If a government's spending exceeds its revenue, the resulting deficits have to be financed either through borrowing or issuing money. However, borrowing is limited by the public's capacity or willingness to hold additional government debt, and monetary expansion leads to inflation. Although inflation is socially inefficient and politically unpopular for many reasons (1), it has been either recurrent or persistent in many economies. Although policy mistakes seem to provide an explanation for this, it is inadequate because learning from past mistakes would prevent inflation from being either recurrent or persistent over long periods. Revenues from inflationary monetary expansion that benefit governments and special interest groups, on the other hand, help explain why inflation is recurrent or persistent.
This study takes into account such special group incentives for inflation in investigating the relationship between budget deficits and inflation. This article argues that besides the social or political concerns of governments, a large measure of budget deficits results from organized interest groups that pressure the government to spend beyond its revenues. Especially in less developed countries, where both the financial market and tax collection mechanisms are not sufficiently developed to provide the government with the resources it needs, a major way to finance these deficits is money creation. Although money creation generates seignorage revenues, it also leads to inflation tax. In contrast with other forms of taxation, inflation tax is easy to implement, and its costs may be hidden temporarily, even though its long-term costs are widely dispersed. It is therefore socially efficient to build institutions that serve long-term price stability.
The main hypothesis of this article is that budget deficits lead to inflation particularly when the financial market is not developed and the central bank is not independent. The author hypothesizes that the degrees of both financial market development and central bank independence affect not only the degree of monetary accommodation of budget deficits in a given period but also the expectations about future monetary accommodation of budget deficits.
Financial market development results from both market forces and an institutional framework that facilitates efficient allocation of financial resources. Developed financial markets allocate funds to maximize profits and typically generate funds through their own operations, rather than through central bank lending. Therefore, they offer non- or less inflationary means to finance budget deficits. In addition, financial intermediaries are net lenders because they usually engage in long-term lending at fixed rates and short-term borrowing at variable market rates. Unanticipated inflation thus threatens the well-being of at least a part of the financial system. A financial sector that operates with a profit motive and relies on its own resources would therefore tend to advocate anti-inflationary policies. Recent studies (for example, Goodman, 1991; Posen, 1994, 1995; Maxfield, 1994; Al-Marhubi and Willett, 1995) argue that politically powerful interest group incentives play an essential role in building institutions, such as an independent central bank, to credibly commit to price stability. Moreover, both Goodman (1991) and Posen (1994, 1995) argue that the financial sector, along with the support of the nonfinancial sector, is most likely to generate such powerful anti-inflation lobbies that support an independent central bank, which targets price stability.
Central bank independence is generally viewed as an institutional device for committing to price stability (see, for example, Rogoff, 1985; Alesina and Tabellini, 1987; Cukierman, 1992). It may, however, result due to either a government with long-term expected tenure that therefore cares for the long-term costs of inflation or governments that have short tenure and would like to limit their successors' control over monetary policy (see Goodman, 1991). …