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

By Goohoon Kwon, Lavern McFarlane, Wayne Robinson

May 1, 2006

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Goohoon Kwon, Lavern McFarlane, and Wayne Robinson. Public Debt, Money Supply, and Inflation: A Cross-Country Study and Its Application to Jamaica, (USA: International Monetary Fund, 2006) accessed December 26, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

This paper provides comprehensive empirical evidence that supports the predictions of Sargent and Wallace's (1981) "unpleasant monetarist arithmetic" that an increase in public debt is typically inflationary in countries with large public debt. Drawing on an extensive panel dataset, we find that the relationship holds strongly in indebted developing countries, weakly in other developing countries, but generally not in developed economies. These results are robust to the inclusion of other variables, corrections for endogeneity biases, and relaxation of common-slope restrictions and are invariant over sub-sample periods. We estimate a VAR to trace out the transmission channel and find the impulse responses consistent with the predictions of a forward-looking model of inflation. Wealth effects of public debt could also affect inflation, as posited by the fiscal theory of the price level, but we do not find supportive evidence. The results suggest that the risk of a debt-inflation trap is significant in highly indebted countries, and pure money-based stabilization is unlikely to be effective over the medium term. Our findings stress the importance of institutional and structural factors in the link between fiscal policy and inflation.

Subject: Fiscal policy, Government debt management, Inflation, Monetary base, Public debt

Keywords: Exchange rate, Money supply, WP

Publication Details

Pages:

39
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2006/121
Stock No:

WPIEA2006121
ISBN:

9781451863819
ISSN:

1018-5941

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