The Relationship between Inflation and the Budget Deficit in Turkey

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The Relationship between Inflation and the Budget Deficit in Turkey Author(s): Kivilcim Metin Source: Journal of Business & Economic Statistics, Vol. 16, No. 4 (Oct., 1998), pp. 412-422 Published by: American Statistical Association Stable URL: http://www.jstor.org/stable/1392610 . Accessed: 03/05/2011 18:24 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . http://www.jstor.org/action/showPublisher?publisherCode=astata. . Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].

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Between Relationship in Turkey Deficit Budget

Inflation

The

and

the

Kivilcim METIN Departmentof Economics,BilkentUniversity,Ankara,Turkey([email protected]) This articleanalyzesthe empiricalrelationshipbetweeninflationand the budgetdeficit for the Turkisheconomyby a multivariatecointegrationanalysis.A single-equationmodel shows that the scaled budgetdeficit (as well as income growthand debt monetization)significantlyaffects inflationin Turkey.The conditionalmodelof inflationis constant,andit encompassesa previously estimatedmodel. KEY WORDS: Cointegration; Encompassing; Exogeneity;Turkishinflation.

An extensiveliteraturehas examinedthe relationshipbe- cal expansionwas a determiningfactor for inflation.The tweenthe budgetdeficitandinflation.At a theoreticallevel, excess demandfor money affectedinflationpositively,but SargentandWallace(1981) showedthatundercertaincon- only in the short run. On the other hand, importedinfladitions,if the time pathsof governmentspendingandtaxes tion, the excess demandfor goods, and the excess demand are exogenous,bond-financeddeficits are nonsustainable, for assets in the capitalmarketshad little or no effect on andthe centralbankshouldeventuallymonetizethe deficit. inflation.A key policy implicationof Metin (1995) is that This will increasethe money supply and inflationin the Turkishinflationcould be reducedrapidlyby eliminating long run. These findingshave subsequentlybeen general- the budgetdeficit. The aforementionedgeneralliteratureinfluencesthe curized for the open economy case and for alternativeforms rentstudy,whichbuildsdirectlyon Metin(1995).The large of financing(see Scarth1987;Langdana1990). The empiricalrelationshipbetween the deficit and in- public-sectorbudgetdeficitsandthe relativelyhighinflation flation in developedcountrieshas been studied in detail in Turkeyduringthe last four decades have sparkedde(see HamburgerandZwick 1981;Dwyer 1982;Hein 1983; bate on their consequencesfor the Turkisheconomy.The Ahkingand Miller 1985;King and Plosser 1985; Protopa- main questionis whetherbond-financeddeficits are inflapadakisand Siegel 1987; Burdekinand Wohar 1990; Ho tionaryor whetheronly monetizeddeficitsare inflationary. 1990). Empiricalstudies of developingcountriesinclude To answerthis question,this article investigatesthe relathose of Dornbushand Fisher (1981), Bhalla (1981), Sid- tionshipbetweenTurkishinflationandbudgetdeficitsover diqui (1989), Choudharyand Parai(1991), Buiter and Pa- 1950-1987. Althoughthe governmentshiftedfrom monetel (1992), Dogas (1992), Sowa (1994), Hondroyiannisand tizing the deficit to bond financingin the mid-1980s,the Papapetrou(1994),andMetin(1995).These studiesdid not short annualsample on Treasurybonds precludedsorting yield conclusiveresultson the relationshipbetweenthe bud- out the effectsof this alternativemeansof deficitfinancing. get deficitandinflation,eitherin the shortrunor in the long Therefore,I have used Metin's (1995) datasetfor analyzrun. Specifically,Hamburgerand Zwick (1981) found that ing the relationshipbetweeninflationandthe public-sector growthin FederalReservedebt holdingsexerteda signif- budgetdeficit,consideringa closed-economypublic-finance icant inflationaryimpacton the U.S. economyover 1961- approach.The closed-economyassumptionmay appearre1982, yet a growth in nonmonetizeddebt had a negative strictive,but Metin (1995) showedthe lack of externalefshort-runeffecton inflation.AhkingandMiller(1985)mod- fects in the determinationof Turkishinflation.The empirieled deficits,money growth,and inflationover 1950-1980 cal analysishereinis of generalinterestbecausemanyother as a trivariateautoregressiveprocess.They found govern- developingcountrieshaveexperiencedbudgetandinflation ment deficitsto be inflationaryin the 1950s and 1970s but difficultiessimilarto those in Turkey. Section 1 presentsa historicalbackgroundto the Turknot in the 1960s.Using a rational-expectations macromodel ish economyfor 1950-1987, and Section2 developsa theof Peruvianinflation,Choudharyand Parai (1991) found oretical frameworkbased on the public-financeapproach. that budgetdeficits, as well as the growthrate of money Section 3 tests for budgetdeficitsand inflationbeing coinsupply,have significantimpactson inflation.Similarly,Dofindsthatthey are).Althoughweak exogene(and gas (1992) found that the public deficit affects inflationin tegrated does not appearvalid,a parsimoniousconditionalmodel Greece. Hondroyiannisand Papapetrou(1994) also found ity is still developed(Sec. 4). This model is empiricallycona relationshipbetween the Greek governmentbudgetand whereas the correspondingmarginalmodel is not, stant, model, Sowa (1994) price level. Using an error-correction thus showing super exogeneity for dynamicsparameters. found that inflationin Ghanais influencedmore by output volatilitythanby monetaryfactors,bothin the long runand in the shortrun. ? 1998 American Statistical Association For Turkey,Metin(1995) analyzedinflationusing a genJournal of Business & Economic Statistics eral frameworkof sectoralrelationshipsandfoundthatfisOctober 1998, Vol. 16, No. 4 412

Metin:The RelationshipBetween Inflationand the BudgetDeficitin Turkey

413

Additionally,the new conditionalmodel encompassesthe SEE's, which had financialdeficits due to both increased model of Metin (1995). wage costs anda rise in the rateof investmentby the SEE's (see Onis and Riedel 1993). The growth of government spendingduringa boom in the mid-1970sled to risingbud1. HISTORICAL BACKGROUND get deficits, for which the CentralBank provideda major This sectionpresentsa brief economichistoryof Turkey, partof the financing.The public sectorborrowingrequirefocusing on inflationandbudgetfinancing. ment (PSBR)was 4.3%of gross nationalproduct(GNP)in Fromthe 1950s until 1980, the Turkishgovernmentcon- 1973, more than doublingto 10.7%in 1979. sistentlyfollowed a policy of importsubstitution,with proInflationreachedabout 100%in 1980, apparentlyfed by hibitionson importsof commodities.State economic en- monetizationof the public-sectordeficit. Policy changes terprises(SEE's) were establishedto produceagricultural in the early 1980s were designedto shift Turkey'sgrowth commodities,several manufacturedgoods, and minerals. strategyaway from importsubstitutionand towardgreater In the late 1950s, the Turkisheconomy experiencedse- integrationwith the internationalmarket.The 1980 stabidifficultiesandrisinginflation.Ef- lization programattemptedto deal with inflationby creverebalance-of-payment forts to controlinflationconsistedlargelyof pricecontrols. ating greater efficiency in operatingthe SEE's, restrainPrivate-sectorfirmsrespondedeither by shuttingdown or ing the growth of public expenditure,reducingsubsidies, by selling on the black market.SEE's,however,sold at of- and attemptingto improverevenuecollection. Under the ficial prices and experiencedlosses. As inflationincreased, government'sliberalizationprogram,the financialperforthese losses reachedenormousamounts.The losses were mance of SEE's improvedsubstantially.Unlike their perautomaticallyfinancedby the creditsextendedby the Cen- formanceduringthe previousdecades,SEE's appearedto tralBankto the SEE's,resultingin high moneygrowth(see have contributedpositivelyto the financialposition of the Aktan 1964; Okyar 1965; Fry 1972, 1980; Krueger1974, centralgovernmentin the 1980s.The government'srestric1995;Onis and Riedel 1993). tive stance could not be fully maintained,however.The In 1958, Turkeyimplementeda fairly typical Interna- PSBR remainedat about6% of GNP duringthe first half tional MonetaryFund (IMF)-supportedstabilizationpro- of the 1980s and rose to 8.3% in 1987, the highest since gram, which improvedthe foreign-exchangesituationand 1980. Contributingfactors included slow growth of revdrasticallyreducedinflation.The most importantcompo- enues, a strongincreasein budgettransfersto loss-making nent of the programwas an increasein the prices of SEE SEE's, higher than plannedwage and salaryraises in the goods, a componentthat was featuredprominentlyin the public sector, and an election. After 1980, policy reforms 1970and 1980reformsas well. Raisingthosepricesin 1958 continued.Althoughinflationfell to approximately35%in resultedin an immediateand once-and-for-allincreasein 1982, it startedrising againand continuedto be a problem the price level, after which the reducedrate of expansion throughoutthe 1980s. of CentralBank creditsreducedinflation.Althoughinflation droppedfrom25%in 1958to less than5%in 1959,real FRAMEWORK 2. THEECONOMIC gross domesticproduct(whichhad been declining)started This sectionsummarizesthe theoreticalmodelunderlying growingimmediatelydue to the greateravailabilityof imthe empiricalanalysis.In a closed economy,it is assumed ports. that all public debt takes the form of noninterest-bearing Turkeywas amongthe morerapidlygrowingdeveloping countriesduringmost of the 1960s, with an annualinfla- money.The public sectorbudgetidentityis then tion rate of 5%-10%.The nominalexchangerate was kept G - T = AH (1) constantafter the 1958 devaluation.Investmentspending increasedand was financedmainly by foreign aid. In the or late 1960s, foreign aid did not increase,but the rate of inAH G-T (2) vestmentspendingwas maintained.In addition,some dif= py PY ' ficultiesappearedin obtainingimports,creatingvisible rewhere G is public-sectorexpenditures,T is public-sector straintson economicactivityand growth. Y is real income, P is the price level, and H is revenues, Althoughinflationwas risingat the time,the mainreason base In a steady-stategrowingeconomy,it follows money. for the 1970 devaluationwas foreign-exchangedifficulties. that After the devaluation,export earningsincreasedsharply, and Turkishworkersin Germanyand other western EuLY zP A(H*) =(H*) Q4H ropeancountriesstartedremittinga significantamountof foreign exchange.Because there was no mechanismreadS AH ily at handfor the CentralBank to sterilizethese inflows, (3) - H* (Ap + Ay), pY the moneysupplyexpandedrapidlyandinflationincreased, reachingan annualrate of 25% by 1973. In the early and where A is the differenceoperator;H*, Ap, and Ay are the mid-1970s, the problemof the growing public-sector scaledbase money (H/PY), inflation,and the growthrate deficit also arose from the expenditureside. In particular, of realincome,respectively;andvariablesin lowercase are large salary increaseswere grantedto civil servants,and in logarithms.It is assumedthat the long-runincome elassubstantialincreases in transferpaymentswere made to ticity of the demandfor moneyis unity.Thenthe simplified

414

Journalof Business & EconomicStatistics,October1998

2.0 2.1

1/.4

.78

.12

=

- 4.2B

c

-

+

(5)

-.04

-4.9 1950

1955

1969"

1965

197

1975

985

1989

Price Indexand and Base Consumer Price Index Base Money: Figure1.!. Consumer Money:pp

Figure

=

,

,

h h

1955

1960

1965

1970

1975

1980

1985

1990

Figure3. The GrowthRate of Real Income:Ay =

=

=

3.1 The Data and Unit-Root Tests

budgetconstraintis A(H*) _B PY1

-

(4)

H* (Ap + Ay).

Solving (4) for Ap, I obtainthe following relation: Ap = c + 1B - Vb2Ay,

(5)

where B is the scaled budget deficit (G - T)/H, c is the

constantterm (interpretableas the inertialinflationrate), and V) and V2 are slope coefficientsassociatedwith the scaleddeficitandincomegrowth.Here,V1and'Q2 areequal coefficientswith an oppositesign [see Phelps(1973),Anand and van Wijnbergen(1989), and Rodrik(1990) for theory andempiricalanalysis].The remainderof this articleempirically analyzesthe relationshipbetweenthe budgetdeficit, inflation,base money,and real income growth. 3.

1950

1999

THE DATA,UNIT-ROOTTESTS, AND COINTEGRATIONANALYSIS

This section tests for unit roots in the series of interest (Sec. 3.1) and for cointegrationbetween the series (Sec. 3.2).

The dataused areannualover 1950-1987. Budgetexpenditures (G) and budgetrevenues(T) are from the budget and final accounts,respectively[Turkishlira (TL)Billion]. The generalbudgetdeficit (G - T) is the primarydeficit, which excludesinterestpayments(TL Billion).The budget deficit does not includethe SEE's deficit.Becausereliable statisticsabout SEE's deficits are availableonly after the secondhalf of the 1970s,the generalbudgetdeficitis therefore used as a proxyfor the totaldeficit.The pricelevel (P) is the consumerprice index with base year 1980, Y is real GNP (TL 1980 Billion),and H is base money.The componentsof base moneyare currencyin circulation,vaultcash, legal reserves,andCentralBanksightdeposits(TLBillion). The Appendixdescribesthe datain greaterdetail. Figures 1--4show (h,p), (t, g), Ay, and (Ap, B), respectively.Visually,all seriesappearat least I(1);the augmented Dickey-Fuller(1981) (ADF) test statisticsin Table 1 support the graphicalexplanation.p and h appear1(2)(Fig. 1), and h* is I(1). Governmentexpenditures(g) and revenues (t) also seem to be 1(2)(Fig. 2), but the scaled deficitB is clearly I(1). Ay is I(0) and, from its plot, looks like a

.64r.56 .48

6.3-

-.9.

1.8.

1959 1959

1955

Figure 2.

1969

1965

1979

1975

Revenues and Taxes: g =

1989

1985

,t=

--.

1999

1955

1969

1965

1979

1975

1989

1985

Figure4. Inflationand the Rescaled Budget Deficit:zp = B =-

-

1999

Metin: The Relationship Between Inflationand the Budget Deficit in Turkey

415

Table1. AugmentedDickey-FullerTestStatistics Variable B

Nullorder

g

t

I(1)

-1.15

-.89

(10)

(1)

1(2)

-2.14 (3)

-2.20 (3)

I(3)

-5.95** (2)

-6.68** (2)

p

h

-1.03

-.28

-.44

-1.39

(2)

(1)

(1)

(5)

-2.78 (0)

-3.68 (0)

-7.26** (0)

-9.02** (0)

-8.07** (1)

h*

y

-8.51** (0)

-1.11

(3) -5.04** (2)

NOTE: Fora givenvariableand nullorder,twovaluesare reported.The firstrowis the t value,whichis the ADFstatistic,and the second rowis the longestsignificantlag withsignificantt value. Five lags are allowedin each variable'sADFregression,but twelvelags are allowedforg and t. Allregressionsincludea constanttermand a trend.The sample is 1954-1987 (T = 34) if the variablesare in theirlog levels (exceptB), 1955-1987 (T = 33) iftheyare infirstdifferences,and 1956-1987 (T = 32) ifvariablesare insecond differences.The criticalvaluesare fromMacKinnon (1991,table 1). Hereand elsewherein this article,** and * denote rejectionat the 1%and 5%criticalvalues.

stationaryheteroscedasticseries (Fig. 3). Figure4 captures grating vectors are identifiedX2(2) = 1.1559[.5611](see the essence of the cointegrationanalysis:Both Ap and the Johansen1991, theorem5.1). From the standardized3' eigenvectors,the first cointescaled budgetdeficit B sharethe same upwardtrendover time. gratingvectoris the growthrateof real income.The second one is an inflationrelation: 3.2 System CointegrationAnalysis (6) This subsection tests for cointegrationamong the seAp = .58B + .35h*. ries (Ap, h*, B, Ay). I test for cointegrationin a first-order vector autoregression(VAR),using the multivariatecoin- The publicsectordeficitB enterswith a positivecoefficient tegrationprocedureof Johansen(1988) and Johansenand (.58), and scaled base money h* also has a positive coefJuselius(1990).The VARincludesa constantterm,a trend, Table2. A Cointegration Analysisof {Ay, Ap, B, h*} and an impulsedummy(i1980). The impulsedummyrepresentsthe structuralchange in the Turkisheconomy that Eigenvalues .662 .085 .739 .445 took placein 1980.The constantandi 1980 enterthe system r< 3 r< 1 r< 2 r= 0 Hypotheses The trendis restrictedto lie in the cointegraunrestrictedly. 17.7 2.7 32.5 Max statistic 40.4 tion spacebecausea quadraticdeterministictrendin levels 95% critical value 27.1 14.1 3.8 21.0 of economic variablesis not usually a sensible long-run 2.7 20.4 93.2 52.9 Trace statistic outcome (see Doornik and Hendry 1994). The cointegra- 95% critical value 47.2 3.8 29.7 15.4 tion resultsarequite sensitiveto the lag lengthof the VAR. StandardizedeigenvectorsP' Ourchoice of one lag is basedon the SchwarzandHannanB Trend h* Quinncriteria,both of which pointedto a single lag. The Variable Ay Ap estimationperiodis 1952-1987. -.124 .0006 1 .188 -.088 Table2 summarizesthe cointegrationresults.It includes .0128 1 -1.222 -2.515 -.769 1 .009 -.0191 -1.042 1.745 the eigenvalues,the max and trace statistics,the standard1 .0052 .611 -.443 .125 ized estimatedfeedback coefficientsa and cointegrating vector p', and statisticsfor testing restrictionson a. The Standardizedadjustmentcoefficientsa cointegrationtest statistics are correctedfor sample size .006 .097 .054 -1.200 Ay (see Reimers 1992), and they suggest three cointegrating Ap .042 -.129 -.201 -.692 vectors.The residualmisspecificationtests appearsatisfac- B .337 -.185 .071 .079 andthe h* .076 -.037 -.115 -.016 tory.None of the equationsexhibitsautocorrelation, equationsfor B and Ay have nonnormalresiduals. Weakexogeneitytest statistics BecauseI findthreestationaryrelations,I needto identify B h* Ay p the estimatedcointegratingvectorsbeforeI interpretthem. Variable the second row of the trend that is 12.506 38.848 Ay stationary, 2.41 12.963 Assuming X2(5) [.4911] [.0047]** [.0058]** [.000]** p3is an inflationrelation,and the thirdcointegratingvector p value is includingjust Ap and B, I test the identificationof all Diagnosticstatistics cointegratingvectors.The expected/3' matrixwill be B h* A Variable

1

'=

0

01.*0

0

0

0 ? 10,J

,

and implementingthose identificationrestrictionsleads to the restrictedform /' anda matrixreportedin Table3. The likelihoodratio test statisticsuggests that all three cointe-

Normality X2(2) ARCH 1 F(1, 25) AR 1-2 F(2, 25)

y

11.35** 1.14 .86

p

.61 .58 1.29

7.93* .25 1.27

.24 1.61 1.44

vectors.The criticalvaluesforthe cointeNOTE:r is the hypothesizednumberof cointegrating test statistic (1992).The Jarque-Bera(1980) normality grationtests are fromOsterwald-Lenum with2 df underthe nullof normalerrors.ARCHF(dfl, df2) refersto the has a X2 distribution test forARCHerrors,introducedby Engle(1982).The AR1 F(dfl, df2) is the test for residual autocorrelation.

Journal of Business & Economic Statistics, October 1998

416

Table3. A Restricted-Form Cointegration Analysis Standardizedeigenvectors/' Variable

Ay

Ap

B

h*

1.000 0.000 0.000

0.000 1.000 1.148

0.000 -0.585 1.000

0.000 -0.349 0.000

Standardizedadjustmentcoefficientsa Ay Ap B h*

-.024 -.487 .747 .162

-1.348 -.348 -.157 -.067

-.038 -.085 -.611 -.134

Weakexogeneitytest statistics Variable X2(6) p value

Ay

Ap

B

74.151 [.000]

16.136 [.000]

23.989 [.000]

for Ay), Juselius's (1992) approachis used for singleequationmodeling.Recallingthe cointegrationanalysisin the previousSection 3.2, a single inflationequationis conTrend structed.The inflationmodel includesthe error-correction terms(ECM's)obtainedfromthe earliercointegrationanal0.000 0.000 ysis. The firstECM(CI2)is constructedusingEquation(6), -0.012 andthe secondECM(CI3)is obtainedfromthe thirdrowof the f' matrixgivenin Table3. Thenthe generalECMmodel involvesA2p,AB, Ay (becauseit is stationary),Ah*, their lags, and the lagged ECM's.Here, single-equationmodeling startswith an unrestrictedfourth-orderautoregressive distributedlag (ADL) in the (log) levels of the variables, model: writtenas an error-correction k-2

k-2

k-2

liABt-Bi -ES

A2pt = E

i=O

2iAYt-i +

i=O

5E 3iAh;-i i=O

k-2

ficient (.35). The third stationaryrelationshipis between inflationandthe scaledbudgetdeficit. The standardized a coefficientsshowthatthe maineffect of the firstcointegratingvectoris on Ay. Fromthe second columnof a, feedbackof the second cointegratingvector on both B and Ap is .75 and -.49, respectively.The third cointegratingvector primarilyaffects the scaled deficit B. Weak exogeneity for 3 can be tested using the Johansen (1992a,b)procedure.The results suggest that Ap, B, and h* cannotbe assumedweaklyexogenousfor 0, but Ay can be (see Table2). Weakexogeneityof the variablesis also testedjointly with identificationrestrictionandrejectedfor Ap, B, and Ay (see Table3). For inference,conditionalmodelsshouldhaveregressors thatare weaklyexogenous;see Engle,Hendry,andRichard (1983). In the context of cointegration,weak exogeneity meansthatinferenceaboutthe cointegratingvectorcan be performedon the conditionalmodel withoutloss of information relative to a system analysis. Even lacking weak exogeneity, single-equationmodeling can proceed, treating the system-basedestimatedcointegrationcoefficientsas given; see Juselius(1992). Section 4 developssuch a conditionalmodel and examinesits properties.

+ 5E04iA2pt-i + 5CI2t-1 i=o

+ 6CI3t-1+ c + ut,

(7)

where k = 4 and c representsthe constantterm,trend,and impulsedummiesi1980 and d55. The model sufferedfrom a majoroutlierin 1955 that was not explainedby the variables in the informationset and did not correspondto any previoushistoricalevents. Thus, I createda dummy(d55) to pick this up. This equationis a reparameterization of the ADL model and is in I(0) space. Furthermore,this equation obviatesthe need for weak exogeneitywith respectto the cointegratingestimatesfrom the Johansen-systemprocedure. Equation(7) is fittedover 1954-1986. Estimationresults and diagnosticstatistics are reportedin Table 4, column 2. The diagnosticstatisticstest againstseveralalternative (DW andAR), skewhypotheses-residual autocorrelation ness and excess kurtosis (normality),autoregressiveconditionalheteroscedasticity(ARCH),and heteroscedasticity (RESET).The estimatedECMmodelembodiesthe sensible long-runsolutionin (6) and has good diagnosticstatistics. The RESETtest suggesteda possible nonlinearityin the model,however,perhapsbecausemanyof the disequilibria are likely to interact. 4. SINGLE-EQUATION MODELING The generalECM can be simplified.Modeling general This sectiondevelopsa parsimonious,conditional,single- to specific, a parsimoniousmodel of inflationis obtained equationmodel for inflation,in which inflationdependson (Table4, col. 3): the scaled budgetdeficit, the real growthrate of income, A2pt = + .2487 + .002153trend + .3762i1980 andscaledbasemoney.Section4.1 developsa parsimonious [.1912] [.00142] [.0479] conditionalmodelfroma generalautoregressivedistributed +.3357d55 - .3729A2pt_1 + .2031ABt lag andshowsthe constancyof this conditionalmodel.Section 4.2 estimatessome marginalequationsand tests their [.0583] [.1864] [.1451] constancy.Finally, Section 4.3 comparesthe model esti-.704Ayt + .5179Ayt_2 + .5045Ah•_2 matedby Metin (1995) with the conditionalmodel devel[.2884] [.3809] [.3128] opedin this article,usingthe standardencompassingframe-.1772 CI2t-1 .1062 CI3t_1 (8) work. [.1110]

4.1 Single-EquationAnalysisand the Constancyof a ConditionalModel

[.0561],

where R2 = .89,& = .0476, DW = 1.60, AR(2, 20) = 1.77, ARCH: F(1,20) = .13, Normality: X2(2) = 1.85, and Because weak exogeneitydoes not appearvalid (except RESET: F(1, 21) = 4.57.

Metin: The Relationship Between Inflationand the Budget Deficit in Turkey

417

Table4. The Conditionaland MarginalModels Dependentvariable A2p

A2p

AB

Ah*

Ay

Estimationmethod

Sample Constant Trend il1980 d55 A2Pt-1 A2Pt-2 ABt ABt-1 ABt-2 ABt-3 A Bt4 ABt-5 Ayt Ayt-1 AYt-2 Ayt-3 AYt-4 Ayt-5 Ahb* Aht,_ Ah_2

OLS

OLS

1954-1986

1954-1986

.097(0.659) .0019(0.0019) .340(0.159) .350(0.078) -.359(0.282) .0532(0.201) .165(0.278) .140(0.591) .079(0.355)

.249(0.191) .0021(0.0014) .376(0.048) .336(0.058) -.373(0.186)

-.739(0.567) -.010(0.580) .435(0.494)

-.704(0.381)

RLS

RLS

RLS

1954-1986

1954-1987

1954-1986

.038(0.026)

.057(0.013)

.351(73.44)

-.067(157.94)

-.324(170.72)

.203(0.145) -1.04(0.185) -.862(0.326) -1.100(0.603) -.680(0.316) -.437(0.314)

.518(0.313) -.392(0.223) .358(0.154)

-.183(0.230) .139(0.271) .495(0.450)

.505(0.288)

Ah_ Ah_ t-3

t-4

.400(0.115)

Ah*_5 CI2t-1 CI3t-

-.086(0.104) -.138(0.361)

-.177(0.111) -.106(0.056)

R2 & F, df DW Normality X2 AR1-2 F, df ARCH 1 F, df RESET F, df

.9032 .0533 9.3352(16, 16) 1.62 .2379 1.9397(2, 14) .205(1, 14) 4.747(1, 15)*

.8937 .0476 18.494(10, 22) 1.60 1.848 1.77(2, 20) .1306(1, 20) 4.571(1, 21)*

.5896 .0967 6.226(6, 2.01 6.130* .168(2, .561(1, .027(1,

26)

24) 24) 25)

.4347 .0385 7.433(3, 2.55 1.009 1.580(2, .869(1, .000(1,

.4680 .0674 29)

27) 27) 28)

1.68 .145 .925(2, 29) .634(1, 29) 1.194(1, 30)

of the ARCHform(ARCH NOTE:The diagnosticchecksforresidualautocorrelation (AR1-2Ftest withthe degrees of freedomshown)confirmthe choiceof relevantlag, residualheteroscedaticity 1 F test) suggested by Engle(1982). RESET-Fis a regressionspecificationtest. Ittests the nullof correctspecificationof the originalmodelagainstthe alternativethatpowersof the dependent variableare present.

White (1980) estimatedstandarderrorsare in parentheses. A2p dependson its own firstlag andthe currentscaled public-sectordeficit. It is also influencedby real income growth,its second lag, and the lagged monetizationof the economy. The time trend and dummies have an impact on inflation.Equation(8) suggests a positive relationship between inflationand an appropriatelyscaled deficit. The ECM's explainthe behaviorof inflationby revealingrelatively rapidreactions.This model closely matchesthe theory model and appearsstatisticallysatisfactoryfrom the diagnostictests except for the RESETF. Parameterconstancyis also an importantstatisticalproperty.To examineconstancy,recursiveleast squaresis used because sequences of constancy tests yield tools for investigatingconstancyfrom the correspondingone-stepinnovations.From the sequenceof innovations,Chow tests can be constructedfor parameterconstancy[distributedas F(1, t - k - 1) on the null]. Graphsprovidea convenient way of portrayingevidenceaboutconstancy.Figure5 shows

the recursivelyestimatedcoefficientsof variablesin (8) and plus or minustwice theirrecursivelyestimatedstandarderrors.Coefficientsvaryonly slightlyrelativeto theirex ante standarderrors.Figure 5 also records one-step residuals and correspondingcalculatedequationstandarderrorsfor conditionalinflationequationwith 0 ? 2 estimatedstandard errors.The equationstandarderrorvaries little. Figure 5 finally plots the breakpointChow (1960) statistic for the inflationequation,whichremainsconstantover the sample periodconsidered. 4.2 Nonconstancyof MarginalModels Nonconstancyof the marginalmodels is relatedto the conceptof superexogeneity,whichimpliesthatthe parameters of the conditionalmodel remainconstant,even while those of the marginalmodelchange(i.e., the Lucascritique does not hold). This subsectionestimatesmarginalmodels for Ay, AB, andAh*. Becauseof the resultsin Section3.2, the parametersof interesthere includejust the parameters

418

Journal of Business & Economic Statistics, October 1998

Constant = + 2S.E.= ......

Trend = + 2S.E. = .....

-

.9

.

8 -

-

,

.6 . .....

"99.4

A2LP.1= 2SE =. .

.

...................

,

..3.

.3

9.004-

4.3 S.......... ,':. ......... .........' .

-.3 1975

ABt = + 2S.E.

.. .

.................

. -.6

-. e99-

-9

.-.912 1980

1985

1990

1975

=..

1980

1985

1975

1998

Ayt =

Ayt-2=.

+ 2SE. =...

+ 2SE.=

1980

1985

1990

1985

1990

1

8

-

.6

.4

,

.8

.4

.69

.2 -

-

.

--.4 -.2-.8

..2

Ah

.

012

2

=

-

=

Cl3'

.3 -

6

... .3

-1.2

. ......

?..

...

.6

9

. .......

.'9

-

/

-.1

-

-.2...... -.4 -.3-

-.3

-.6

-.6 1975

1980

1985

-.4 1975

1990

1985

1980

1990

1975

1980

(a)

CHOW

Resi2StepW .E.=..2 ..

h- +22SE =

..

1%crit= ......

.1

-.1 -.15

-."

"..

9

---

Metin:The RelationshipBetween Inflationand the Budget Deficitin Turkey

419 N4 CHOWs=_

ReslStep= S2 S. E ......

1%. crit=......

1.518

1.2 1.2

.. .

?0 .9 . .. ..

.. ..- ...t...

.

.

. ..6.-

.09 ........................

-.18 -.27

1980

1975

1985

1990

0

1975

1980

(a)

ReslStep=

+ 2-S.

N4

E.=. 1

.12-

.08

-

.....

...........

1990

.985

(b)

........

.

CHOWs=

cr it=

I_.%

-

..8

.04

.6 .4

/

/4

1

..1 ........................... 1975

1985

1980

1990

1975

1980

(C)

N4 CHOWs=

ReslStep=_

+ 2*S. E.-=

.18

1985

1990

(d)

IV. cit=

......

-

1-

0..86

-.18

..4

.

-.06

1975

1980

1985

(e)

1990

.2

1975

...

1980

....

t985

1990

(f)

Figure 6. (a) One-Step Residuals From a Marginal Model for AB With 0 ? 2 Estimated Standard Errors; (b) Breakpoint Chow Statistics for a Marginal Model of AB Normalized by Their One-off 1% Critical Values; (c) One-Step Residuals From a Marginal Model for Ay With0 f 2 Estimated Standard Errors;(d) Breakpoint Chow Statistics for a Marginal Model of Ay, Normalized by Their One-off 1% Critical Values; (e) One-Step Residuals From a Marginal Model for Ah* With 0 f 2 Estimated Standard Errors;(f) Breakpoint Chow Statistics for a Marginal Model of Ah*, Normalized by Their One-off 1% Critical Values.

for dynamicsin the conditionalmodel. For each marginal reductionprocedure.The results are reportedin Table 4, variable,we beganwith fifth-orderautoregression(includ- columns 4-6. For AB all lags matter.The residualsare ing a constant,trend,and i1980) and applieda sequential nonnormal.Figure6, (a) and (b), graphsthe one-stepresid-

420

Journalof Business & EconomicStatistics,October1998 Table5. EncompassingTestStatisticsforEquation(8) and Metin's(1995) Equation(9) Nullhypothesis Equation(8) Distribution

Statistic

Metin(1995) Distribution

Cox Ericsson

N(0, 1) N(0, 1)

-2.75 1.86

N(0, 1) N(0, 1)

-7.39 3.95

Sargan F

X2(6) F(6, 15)

6.79 1.19

X2(9) F(9, 15)

14.71 2.63

&

.0487%

.0601%

ECM-PPP,andECM-UIPwere derivedfrom the monetary sector,from purchasingpowerparity,and from uncovered interest-rateparity,and d55 is a dummy variable,which picks up a majoroutlierin 1955. Finally Ap, is consumer price index (CPI)inflationfor industrialcountries.Table5 reportsthe encompassingtest results.As shownin Table5, Equation(8) variancedominatesEquation(9) (.00487 vs. .0601). None of the encompassingtests reject (8), and all reject (9); the new model encompassesthe old one. (Note that APtl was addedto (8) to calculatethe encompassing tests.)

NOTE: T = 1954-1986.

uals andthe sequenceof breakpointChow statistics,which show considerablenonconstancy,with possible breaks in 1977 and 1984. For Ay, the thirdand fifth lags matter.Statistically,the model appearswell specifiedwith no rejectionsfrom the diagnostictests available.Figure6, (c) and(d),plots the recursivelyestimatedequationstandarderrorsandthe breakpoint Chow statistics.The marginalmodel of Ay appears constant. For Ah*, only the fifth lag matters.The equationis statisticallysatisfactory,andit appearsconstant[Fig.6, (e) and (f)]. Becausethe conditionalmodelfor A2p is constantand the marginalmodel of AB is nonconstant,AB (at least) appearssuperexogenousfor the dynamicparametersin the inflationequation. 4.3 EncompassingImplicationsof the ConditionalModel A congruentmodel should encompasspreviousempirical findingsexplainingthe same dependentvariable(see HendryandRichard1982, 1989;MizonandRichard1986). Considertwo rivalexplanations,denotedMl and M2. The questionwas whetherM2 can explainfeaturesof the data thatMl cannot.This can be a test of Ml, with M2 providing an alternativeto see whetherM2 capturesany specific informationnot embodiedin Ml (see DoornikandHendry 1994, p. 237). Severalvariantsof encompassinghave been proposed-variance(Cox 1961),parameter(Hendry1983), reduced-form(Ericsson1983), exogeneity (Hendry1988), and forecast(Chongand Hendry1986). In this subsection we compareEquation(8) with an inflationequationestimatedby Metin(1995),using suchencompassingtests. The model from Metin (1995) is Apt = -

.064 + 1.111Bt [.039]

+

[.135] +

3.901A((G- T)/Y)t [.670]

.229AECM-Mt [.099] - .272(ECM-UIP)t/2 + .074ECM-PPPt_1 [.044] [.093] + .257d55t - .234Ayt, (9) 1.663Apv,

[.362]

REMARKS 5. CONCLUDING This articleexaminesthe relationshipbetweenthe publicsector deficit and inflation.System cointegrationanalysis suggeststhree stationaryrelationships.Althoughweak exogeneitydoes not hold for variablesconcerned(exceptAy), one is still ableto developa conditionalmodelfor inflation. In thatmodel,an increasein the scaledbudgetdeficitimmediatelyincreasesinflation.Real incomegrowthhas a negative immediateeffect and positive second-lageffect on inflation.Monetizationof the deficitalso affectsinflationat a secondlag. Thesedynamicsareconsistentwithinstitutional and general knowledge of the economy.The conditional model of inflationis constantover the sampleperiod,even though several significantstructuralbreaksoccurredduring the period.Breaks includedthree devaluations,structural stabilization,and economic liberalizationprograms. As furtherevidenceof its specification,the new conditional model of inflationencompassesthe inflationequationof Metin (1995). The majorfindingfrom the new equationis thatbudgetdeficits(as well as real incomegrowthanddebt monetization)significantlyaffect inflationin Turkey. ACKNOWLEDGMENTS I am indebtedto Neil Ericsson,David Hendry,and the refereesfor helpfulcomments.EbruVoyvodahas provided valuableresearchassistance. APPENDIX:DATA This appendixdescribes the data, lists the definitions used, and gives theirunits and sources.The sampleperiod is 1950-1987. G, T: The budgetexpenditure(G) and the revenue(T) are the generalbudgetexpendituresandrevenuesfromthe budget and final accounts,respectively(TL Billion). Ministry of Finance and Custom General Directorate of Accounting, Statistical Year Book of Turkey 1990, State Institute

of StatisticsPrimeMinistryRepublicof Turkey,TableNo. 367, page 471. G - T: The generalbudgetdeficitis the generalbudgetexpenditureminus the general budget revenue-that is, the [.020] [.166] primarydeficit,which excludesinterestpayments(TL Bilwhere R2 = .8973,& = .0601, DW = 2.072, AR(2,26) lion). The budgetdeficitdoes not includethe SEE'sdeficit. = .55, ARCH: F(1,26) = 2.77, normality: X2(2) = 1.33, BecausereliablestatisticsaboutSEE'sdeficitsareavailable and RESET:F(1, 27) = 3.74. In the work of Metin (1995), only afterthe secondhalf of the 1970s, the generalbudget ECM representssectoralexcess demands,where ECM-M, deficitis thereforeused as a proxy for the total deficit.

Metin:The RelationshipBetween Inflationand the BudgetDeficitin Turkey

421

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