional factors should be considered in an analysis of the stability of real demand for public debt. One is related to the overall confidence inspired by the economic policies followed by the government. In general, the persistence of high rates of inflation is likely to lead to an erosion in the confidence of economic agents in the authorities’ ability to conduct sound economic policies. Such an erosion leads to a fall in the credibility of the government, which may in turn lead to a desire to reduce the exposure of individual portfolios to assets linked directly to government policies. A credibility crisis will tend, therefore, to shift preferences away from government bonds and, most likely, toward foreign or speculative domestic assets. As already mentioned, tax considerations are likely to contribute to this shift.

The second consideration is related to financial innovation. Although new financial instruments are constantly introduced into the system, it is in periods of high and sustained inflation that many new alternatives to the existing instruments enter the market in response to the demand for inflation hedges. In those circumstances, the demand for government bonds may not be stable enough to warrant the assumption of full refinanceability of the whole volume of inflation-induced interest payments.

Liquidity Effects

Another important consideration that bears on the question of whether debt service should be included or excluded from the deficit measure is the potential impact of the volume of nominal government debt on the general monetary conditions of the economy. Even if full refinanceability of the debt service were assured, its relevance could still be challenged from a conceptually different angle. When the rate of inflation accelerates and becomes high, the government is likely to be forced to increase the effective real return on its liabilities through an improvement in the quality of debt instruments; that is, by increasing their liquidity.34 Such an increase in liquidity would increase the “money-ness” of the public debt, making it more suitable to replace part of the monetary base in its role as a medium of exchange. This possibility of substitution would accelerate the reduction in the demand for the monetary base with inflationary and, depending on the behavior of the exchange rate, balance of payments consequences similar to those associated with an increase in its supply.35 If, as inflation accelerated, this substitution process were carried to the extreme, the government debt could become the relevant money supply in the system, and its inflationary service could be equivalent to indexing the money supply. Again, this effect on the demand for money associated with the increasing liquidity of public debt has been observed in countries with very high rates of inflation.

It may thus be concluded that the inflationary component of the debt service (whether arising from interest or indexation payments) is likely to put less pressure on financial or goods markets than the real component of interest payments or other government expenditures. The many qualifications to that conclusion—and the likely monetary consequences of this type of expenditure—make it doubtful, however, that a complete exclusion of inflationary debt services from deficit calculations is warranted.

III. An Alternative Definition: The Operational Fiscal Deficit

Once the shortcomings of the conventional definition of the fiscal deficit in an inflationary context are recognized, the question to be asked is whether there are alternative measures that would solve some of its analytical problems. An alternative that is sometimes used is the so-called operational fiscal deficit, which is defined as the conventional deficit minus the part of the debt service that compensates debt holders for actual inflation; alternatively, it is equal to the primary deficit plus the real component of interest payments. Only real interest payments—that is, the part of interest payments that exceeds the product of the outstanding debt and the actual inflation rate—are included among the government expenditures that determine the operational deficit. The economic rationale of this definition is the assumption that inflation-induced interest payments are similar in their effects to amortization payments. Conventional deficits exclude amortization payments from deficit calculation independently of the way in which those payments are financed. The operational deficit concept excludes only the portion of the debt service that compensates for inflation.

In addition to the objections discussed in the previous section to the assertion that the part of debt service that compensates for inflation is fully refinanceable, calculation of the operational deficit requires precise estimation of the part of interest payments that compensates for inflation. This estimation often involves great technical difficulties; for instance, among the several inflation indices that could be chosen to calculate real interest rates, a selection has to be made of the most appropriate one. And, of course, none of these indices may reflect the expected rate of inflation. Another problem arises when interest rates are negative in real terms. To apply a general index in these circumstances would mean to adjust downwards the conventional deficit measure by a magnitude that is larger than the actual interest payments. What is the appropriate adjustment under such circumstances? Is bond refinanceability better measured by actual interest payments or by the inflationary erosion of the principal value of outstanding public debt? In this particular case, a third possibility has been suggested, namely, to reduce the computable interest payments to an amount equivalent to a (trend) real interest rate calculated over the outstanding public debt; the difficulties of choosing the appropriate methodology originate from the evaluation of which alternative better reflects bondholders’ behavior.36

Despite these difficulties, the operational deficit definition can provide useful information to policymakers when the rate of inflation is very high. It would, in principle, reflect a lower-bound estimate for the public sector deficit, which would be relevant only if the refinanceability of the debt service is feasible to the assumed extent and does not itself have inflationary implications.

IV. Conclusions

In the presence of floating-interest domestic debt, inflation gives rise to three major shortcomings in the conventional definition of fiscal deficits. (1) Inflation makes it difficult to evaluate the precise meaning and implications of the fiscal deficit. (2) The evaluation of fiscal performance over time is complicated by changes either in the rate of inflation or the composition of the debt, or both. (3) It is difficult to compare conventionally defined deficits of countries with different rates of inflation and different uses of debt instruments.

What the Fiscal Deficit Means

The fiscal deficit is, under any circumstances, a crude tool for assessing the impact of fiscal policy on the economy. When supported by relevant economic analysis, however, it can be an indicator of the need for and the extent of adjustment either on the expenditure or the revenue side of the budget. Despite its obvious limitations, it is generally considered a useful tool for the interpretation of economic developments and for meaningful discussions of policy choices. It has nevertheless been observed that countries with identical but substantial rates of inflation, identical ratios of receipts and noninterest expenditure to GDP, and equal debt to GDP ratios may show very different fiscal deficits when the composition of their total debt is different. This observation raises difficult questions as to the interpretation of the fiscal deficit as conventionally defined under inflationary circumstances. For this reason, as the rate of inflation accelerates, it becomes essential to supplement in various ways the information provided by the conventional deficit.

Evaluation of Fiscal Performance Over Time

The complications introduced by an acceleration or deceleration of inflation in the interpretation of conventional fiscal deficits create difficulties in the evaluation of fiscal performance over time. A pure debt management action that changes the composition of the public debt without affecting its size can illustrate the nature of this problem. Under inflationary circumstances, debt management policies that modify over time the debt structure between floating interest domestic debt and foreign debt, for example, would affect the apparent magnitude of the conventional deficit, changing the image of the country’s fiscal performance.37 Changes in the availability of foreign financing or in the level of reserves may allow for large changes in the stock of floating interest domestic debt that, under inflationary circumstances, would bear important consequences for the conventional deficit figure.38 Therefore, such policy action would project an image of fiscal improvement when actually there may not have been any basic change in the fiscal policy of the country.

Comparison of Fiscal Policies Across Countries

The factors already described will also affect any exercise of comparability across countries. As an example, countries that have identical debt ratios to GDP, similar but high inflation rates, and otherwise identical fiscal positions may show quite different levels of conventional deficits if the mix of government debt instruments is different. This problem may be serious when the comparison concerns countries with high and accelerating inflation. It may also be of some relevance for comparability among countries with milder inflation, provided that their total debt to GDP ratios are high and that the structure of their debt differs significantly.

General Conclusions

High rates of inflation can affect the usual or conventional definition of the fiscal deficit in various ways. On the one hand, as the rate of inflation rises, the picture emerging from the conventional measure may, under certain circumstances, become somewhat blurred, since the conventional measure may magnify the size of the fiscal adjustment that a country needs. For example, a country with a high rate of inflation and a high domestic debt ratio that, say, shows a conventionally measured deficit of 20 percent of GDP, is unlikely to require an increase in revenue or a reduction in noninterest public spending of that magnitude in order to restore fiscal balance. Normally, a smaller adjustment would suffice because the fiscal adjustment undertaken would reduce the rate of inflation and, thus, interest payments. Ex post, the conventional deficit would decrease by more than the ex ante fiscal adjustment.

On the other hand, under inflationary conditions, a definition, such as the operational fiscal deficit, that subtracts from the conventional deficit all inflation-induced interest payments is not likely to be fully comparable to the deficit of countries with low inflation and would thus not be the relevant one to guide fiscal policy. Such an alternative definition may give the impression that no fiscal adjustment is required, a conclusion that is often invalid in countries with high inflation. In other words, whereas in high-inflation countries the conventional measure may overstate the size of the fiscal adjustment required, the operational measure in all likelihood understates that adjustment, because a measure that corrects the deficit ex post for the effect of inflation may miss its ex ante impact on inflation.

The implicit conclusion that follows is that when the rate of inflation of a country rises and becomes high, the usual interpretation given to single and standard measures of fiscal deficits should be qualified. In high-inflation countries both the conventional measure of the deficit, as well as a measure that adjusts the deficit for the effect of inflation, should be provided. Both measures have their own shortcomings and both are based on specific behavioral assumptions. However, jointly they provide more information than either one in isolation.39

Whether the fiscal adjustment required comes closer to the conventional measure or to the inflation-corrected measure should be determined on a case-by-case basis that takes into account the behavior of prices, the current account of the balance of payments, the financial resources available to finance the deficit, and the main identifiable cause of inflation. As a practical matter, the size of the debt service that compensates bondholders for the reduction in the real value of their assets arising from inflation should be made explicit. It would then be possible to indicate the part of the deficit whose impact depends mainly on portfolio decisions regarding the public’s demand for government bonds, and on the potential effects of these bonds on the monetary and liquidity conditions of the economy.


Effect of Inflation on the Deficit in the Presence of Alternative Types of Debt Instruments

In this appendix, a formal demonstration is developed to show the differential impact of inflation on conventionally defined deficits in the presence of alternative types of debt instruments.

To keep the demonstrations as simple as possible, it is assumed that: (1) real income is constant over time; (2) the budget is initially in equilibrium, with (real) interest payments being financed by a surplus from all other operations; (3) nominal interest rates on the public debt change immediately following changes in the inflation rate, so as to keep the real rate of interest constant; (4) expected and realized inflation rates are equal; (5) government policies keep revenues and noninterest expenditures growing apace with inflation; and (6) the rate of inflation is constant.

Initial equilibrium in the budget implies that



D0 = fiscal deficit in the initial period

R0 = revenues in the initial period

G0 = noninterest expenditures in the initial period

S0 = stock of public debt at the beginning of the initial period

r =real rate of interest.

The Case of Floating-Interest Debt

The assumption of full adjustment of the nominal interest rate (i) to inflation implies that


The fiscal deficit in period n(Dn) would then become


The first term of the right-hand side of equation (9) reflects the assumption that government revenues and noninterest expenditures grow at a pace with inflation. The second term represents the amount of interest payments in period n; the stock of debt on which nominal interest is paid in period n is equal to the stock of debt in period O (S0), plus the accumulated deficits until the beginning of period n.

Equation (9) implies that, given equation (7), the deficit in period 1 is


For period 2, equation (9) becomes


As a genera] result,


Given the assumption of a fixed real income level—that is, that nominal GDP grows at the same rate as inflation, we have


It can therefore be concluded that the deficit in terms of GDP,


becomes a positive function of the rate of inflation and of the initial stock of floating interest debt in terms of GDP. Table 1 reproduces the numerical results of equation (12) for alternative rates of inflation and of floating interest debts in terms of GDP.40

Table 1.

Effect of Inflation on Conventional Fiscal Deficits in the Presence of Floating-Interest Domestic Debt

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Note: It is assumed for simplicity that there is no fiscal deficit when inflation is zero and that tax revenues and noninterest expenditures grow in proportion to the price level. The methodology and assumption for the construction of this table are explained in the text and follow equation (12) in Appendix I.

The Case of Foreign Debt

In the case of foreign debt, as well as in the case of domestic indexed debt in which indexation is not treated as deficit-determining expenditure, the rate of interest is not affected by domestic inflation;41 total interest payments will, however, grow with inflation, because the nominal value of the stock of debt in domestic currency terms grows as the exchange rate depreciates. Equation (9) has to be reformulated therefore in the following terms:


The second term of the right-hand side reflects the interest payments; the interest rate (r) is applied over the initial debt indexed by the currency’s depreciation rate (d) and over the debt accumulated out of subsequent deficits, indexed also up to the end of period n. Under the assumption that d = r, equation (9a) for period 1 becomes


and for period 2 becomes


The budget therefore stays balanced, as the increase in nominal interest payments is equal to the increase in the original excess of revenues over noninterest expenditures.

APPENDIX II: Inflation and National Accounts

The purpose of this appendix is to indicate the distortions and consequent limitations of national account figures in the presence of inflation. It is the usual practice to adjust the measures of GDP or gross national product (GNP) by inflation so as to obtain a measure of changes in output in real terms. A similar adjustment is not usually performed, however, for the sectoral income and expenditure flows from which indicators such as the personal savings ratio, the budget deficit, and the current account are built.

The usual identity between output produced and sold is


which states that GDP equals private consumption, plus investment, plus government expenditure, plus exports minus imports; government expenditure is defined as excluding all transfer payments, both interest payments and subsidies. Therefore, it comprehends only government purchases of goods and services. Real GDP is estimated by deflating the components on the right-hand side by either an average GDP deflator or by the application of price indices relevant to each component.42

Alternatively, the adjustment of nominal to real figures could be done on a GNP figure, which is obtained by adding or subtracting net factor income from abroad to GDP.43





FI = factor income from abroad

CA = current account.

Another usual presentation of the national accounts involves sectoral flows; assuming that GNP equals national disposable income, personal disposable income (Yd) would be:



R = transfers received by the private sector, including nominal interest payments on the public debt

T = taxes paid

C = private consumption

S = private savings.



and, replacing C in equation (17),


Equation (20) states that the current account of the balance of payments must be equal to the deficit of the public sector plus the net balance of the private sector. As usually presented, these sectoral flows are not adjusted for inflation. In the public accounts, interest payments are included in nominal terms as transfers (R), and they are implicitly considered as disposable income of the private sector (see equation (18)), except for the case of interest payments abroad. In the presence of inflation, the deficit of the public sector may no longer be identified with increases in the public debt in real terms. Similarly, savings of the private sector would reflect an increase in its assets in nominal rather than in real terms.

Equation (20) is an identity that suggests important relations between the accounts of the government, the private sector, and the current account. Some attempts have been made to bring a behavioral content into these identities in the context of the fiscal approach to the balance of payments. Even in the absence of inflation, testing the hypothesis that changes in fiscal deficits would be followed by similar changes in current account disequilibria involves the assumption that the net balance of the private sector will remain constant. This condition may change due to many factors, such as changes in fiscal policies (for example, tax changes) or exogenous shocks. The test would then also implicitly assume either that the net private balance does not change, or that it changes ex ante, and the unavailability of foreign credit to the private sector and the lack of accommodation of domestic credit policies would thus leave the ex post net balance of the private sector unaltered.

The assumed independence between changes in the fiscal deficit and the behavior of the net balance of the private sector may be further complicated under inflationary conditions. Changes in the size of conventional fiscal deficits caused by changes in the inflationary service of the public debt may be reflected by changes of similar magnitude, but of opposite sign, in the net balance of the private sector. This result would be obtained if bondholders willingly reinvested the inflationary service of the public debt so as to keep their stock of real bonds unaltered in real terms.

Inflation may also weaken the relation between conventional fiscal deficits and current account disequilibrium, since it would increase the nominal demand for monetary base. The inflation tax on the monetary base is an alternative source of financing the deficit, which is likely to be intensively used when the availability of foreign credit and reserves is exhausted. In general, there is a strong presumption that the fiscal deficit will influence current account developments when a country’s foreign financing possibilities are opened and its foreign reserves are plentiful. This presumption will also hold if there is a desire to avoid crowding the private sector out of financial markets. However, when foreign financing becomes tight and foreign reserves are exhausted, the size of the current account deficit may be limited. Inflation may then become the main consequence of fiscal deficits. In any of those conditions, the refinanceability of the inflationary service of the public debt reduces the need for either foreign financing or monetization of deficits, without crowding the private sector out of financial markets.


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Mr. Tanzi is Director of the Fiscal Affairs Department of the Fund. He holds a Ph.D. in Economics from Harvard University. Mr. Blejer is Division Chief of the Special Fiscal Studies Division in the Fiscal Affairs Department. He earned his degrees in economics from the Hebrew University of Jerusalem and holds a Ph.D. from the University of Chicago. Mr. Teijeiro is a consultant in the Fiscal Affairs Department, He holds degrees in economics from the University of Buenos Aires and the University of Chicago. The authors are grateful for the many comments received from col leagues throughout the Fund. They retain responsibility, however, for any remaining errors.


For a detailed discussion of ways in which inflation affects real tax revenues, see Tanzi (1980). See also Tanzi (1985b).


To simplify the presentation, in all these examples the effect of compounding and the complications created by the existence of progressive income taxes levied on nominal interest incomes are ignored. For details see Tanzi (1976).


There is a large and growing literature on inflationary accounting of fiscal deficits and on the different deficit definitions that should apply in the presence of inflation. See, among others, Buiter(1983), Cukierman and Mortensen (1983), Eisner and Pieper (1984), Eisner (1986), and Miller (1982). Given its important operational implications, this issue has been the subject of much research among Fund staff members. Some of their recent contributions include Bierman (1985); Catsambas (1986); Heller, Haas, and Mansur (1986); Mackenzie (1984); Molho (1986); and Tanzi (1985a).


Whether his beuavior as an investor will continue to be the same is a different issue, which will be discussed later.


By fiscal adjustment we mean here the increase in the ratio of government revenue to GDP, or the reduction in the ratio of noninterest government expenditure to GDP. Thus, fiscal adjustment is related to the so-called primary deficit—that is, the conventional fiscal deficit net of interest payments.


See International Monetary Fund, Manual on Government Finance Statistics (1986).


This definition differs from the System of National Accounts (SNA) definition in two important respects: it is calculated on a cash basis, whereas the SNA definition is based, in principle, on accrual concepts; it considers net lending to the private sector as expenditure contributing to the determination of the deficit.


A measure of monetary transfer needs from the central bank would be given by the difference between total expenditures and total receipts (including receipts from the sale of bonds).


A measure of gross financing needs would be given by the difference between total outlays and total receipts excluding borrowing proceeds. As this is a cash concept, changes in the size of arrears do not affect its size.


The above assumption about the de facto behavior of tax revenue is somewhat unrealistic, especially when the rate of inflation accelerates or decelerates (see Tanzi (1977)). Reduction of collection lags, adjustment of tax bases, as well as increases in the tax rates of some excises are measures that would prevent the deterioration of revenues in real terms. Indexation of brackets and deductions would prevent the fiscal drag.


Obviously, the government may try to control interest rates or suspend indexation clauses. This alternative could, however, be ruled out for an extended period of time due to its undesirable consequences in terms of sectoral transfers, misallocation of resources, and capital flight.


The primary deficit is the difference between government expenditure, excluding all interest payments, and government revenue.


Of course, if the actual rate of inflation diverges from the expected rate, the ex post real rate will change.


See Table 1 (in Appendix I) for a numerical example.


This is applicable to index-linked domestic debt as long as the increase in the nominal value of the debt due to indexation is excluded from the conventional definition of the deficit. If the indexed part is included, the results are the same as with floating debt.


That is, no change in the real exchange rate takes place. Furthermore, it is assumed that foreign inflation is zero.


In this case, the government has an inflationary gain at the expense of the holders of long-term bonds. There is, therefore, an implicit capital levy on those who hold the public debt. This capital levy can be considered part of the inflation tax levied by the government on its monetary and other nominal liabilities.


Long-term fixed-interest domestic debt may be found to be relevant only in countries with mild levels of inflation or where inflation is a new phenomenon. In the United States the high level of public debt accumulated during World War II consisted of long-term bonds carrying low interest rates in anticipation of very low rates of inflation after the war. The inflation rate that accompanied the postwar period, although low, was enough to substantially reduce the burden of the debt until the late 1970s.


Neither the guidelines of the International Monetary Fund’s Manual on Government Finance Statistics nor those of the National Accounting System recommend including indexation payments or accruals as deficit-determining expenditure.


This assumes that the index used for the monetary correction does not diverge from the one reflecting the rate of inflation of GDP. It also assumes that real GDP does not change.


Other types of debt instruments are the so-called zero-coupon bonds. They constitute a particular case that creates some conceptual difficulties even in the absence of inflation arising from the distinction between accruals and realizations; they are likely to be irrelevant in high-inflation countries, however, because the risk associated with the expected real return on that type of asset will grow significantly with inflation.


In a medium-term framework, monetization of the deficit would lead to inflation, reserve losses, or both; foreign financing would lead to appreciation of the real exchange rate and current account disequilibrium as well as inflation if the nominal exchange rate is not allowed to appreciate; domestic financing would push interest rates up, crowding out domestic investment or encouraging capital inflows and a consequent current account deficit. In the short run, changes in the deficit may also affect the level of economic activity.


It is well known that real expenditures may have different effects on demand from transfer payments. This distinction is ignored in this discussion. For a discussion of the issue, see Borpujari and Ter-Minassian (1973) and Hansen and Snyder (1969).


This issue is similar to that encountered in the taxation of interest income during inflation; it has been argued that only real interest should be taxed (see Tanzi (1976)).


This, or course, does not necessarily mean that there would not be any such implications at all, but rather that they would be the same as for explicit amortization payments.


A further discussion of some of these aspects is contained in Appendix II.


Notice that DP<0 indicates an increase in private sector net nominal savings.


Alternatively, I stands for the accrued increase in the nominal value of indexed debt, if such increase is treated as a deficit-determining expenditure.


The fiscal deficit in this case could also be identified with a definition in which the accrued increase in the value of indexed principal is treated as interest payments.


What is implicitly assumed here is that the issuance of new bonds is limited to the refinancing of the inflationary component of the debt service; issuance of bonds over and above that level would clearly crowd out the private sector from financial markets.


The “same conditions,” means at a given real rate of interest and at given liquidity characteristics.


There is very little empirical evidence about the independent role of inflation in the determination of the real demand for bonds. Some preliminary results based on portfolio analysis for the United Kingdom are presented in Perraudin (1987).


On the relationship between high inflation and the variability of relative prices, see Blejer (1983) and Hercowitz (1981). There is, however, evidence that relative price variability may result in a reduction in economic activity and in a contraction of real income (Blejer and Leiderman (1980)). In this case, the real demand for bonds may be negatively affected, offsetting the positive effect from indexation described above.


In the absence of this increase in liquidity, the government may have to increase the real interest rate by much larger amounts. A shortening of the maturity structure of public debt has been observed in several countries experiencing high rates of inflation.


In addition to reducing the real demand for money in a once-and-for-all fashion, the introduction of close monetary substitutes also increases the elasticity of the money-demand function, which implies a larger sensitivity of money balances to further changes in the rate of inflation. It also implies a fall in the revenue from the inflation tax.


In some cases, the suggestion to adjust the deficit measure for inflation has gone far enough to correct for the inflationary impact on all public debt, including the non-interest-bearing monetary base; such a proposal would additionally amount to considering as fiscal revenue the inflation tax on the monetary base. The problem with this extreme formulation is that it excludes inflation from the variables to be explained by fiscal deficits.


Real interest rate differences explained by exchange risk premiums are, however, legitimate elements in the computation of the deficit.


That is, greater recourse to foreign financing would help to reduce the deficit as conventionally measured, provided that such financing is used to repay floating interest on the domestic debt.


It would also be worthwhile to provide a measure of the primary deficit that excludes the total interest payment in order to focus on the variables (current revenue and noninterest expenditure) that are, to some extent, under direct government control and must reflect the necessary fiscal adjustment.


It is possible to arrive at somewhat different results depending on whether inflation rates are defined on an annual, monthly, or even daily basis. What the relevant rate is depends on the time profile of government revenues and expenditures; for construction of Table 1, inflation rates have been defined on a daily basis, reflecting the implicit assumption of a uniform daily flow of revenues and outlays.


Foreign inflation is assumed to be zero.


Differences between both methods may be significant in the presence of changes in the terms of trade if foreign trade is important.


In this case, the problem of choosing the appropriate indices to deflate the nominal figures is compounded if factor payments (that is, interest on foreign debt, worker’s remittances) are important. In general, changes in the terms of trade or in foreign debt interest rates or in migrant remittances may produce serious divergences between the volume and purchasing power measures of the national product.

IMF Staff papers: Volume 34 No. 4
Author: International Monetary Fund. Research Dept.