Public Debt, Money Supply, and Inflation

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.Public debt;Economic models;inflation, money supply, price level, monetary policy, money growth, central bank, quantity theory of money, monetary economics, money demand, quantity theory, theory of money, monetary fund, aggregate demand, rising inflation, price stability, high inflation, inflation dynamics, nominal interest rates, inflation targeting, real output, average inflation, increase in inflation, monetary data, monetary aggregate, inflation money, monetary response, monetary financing, long-term interest rates, rational expectations, rise in inflation, monetary phenomenon, low inflation, monetary model, inflation forecasts, real money, monetary models, monetary growth, discount rate, high inflations, high inflation episodes, reduction of inflation, percent inflation, real interest rate, real discount rate, monetarism, lower inflation, demand for money, real interest rates, annual inflation, monetary arrangement, monetary aggregates, macroeconomic performance