ABSTRACT
Are budget deficits always inflationary? Within the context of the countries in our sample, this is the question we examine in Chapter 5. Using the Sargent and Wallace (1981) framework, it was pointed out in the previous chapter that in a regime of fiscal dominance, given that the inter-temporal budget constraint of the government must be satisfied, the central bank will be obliged to monetize the deficit either now or in later periods. To the extent that such monetization takes place, it will lead to increases in money supply and, ceteris paribus, in the rate of inflation, at least in the long run. This quantity theory result is widely accepted and need not be explored in great detail here. However, it is important to keep in mind that this result cannot be guaranteed, at least in the short run, in view of the results of the previous chapter. There we found that only a relatively weak relationship existed between budget deficits and money growth, whether in the static sense or in the dynamic sense.
