A Note on Inflation Dynamics, Price Volatility, and Fiscal Activism

Abstract

Using a panel of 54 countries between 1980 and 2013, we find empirical support for the view that changes in the fiscal policy stance (year-on-year change in the cyclically adjusted primary balance) have a significant positive correlation with inflation volatility. An increase in the volatility of discretionary fiscal policies by one standard deviation raises inflation volatility by about 6%. Moreover, results using alternative inflation volatility proxies confirm that an expansionary fiscal stance increases price volatility. Another relevant outcome is that in a context of economic expansions (recessions) the harmful impact of fiscal activism on price volatility is soft (heightened), while the negative impact of fiscal activism on price stability is higher when fiscal policy is expansionary. Finally, fiscal activism fuels inflation volatility much more pronouncedly in emerging market economies vis-à-vis advanced economies.

Application of Bootstrap Simulation and Asymmetric Causal Approach to Fiscal Deficit-Inflation Nexus

“…Its impact on inflation depends on how long it lasts and how it is financed (Ali & Khalid, 2019; Bianchi & Ilut, 2017; Hoang, 2014; Nwakobi et al, 2018). Inflation occurs if budget deficits are persistent and financed through money creation (Afonso & Jalles, 2019; Catão & Terrone, 2005; Lin & Chu, 2013; Mishkin, 2004; Sargent & Wallace, 1981). On the other hand, if budget deficits are temporary it could only produce a temporary increase in the price level, but not inflation, no matter how it is financed (Hoang, 2014).…”

“…The relationship between budget deficits and inflation has attracted increasing academic interest across the globe and the results of their research outputs have continued to be mixed and inconclusive (Afonso & Jalles, 2019; Chukwu, 2013; Kaur, 2019; Lin & Chu, 2013). While some studies have established that it is the fiscal deficit that precedes and explains inflation ( Catão & Terrone, 2005; Erkam & Çetinkaya, 2014; Lin & Chu, 2013; Maio Bulawayo & Seshamani, 2018; Oladipo & Akinbobola, 2011; Olubiyi & Bolarinwa, 2018; Onwioduokit, 1999; Ozurumba, 2012; Ssebulime & Edward, 2019), some other studies indicate the causal link running from inflation to fiscal deficit (Ishaq & Mohsin, 2015; Ndanshau, 2012; Ogunmuyiwa, 2008).…”

Euro Area Inflation Differentials: The Role of Fiscal Policies Revisited

“…While Rother (2004) finds in panel estimations of 15 OECD countries that activist fiscal policies might have an important impact on Consumer Price Inflation (CPI) volatility, Badinger (2009) can only find an indirect effect through output volatility in a similar sample. More recently, Afonso and Jalles (2020) find that the year-on-year change in the cyclically adjusted primary balance has a positive correlation with inflation volatility during 1980-2013, albeit only significantly in the emerging market subsample of the 54 countries considered.…”

Fiscal Sustainability and the Role of Inflation

“…Several studies have addressed this topic, notably Sargent and Wallace (1981), Leeper (1991), Sims (1994), Woodford (1995), andCochrane (2001), and they propose a reverse link between fiscal sustainability or unsustainability and inflation. The study by Afonso and Jalles (2020) for instance observes a significant positive correlation between changes in the fiscal policy stance through year-on-year adjustments in the cyclically adjusted primary balance and inflation volatility, across a panel of 54 countries from 1980 to 2013. Contrary to this, Cevik and Miryugin (2023) report from a panel of 139 countries spanning from 1970 to 2021 that both headline and core inflation increase in response to expansionary fiscal policies.…”