BUDGET DEFICITS, MONEY SUPPLY AND INFLATION: THE CASE OF FRAGILE FIVE COUNTRIES

Abstract

In this research, the long-term and the short-term relationships between budget deficits, money supply and inflation in Fragile Five Countries for the period between 1980-2018 were investigated. In the model, inflation (INF) was defined as dependent variable, while budget deficit (BD), money supply (MS), interest rate (IR) and exchange rate (EXR) are independent variables. The long-term results of PMG Estimator revealed that money supply, interest rate and exchange rate have a positive impact on inflation. In the long-term: (i) a 1% raise in money supply increases inflation by 0.36%; (ii) a 1% raise in interest rates increases inflation by 0.73%; (iii) a 1% raise in exchange rate increases inflation by 0.0015%; and (iv) Budget deficits do not have any impact on inflation. In the short-term, money supply and interest rate have an impact on inflation, while budget deficit and exchange rate do not have any impact on inflation. Accordingly; (i) a 1% raise in money supply increases inflation by 0.18%; (ii) a 1% raise in interest rates increases inflation by 0.47%. However, it is seen that the variables create a joint effect in the long-term by interacting each other in the short-term. Although the short-term and long-term results indicate that budget deficits do not cause inflation, the interaction of variables with each other in the short-term budget deficits could increase inflation through interest rates and money supply. These results support the views of classical and monetarist.