It’s Never Different: Fiscal Policy Shocks and Inflation

It’sNeverDifferent:FiscalPolicyShocksandInflation SerhanCevikandFedorMiryuginWP/23/98 2023 MAY ©2023InternationalMonetaryFundWP/23/98 IMFWorkingPaper EuropeanDepartment It’sNeverDifferent:FiscalPolicyShocksandInflationPreparedbySerhanCevikandFedorMiryugin1 AuthorizedfordistributionbyBernardinAkitoby May2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. Abstract Thispaperinvestigatestheimpactoffiscalshocksoninflation,usingalargepanelof139countriesovertheperiod1970–2021.First,bothheadlineandcoremeasuresofinflationincreaseinresponsetoexpansionaryshiftsinthefiscalpolicystance.Second,wesplitthesampleandobserveanintriguingpatternthatfiscalpolicyshocksareprimarilysignificantindevelopingcountries.Third,theinflationaryimpactoffiscalpolicyshocksisdependentonfiscalspaceandeconomicconditions,aswellasmonetarypolicytype,exchangerateregimesandfiscalrules,atthetimeoftheshock.Weconfirmtheseresultsbyusingthenarrativeapproachandforecasterrors,aswellascyclically-adjusteddataongovernmentrevenuesandnon-interestexpenditures,toidentifyexogenouschangesinfiscalpolicy.Theanalysishasseveralimportantpolicyimplications:(i)fiscalpolicyisacriticalanchorofmacroeconomicstability;(ii)fiscalpolicyshouldbeusedwithcareinaggregatedemandmanagementasithassignificanteffectsoninflation,whicharehighlydependentonfiscalspaceandeconomicconditions;and(iii)flexibleexchangeratesandrule-basedpolicymakingprovidegreaterresiliencetoinflationaryshocks. JELClassificationNumbers: E31;E50;E52;E62;E63;H60 Keywords: Inflation;fiscalpolicy;publicdebt;outputgap;localprojections Author’sE-MailAddress: scevik@imf.org;fmiryugin@gwu.edu 1TheauthorswouldliketothankBernardinAkitoby,CarlosGoncalves,AnnetaOrraca-Tetteh,AdrianPeralta,MarcosPoplawski-Ribeiro,FranciscoRoch,TatjanaSchulzeandtheparticipantsofaseminarattheEuropeanDepartmentoftheInternationalMonetaryFund(IMF)forhelpfulcommentsandsuggestions. “Historyrepeatsitself,thefirstastragedy,thenasfarce.” ―KarlMarx I.INTRODUCTION Theworldeconomyisinthemidstoftheworstinflationshocksincethe1970s,withglobalinflationsurgingover10percentin2022,fromanaverageof2.1percentduringtheperiod2010-2020.Thisisnotjustarecurringproblemindevelopingcountries,butitcouldalsobecomeanentrenchedphenomenoninadvancedeconomieswithalonghistoryoflowandstableinflation.Aconfluenceoffactors—rangingfromthestrongreboundinaggregatedemandcausedbyatitanicwaveoffiscalstimulusinthewakeoftheCOVID-19pandemictoglobalsupplyconstraintsandshockwavesthroughinternationalcommoditymarketstriggeredbyRussia’sinvasionofUkraine—hascontributedtothepost-pandemicsurgeinconsumerprices(Biniciandothers,2022). Nevertheless,asshowninFigure1,therearestillconsiderabledifferencesinthelevelofinflationandhowtheinflationprocesshaschangedacrosscountriesovertime.Inthispaper,weexamineinternationalevidenceontheroleoffiscalpolicyinshapinginflationdynamics,usingalargepanelof139countriesacrosstheworldovertheperiod1970-2021. Weinvestigatethedynamicimpactoffiscalshocksoninflationbyapplyingthelocalprojection(LP)methoddevelopedbyJordà(2005)andestimateimpulseresponsefunctions(IRFs).WeidentifyfiscalpolicyshocksasadeteriorationofonestandarddeviationintheoverallorprimarybudgetbalanceasashareofGDPandexplorethepossibilityofstate-dependenteffectsoffiscalpolicyshocksonconsumerpriceinflationbylookingattwodimensions:(i)thepositionofagiveneconomyinthebusinesscycleatthetimethefiscalshockhits;and(ii)thepublicdebt-to-GDPratio(orinterestpaymentsasashareofGDP)asaproxyoffiscalspaceatthetimethefiscalshockoccurs.Forgreatergranularity,wealsoestimatethemodelsfordifferenttypesofmonetarypolicyframeworks(i.e.,inflationtargeting),exchangerateregimes(i.e.,fixedvs.floating),andthepresenceoffiscalrules. Figure1.HeadlineandCoreInflationAcrosstheWorld A)HeadlineInflation(%)B)CoreInflation(%) Note:Eachboxcorrespondstothe25thand75thpercentileofobservationsinagivenyear,whilethewhiskersshowtheinterquartilerange.Thelineinsideaboxrepresentsthemedian;thereddotdenotestheaverage.Extremeoutlierscoloredinbluewithinflationbelow-30andabove50areremoved. Theempiricalanalysisshowsthatconsumerpriceinflationincreasesinresponsetofiscalpolicyshocks.Adeteriorationofonestandarddeviationintheoverallbudgetbalance-to-GDPratio,forexample,leadstoanincreaseof0.56percentagepointsinheadlineinflationinthefirstyearandby 0.71percentagepointsonacumulativebasisoverthemediumterm.Theinflationaryimpactoffiscalpolicyshocksexhibitsasimilarmagnitudewhenweusetheprimarybudgetbalanceasameasureofthefiscalstancebutisestimatedtobemuchlargeroncoreinflation(excludingfoodandenergy).Thestrengthandpersistenceofinflationresponse,however,arenotuniformacrossdifferenttypesofcountriesandatdifferentstatesofeconomicactivityandfiscalspace. First,wesplitthesampleandobserveanintriguingpatternthatfiscalpolicyshocksareprimarilysignificantindevelopingcountriesthatincludeemergingmarketeconomie