Inflation and the financing of government expenditure : an introductory analysis with an application to Turkey

141,78 THE WORLD BANK ECONOMIC REVIEW, VOL. 3, NO. 1: 1 7-3 8 Inflation and the Financing of Government Expenditure: an Introductory Analysis with an Application to Turkey Ritu Anand and Sweder van Wijnbergen This article presents a simple framework to assess the consistency of appropriately defined fiscal deficits with other macroeconomic targets, such as inflation. It also considers the relation of fiscal deficits to output growth, real exchange rate developments, and management of internal and external debt. Finally, it considers the implications of relying on interest-bearing government debt to postpone the adjustment necessary to restore consistency with inflation targets. It demonstrates how the intertemporal budget constraint of the government creates a tradeoff between current and future adjustment. Real interest rates and output growth rates are shown to determine the terms at which this tradeoff takes place. The usefulness of this framework is demonstrated through an analysis of fiscal policy options in Turkey in 1985. This article presents an integrated framework to assess the consistency between fiscal deficits and output growth, the rate of inflation, and other macroeco- nomic targets. The model centers on the government budget constraint and can be used either to derive the "financeable" deficit given inflation targets or to derive an equilibrium inflation rate for which no fiscal adjustment would be necessary. The financeable deficit is defined as the deficit that does not require more financing than is compatible with sustainable external and internal bor- rowing and with existing targets for inflation and output growth. The work presented here draws on theoretical contributions by Phelps (1973), Dornbusch (1977), Sargent and Wallace (1982), and Buiter (1983). (For similar work in the context of open economies, see also Drazen and Helpman 1987 and van Wijnbergen 1988.) Consistency between fiscal deficits and other macroeconomic targets can be judged starting from the government budget identity. This identity says that Ritu Anand is on the Finance Commission of the Government of India and was an economist in the Europe, Middle East, and North Africa Country Department 2 of the World Bank at the time this article was written. Sweder van Wijnbergen is an economist in the Latin America and the Caribbean Country Department 2 of the World Bank. They are indebted to Halouk Tukel and Teoman Akgur of the Central Bank of Turkey and to participants in seminars at the Central Bank and State Planning Organization in Ankara for helpful comments.