The Relationship between Inflation and the Budget Deficit in Turkey

Author(s): Kivilcim Metin

Source: Journal of Business & Economic Statistics, Vol. 16, No. 4 (Oct., 1998), pp. 412-422
Published by: American Statistical Association
Stable URL: http://www.jstor.org/stable/1392610
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The Relationship Between Inflation and the
Budget Deficit in Turkey

Kivilcim METIN
Departmentof Economics,BilkentUniversity,Ankara,Turkey(kivilcim@bilkent.edu.tr)

This articleanalyzesthe empiricalrelationshipbetweeninflationand the budgetdeficit for the

Turkisheconomyby a multivariatecointegrationanalysis.A single-equationmodel shows that
the scaled budgetdeficit (as well as income growthand debt monetization)significantlyaffects
inflationin Turkey.The conditionalmodelof inflationis constant,andit encompassesa previously
estimatedmodel.
KEY WORDS: Cointegration; Exogeneity;Turkishinflation.
Encompassing;

An extensiveliteraturehas examinedthe relationshipbe- cal expansionwas a determiningfactor for inflation.The

tweenthe budgetdeficitandinflation.At a theoreticallevel, excess demandfor money affectedinflationpositively,but
SargentandWallace(1981) showedthatundercertaincon- only in the short run. On the other hand, importedinfla-
ditions,if the time pathsof governmentspendingandtaxes tion, the excess demandfor goods, and the excess demand
are exogenous,bond-financeddeficits are nonsustainable, for assets in the capitalmarketshad little or no effect on
andthe centralbankshouldeventuallymonetizethe deficit. inflation.A key policy implicationof Metin (1995) is that
This will increasethe money supply and inflationin the Turkishinflationcould be reducedrapidlyby eliminating
long run. These findingshave subsequentlybeen general- the budgetdeficit.
ized for the open economy case and for alternativeforms The aforementionedgeneralliteratureinfluencesthe cur-
of financing(see Scarth1987;Langdana1990). rentstudy,whichbuildsdirectlyon Metin(1995).The large
The empiricalrelationshipbetween the deficit and in- public-sectorbudgetdeficitsandthe relativelyhighinflation
flation in developedcountrieshas been studied in detail in Turkeyduringthe last four decades have sparkedde-
(see HamburgerandZwick 1981;Dwyer 1982;Hein 1983; bate on their consequencesfor the Turkisheconomy.The
Ahkingand Miller 1985;King and Plosser 1985; Protopa- main questionis whetherbond-financeddeficits are infla-
padakisand Siegel 1987; Burdekinand Wohar 1990; Ho tionaryor whetheronly monetizeddeficitsare inflationary.
1990). Empiricalstudies of developingcountriesinclude To answerthis question,this article investigatesthe rela-
those of Dornbushand Fisher (1981), Bhalla (1981), Sid- tionshipbetweenTurkishinflationandbudgetdeficitsover
diqui (1989), Choudharyand Parai(1991), Buiter and Pa- 1950-1987. Althoughthe governmentshiftedfrom mone-
tel (1992), Dogas (1992), Sowa (1994), Hondroyiannisand tizing the deficit to bond financingin the mid-1980s,the
Papapetrou(1994),andMetin(1995).These studiesdid not short annualsample on Treasurybonds precludedsorting
yield conclusiveresultson the relationshipbetweenthe bud- out the effectsof this alternativemeansof deficitfinancing.
get deficitandinflation,eitherin the shortrunor in the long Therefore,I have used Metin's (1995) datasetfor analyz-
run. Specifically,Hamburgerand Zwick (1981) found that ing the relationshipbetweeninflationandthe public-sector
growthin FederalReservedebt holdingsexerteda signif- budgetdeficit,consideringa closed-economypublic-finance
icant inflationaryimpacton the U.S. economyover 1961- approach.The closed-economyassumptionmay appearre-
1982, yet a growth in nonmonetizeddebt had a negative strictive,but Metin (1995) showedthe lack of externalef-
short-runeffecton inflation.AhkingandMiller(1985)mod- fects in the determinationof Turkishinflation.The empiri-
eled deficits,money growth,and inflationover 1950-1980 cal analysishereinis of generalinterestbecausemanyother
as a trivariateautoregressiveprocess.They found govern- developingcountrieshaveexperiencedbudgetandinflation
ment deficitsto be inflationaryin the 1950s and 1970s but difficultiessimilarto those in Turkey.
not in the 1960s.Using a rational-expectationsmacromodel Section 1 presentsa historicalbackgroundto the Turk-
of Peruvianinflation,Choudharyand Parai (1991) found ish economyfor 1950-1987, and Section2 developsa the-
that budgetdeficits, as well as the growthrate of money oretical frameworkbased on the public-financeapproach.
supply,have significantimpactson inflation.Similarly,Do- Section 3 tests for budgetdeficitsand inflationbeing coin-
gas (1992) found that the public deficit affects inflationin tegrated (and findsthatthey are).Althoughweak exogene-
Greece. Hondroyiannisand Papapetrou(1994) also found ity does not appearvalid,a parsimoniousconditionalmodel
a relationshipbetween the Greek governmentbudgetand is still developed(Sec. 4). This model is empiricallycon-
stant, whereas the correspondingmarginalmodel is not,
price level. Using an error-correction model, Sowa (1994)
found that inflationin Ghanais influencedmore by output thus showing super exogeneity for dynamicsparameters.
volatilitythanby monetaryfactors,bothin the long runand
in the shortrun.
For Turkey,Metin(1995) analyzedinflationusing a gen- ? 1998 American Statistical Association
Journal of Business & Economic Statistics
eral frameworkof sectoralrelationshipsandfoundthatfis- October 1998, Vol. 16, No. 4

412
Metin:The RelationshipBetween Inflationand the BudgetDeficitin Turkey 413

Additionally,the new conditionalmodel encompassesthe SEE's, which had financialdeficits due to both increased
model of Metin (1995). wage costs anda rise in the rateof investmentby the SEE's
(see Onis and Riedel 1993). The growth of government
1. HISTORICAL BACKGROUND spendingduringa boom in the mid-1970sled to risingbud-
get deficits, for which the CentralBank provideda major
This sectionpresentsa brief economichistoryof Turkey,
partof the financing.The public sectorborrowingrequire-
focusing on inflationandbudgetfinancing. ment (PSBR)was 4.3%of gross nationalproduct(GNP)in
Fromthe 1950s until 1980, the Turkishgovernmentcon- 1973, more than
doublingto 10.7%in 1979.
sistentlyfollowed a policy of importsubstitution,with pro- Inflationreachedabout 100%in 1980, apparentlyfed by
hibitionson importsof commodities.State economic en- monetizationof the public-sectordeficit. Policy changes
terprises(SEE's) were establishedto produceagricultural in the early 1980s were designedto shift Turkey'sgrowth
commodities,several manufacturedgoods, and minerals. strategyaway from importsubstitutionand towardgreater
In the late 1950s, the Turkisheconomy experiencedse- integrationwith the internationalmarket.The 1980 stabi-
verebalance-of-payment difficultiesandrisinginflation.Ef- lization programattemptedto deal with inflationby cre-
forts to controlinflationconsistedlargelyof pricecontrols. ating greater efficiency in operatingthe SEE's, restrain-
Private-sectorfirmsrespondedeither by shuttingdown or ing the growth of public expenditure,reducingsubsidies,
by selling on the black market.SEE's,however,sold at of- and attemptingto improverevenuecollection. Under the
ficial prices and experiencedlosses. As inflationincreased, government'sliberalizationprogram,the financialperfor-
these losses reachedenormousamounts.The losses were mance of SEE's improvedsubstantially.Unlike their per-
automaticallyfinancedby the creditsextendedby the Cen- formanceduringthe previousdecades,SEE's appearedto
tralBankto the SEE's,resultingin high moneygrowth(see have contributedpositivelyto the financialposition of the
Aktan 1964; Okyar 1965; Fry 1972, 1980; Krueger1974, centralgovernmentin the 1980s.The government'srestric-
1995;Onis and Riedel 1993). tive stance could not be fully maintained,however.The
In 1958, Turkeyimplementeda fairly typical Interna- PSBR remainedat about6% of GNP duringthe first half
tional MonetaryFund (IMF)-supportedstabilizationpro- of the 1980s and rose to 8.3% in 1987, the highest since
gram, which improvedthe foreign-exchangesituationand 1980. Contributingfactors included slow growth of rev-
drasticallyreducedinflation.The most importantcompo- enues, a strongincreasein budgettransfersto loss-making
nent of the programwas an increasein the prices of SEE SEE's, higher than plannedwage and salaryraises in the
goods, a componentthat was featuredprominentlyin the public sector, and an election. After 1980, policy reforms
1970and 1980reformsas well. Raisingthosepricesin 1958 continued.Althoughinflationfell to approximately35%in
resultedin an immediateand once-and-for-allincreasein 1982, it startedrising againand continuedto be a problem
the price level, after which the reducedrate of expansion throughoutthe 1980s.
of CentralBank creditsreducedinflation.Althoughinfla-
tion droppedfrom25%in 1958to less than5%in 1959,real 2. THEECONOMIC FRAMEWORK
gross domesticproduct(whichhad been declining)started
This sectionsummarizesthe theoreticalmodelunderlying
growingimmediatelydue to the greateravailabilityof im-
the empiricalanalysis.In a closed economy,it is assumed
ports.
that all public debt takes the form of noninterest-bearing
Turkeywas amongthe morerapidlygrowingdeveloping
countriesduringmost of the 1960s, with an annualinfla- money.The public sectorbudgetidentityis then
tion rate of 5%-10%.The nominalexchangerate was kept G - T = AH (1)
constantafter the 1958 devaluation.Investmentspending
increasedand was financedmainly by foreign aid. In the or
late 1960s, foreign aid did not increase,but the rate of in- G-T AH
vestmentspendingwas maintained.In addition,some dif- = (2)
py PY '
ficultiesappearedin obtainingimports,creatingvisible re-
where G is public-sectorexpenditures,T is public-sector
straintson economicactivityand growth.
revenues, Y is real income, P is the price level, and H is
Althoughinflationwas risingat the time,the mainreason base In a steady-stategrowingeconomy,it follows
for the 1970 devaluationwas foreign-exchangedifficulties. that money.
After the devaluation,export earningsincreasedsharply,
and Turkishworkersin Germanyand other western Eu- zP LY
A(H*) =(H*) Q4H
ropeancountriesstartedremittinga significantamountof
foreign exchange.Because there was no mechanismread-
ily at handfor the CentralBank to sterilizethese inflows, S AH
- H* (Ap + Ay), (3)
the moneysupplyexpandedrapidlyandinflationincreased, pY
reachingan annualrate of 25% by 1973. In the early and where A is the differenceoperator;H*, Ap, and Ay are
the mid-1970s, the problemof the growing public-sector scaledbase money (H/PY), inflation,and the growthrate
deficit also arose from the expenditureside. In particular, of realincome,respectively;andvariablesin lowercase are
large salary increaseswere grantedto civil servants,and in logarithms.It is assumedthat the long-runincome elas-
substantialincreases in transferpaymentswere made to ticity of the demandfor moneyis unity.Thenthe simplified
414 Journalof Business & EconomicStatistics,October1998

2.0

2.1

1/.4

.78
.12

- 4.2B = c + - (5)

-4.9 -.04
1950 1955 1969" 1965 197 1975 1989 985 1999 1950 1955 1960 1965 1970 1975 1980 1985 1990

Figure1.!. Consumer
Figure Consumer Price
Price Indexand
Index and Base
Base Money:pp
Money: = , , h
h =
= Figure3. The GrowthRate of Real Income:Ay =

3.1 The Data and Unit-Root Tests

budgetconstraintis
- (4)
A(H*) _B PY1
Solving (4) for Ap, I obtainthe following relation:
Ap = c + 1B - Vb2Ay,
where B is the scaled budget deficit (G - T)/H, c is the
constantterm (interpretableas the inertialinflationrate),
and V) and V2 are slope coefficientsassociatedwith the
scaleddeficitandincomegrowth.Here,V1and'Q2 areequal
coefficientswith an oppositesign [see Phelps(1973),Anand
and van Wijnbergen(1989), and Rodrik(1990) for theory
andempiricalanalysis].The remainderof this articleempir-
ically analyzesthe relationshipbetweenthe budgetdeficit,
inflation,base money,and real income growth.
3. THE DATA,UNIT-ROOTTESTS, AND
COINTEGRATIONANALYSIS
This section tests for unit roots in the series of in-
terest (Sec. 3.1) and for cointegrationbetween the series
(Sec. 3.2).
The dataused areannualover 1950-1987. Budgetexpen-
ditures (G) and budgetrevenues(T) are from the budget
H* (Ap + Ay).
and final accounts,respectively[Turkishlira (TL)Billion].
The generalbudgetdeficit (G - T) is the primarydeficit,
which excludesinterestpayments(TL Billion).The budget
(5) deficit does not includethe SEE's deficit.Becausereliable
statisticsabout SEE's deficits are availableonly after the
secondhalf of the 1970s,the generalbudgetdeficitis there-
fore used as a proxyfor the totaldeficit.The pricelevel (P)
is the consumerprice index with base year 1980, Y is real
GNP (TL 1980 Billion),and H is base money.The compo-
nentsof base moneyare currencyin circulation,vaultcash,
legal reserves,andCentralBanksightdeposits(TLBillion).
The Appendixdescribesthe datain greaterdetail.
Figures 1--4show (h,p), (t, g), Ay, and (Ap, B), respec-
tively.Visually,all seriesappearat least I(1);the augmented
Dickey-Fuller(1981) (ADF) test statisticsin Table 1 sup-
port the graphicalexplanation.p and h appear1(2)(Fig. 1),
and h* is I(1). Governmentexpenditures(g) and revenues
(t) also seem to be 1(2)(Fig. 2), but the scaled deficitB is
clearly I(1). Ay is I(0) and, from its plot, looks like a

.64r-

.56

.48

6.3-

-.9.

1.8.

1959 1955 1969 1965 1979 1975 1989 1985 1999

1959 1955 1969 1965 1979 1975 1989 1985 1999

Figure4. Inflationand the Rescaled Budget Deficit:zp =

Figure 2. Revenues and Taxes: g = ,t= --. B =- -
Metin: The Relationship Between Inflationand the Budget Deficit in Turkey 415

Table1. AugmentedDickey-FullerTestStatistics

Variable
Nullorder g t B p h y h*

I(1) -1.15 -.89 -1.03 -.28 -.44 -1.39 -1.11

(10) (1) (2) (1) (1) (5) (3)
1(2) -2.14 -2.20 -8.07** -2.78 -3.68 -8.51** -5.04**
(3) (3) (1) (0) (0) (0) (2)
I(3) -5.95** -6.68** -7.26** -9.02**
(2) (2) (0) (0)

NOTE: Fora givenvariableand nullorder,twovaluesare reported.The firstrowis the t value,whichis the ADFstatistic,and the second rowis the longestsignificantlag withsignificantt value.
Five lags are allowedin each variable'sADFregression,but twelvelags are allowedforg and t. Allregressionsincludea constanttermand a trend.The sample is 1954-1987 (T = 34) if the
variablesare in theirlog levels (exceptB), 1955-1987 (T = 33) iftheyare infirstdifferences,and 1956-1987 (T = 32) ifvariablesare insecond differences.The criticalvaluesare fromMacKinnon
(1991,table 1). Hereand elsewherein this article,** and * denote rejectionat the 1%and 5%criticalvalues.

stationaryheteroscedasticseries (Fig. 3). Figure4 captures grating vectors are identifiedX2(2) = 1.1559[.5611](see
the essence of the cointegrationanalysis:Both Ap and the Johansen1991, theorem5.1).
scaled budgetdeficit B sharethe same upwardtrendover From the standardized3' eigenvectors,the first cointe-
time. gratingvectoris the growthrateof real income.The second
one is an inflationrelation:
3.2 System CointegrationAnalysis
This subsection tests for cointegrationamong the se- Ap = .58B + .35h*. (6)
ries (Ap, h*, B, Ay). I test for cointegrationin a first-order
vector autoregression(VAR),using the multivariatecoin- The publicsectordeficitB enterswith a positivecoefficient
tegrationprocedureof Johansen(1988) and Johansenand (.58), and scaled base money h* also has a positive coef-
Juselius(1990).The VARincludesa constantterm,a trend,
and an impulsedummy(i1980). The impulsedummyrep- Table2. A Cointegration Analysisof {Ay, Ap, B, h*}
resentsthe structuralchange in the Turkisheconomy that Eigenvalues .739 .662 .445 .085
took placein 1980.The constantandi 1980 enterthe system r= 0 r< 1 r< 2 r< 3
Hypotheses
unrestrictedly.The trendis restrictedto lie in the cointegra-
Max statistic 40.4 32.5 17.7 2.7
tion spacebecausea quadraticdeterministictrendin levels 95% critical value 27.1 21.0 14.1 3.8
of economic variablesis not usually a sensible long-run 2.7
Trace statistic 93.2 52.9 20.4
outcome (see Doornik and Hendry 1994). The cointegra- 95% critical value 47.2 29.7 15.4 3.8
tion resultsarequite sensitiveto the lag lengthof the VAR.
Ourchoice of one lag is basedon the SchwarzandHannan- StandardizedeigenvectorsP'
Quinncriteria,both of which pointedto a single lag. The Variable Ay Ap B h* Trend
estimationperiodis 1952-1987. 1 .188 -.124 -.088 .0006
Table2 summarizesthe cointegrationresults.It includes -1.222 1 -2.515 -.769 .0128
the eigenvalues,the max and trace statistics,the standard- -1.042 1.745 1 .009 -.0191
ized estimatedfeedback coefficientsa and cointegrating .125 .611 -.443 1 .0052
vector p', and statisticsfor testing restrictionson a. The Standardizedadjustmentcoefficientsa
cointegrationtest statistics are correctedfor sample size
-1.200 .097 .054 .006
(see Reimers 1992), and they suggest three cointegrating Ap Ay
-.692 -.129 -.201 .042
vectors.The residualmisspecificationtests appearsatisfac- B .079 .337 -.185 .071
tory.None of the equationsexhibitsautocorrelation, andthe h* -.016 .076 -.037 -.115
equationsfor B and Ay have nonnormalresiduals. Weakexogeneitytest statistics
BecauseI findthreestationaryrelations,I needto identify
the estimatedcointegratingvectorsbeforeI interpretthem. Variable Ay p B h*
Assuming that Ay is trend the
stationary, second row of the X2(5) 2.41 12.963 12.506 38.848
p3is an inflationrelation,and the thirdcointegratingvector p value [.4911] [.0047]** [.0058]** [.000]**
is includingjust Ap and B, I test the identificationof all
Diagnosticstatistics
cointegratingvectors.The expected/3' matrixwill be
A Variable B h* y p
1 0 0 0 11.35** .61 7.93* .24
Normality X2(2)
'= 01.*0 , ARCH 1 F(1, 25) 1.14 .58 .25 1.61
0 ? 10,J AR 1-2 F(2, 25) .86 1.29 1.27 1.44

NOTE:r is the hypothesizednumberof cointegrating vectors.The criticalvaluesforthe cointe-

and implementingthose identificationrestrictionsleads to grationtests are fromOsterwald-Lenum (1992).The Jarque-Bera(1980) normality test statistic
has a X2 distributionwith2 df underthe nullof normalerrors.ARCHF(dfl, df2) refersto the
the restrictedform /' anda matrixreportedin Table3. The test forARCHerrors,introducedby Engle(1982).The AR1 F(dfl, df2) is the test for residual
likelihoodratio test statisticsuggests that all three cointe- autocorrelation.
416 Journal of Business & Economic Statistics, October 1998

Table3. A Restricted-Form
Cointegration
Analysis for Ay), Juselius's (1992) approachis used for single-
Standardizedeigenvectors/' equationmodeling.Recallingthe cointegrationanalysisin
the previousSection 3.2, a single inflationequationis con-
Variable Ay Ap B h* Trend structed.The inflationmodel includesthe error-correction
1.000 0.000 0.000 0.000 0.000 terms(ECM's)obtainedfromthe earliercointegrationanal-
0.000 1.000 -0.585 -0.349 0.000 ysis. The firstECM(CI2)is constructedusingEquation(6),
0.000 1.148 1.000 0.000 -0.012 andthe secondECM(CI3)is obtainedfromthe thirdrowof
Standardizedadjustmentcoefficientsa the f' matrixgivenin Table3. Thenthe generalECMmodel
involvesA2p,AB, Ay (becauseit is stationary),Ah*, their
Ay -1.348 -.024 -.038
Ap -.348 -.487 -.085 lags, and the lagged ECM's.Here, single-equationmodel-
B -.157 .747 -.611 ing startswith an unrestrictedfourth-orderautoregressive
h* -.067 .162 -.134 distributedlag (ADL) in the (log) levels of the variables,
Weakexogeneitytest statistics
writtenas an error-correction model:
k-2 k-2 k-2
Variable Ay Ap B
A2pt = E liABt-Bi -ES 2iAYt-i +
5E 3iAh;-i
X2(6) 74.151 16.136 23.989 i=O i=O i=O
p value [.000] [.000] [.000]
k-2
+ 5E04iA2pt-i + 5CI2t-1
ficient (.35). The third stationaryrelationshipis between i=o
inflationandthe scaledbudgetdeficit.
The standardized a coefficientsshowthatthe maineffect + 6CI3t-1+ c + ut, (7)
of the firstcointegratingvectoris on Ay. Fromthe second where k = 4 and c representsthe constantterm,trend,and
columnof a, feedbackof the second cointegratingvector
impulsedummiesi1980 and d55. The model sufferedfrom
on both B and Ap is .75 and -.49, respectively.The third a majoroutlierin 1955 that was not explainedby the vari-
cointegratingvector primarilyaffects the scaled deficit B.ables in the informationset and did not correspondto any
Weak exogeneity for 3 can be tested using the Johansen
previoushistoricalevents. Thus, I createda dummy(d55)
(1992a,b)procedure.The results suggest that Ap, B, and to pick this up. This equationis a reparameterization of the
h* cannotbe assumedweaklyexogenousfor 0, but Ay can ADL model and is in I(0) space. Furthermore,this equa-
be (see Table2). Weakexogeneityof the variablesis also tion obviatesthe need for weak exogeneitywith respectto
testedjointly with identificationrestrictionandrejectedforthe cointegratingestimatesfrom the Johansen-systempro-
Ap, B, and Ay (see Table3). cedure.
For inference,conditionalmodelsshouldhaveregressors
Equation(7) is fittedover 1954-1986. Estimationresults
thatare weaklyexogenous;see Engle,Hendry,andRichard and diagnosticstatistics are reportedin Table 4, column
(1983). In the context of cointegration,weak exogeneity 2. The diagnosticstatisticstest againstseveralalternative
meansthatinferenceaboutthe cointegratingvectorcan be
hypotheses-residual autocorrelation (DW andAR), skew-
performedon the conditionalmodel withoutloss of infor- ness and excess kurtosis (normality),autoregressivecon-
mation relative to a system analysis. Even lacking weak ditionalheteroscedasticity(ARCH),and heteroscedasticity
exogeneity, single-equationmodeling can proceed, treat- (RESET).The estimatedECMmodelembodiesthe sensible
ing the system-basedestimatedcointegrationcoefficientsas long-runsolutionin (6) and has good diagnosticstatistics.
given; see Juselius(1992). Section 4 developssuch a con- The RESETtest suggesteda possible nonlinearityin the
ditionalmodel and examinesits properties. model,however,perhapsbecausemanyof the disequilibria
are likely to interact.
4. SINGLE-EQUATION MODELING
The generalECM can be simplified.Modeling general
This sectiondevelopsa parsimonious,conditional,single- to specific, a parsimoniousmodel of inflationis obtained
equationmodel for inflation,in which inflationdependson (Table4, col. 3):
the scaled budgetdeficit, the real growthrate of income,
andscaledbasemoney.Section4.1 developsa parsimonious A2pt = + .2487 + .002153trend + .3762i1980
conditionalmodelfroma generalautoregressivedistributed [.1912] [.00142] [.0479]
lag andshowsthe constancyof this conditionalmodel.Sec- +.3357d55 - .3729A2pt_1 + .2031ABt
tion 4.2 estimatessome marginalequationsand tests their [.0583] [.1864] [.1451]
constancy.Finally, Section 4.3 comparesthe model esti- -.704Ayt + .5179Ayt_2 + .5045Ah•_2
matedby Metin (1995) with the conditionalmodel devel- [.3809] [.3128] [.2884]
opedin this article,usingthe standardencompassingframe- -.1772 CI2t-1 - .1062 CI3t_1
work. (8)
[.1110] [.0561],
4.1 Single-EquationAnalysisand the Constancyof a where R2 = .89,& = .0476, DW = 1.60, AR(2, 20) = 1.77,
ConditionalModel
ARCH: F(1,20) = .13, Normality: X2(2) = 1.85, and
Because weak exogeneitydoes not appearvalid (except RESET: F(1, 21) = 4.57.
Metin: The Relationship Between Inflationand the Budget Deficit in Turkey 417

Table4. The Conditionaland MarginalModels

Dependentvariable
A2p A2p AB Ay Ah*
Estimationmethod
OLS OLS RLS RLS RLS
Sample 1954-1986 1954-1986 1954-1986 1954-1987 1954-1986
Constant .097(0.659) .249(0.191) .038(0.026) .057(0.013)
Trend .0019(0.0019) .0021(0.0014)
il1980 .340(0.159) .376(0.048) .351(73.44) -.067(157.94) -.324(170.72)
d55 .350(0.078) .336(0.058)
A2Pt-1 -.359(0.282) -.373(0.186)
A2Pt-2 .0532(0.201)
ABt .165(0.278) .203(0.145)
ABt-1 .140(0.591) -1.04(0.185)
ABt-2 .079(0.355) -.862(0.326)
ABt-3 -1.100(0.603)
A Bt4 -.680(0.316)
ABt-5 -.437(0.314)
Ayt -.739(0.567) -.704(0.381)
Ayt-1 -.010(0.580)
AYt-2 .435(0.494) .518(0.313)
Ayt-3 -.392(0.223)
AYt-4
Ayt-5 .358(0.154)
Ahb* -.183(0.230)
Aht,_ .139(0.271)
Ah_2 .495(0.450) .505(0.288)
Ah_ t-3

Ah_ t-4

Ah*_5 .400(0.115)
CI2t-1 -.086(0.104) -.177(0.111)
CI3t- -.138(0.361) -.106(0.056)
R2 .9032 .8937 .5896 .4347 .4680
& .0533 .0476 .0967 .0385 .0674
F, df 9.3352(16, 16) 18.494(10, 22) 6.226(6, 26) 7.433(3, 29)
DW 1.62 1.60 2.01 2.55 1.68
Normality X2 .2379 1.848 6.130* 1.009 .145
AR1-2 F, df 1.9397(2, 14) 1.77(2, 20) .168(2, 24) 1.580(2, 27) .925(2, 29)
ARCH 1 F, df .205(1, 14) .1306(1, 20) .561(1, 24) .869(1, 27) .634(1, 29)
RESET F, df 4.747(1, 15)* 4.571(1, 21)* .027(1, 25) .000(1, 28) 1.194(1, 30)

NOTE:The diagnosticchecksforresidualautocorrelation (AR1-2Ftest withthe degrees of freedomshown)confirmthe choiceof relevantlag, residualheteroscedaticity of the ARCHform(ARCH
1 F test) suggested by Engle(1982). RESET-Fis a regressionspecificationtest. Ittests the nullof correctspecificationof the originalmodelagainstthe alternativethatpowersof the dependent
variableare present.

White (1980) estimatedstandarderrorsare in parenthe- the recursivelyestimatedcoefficientsof variablesin (8) and

ses. A2p dependson its own firstlag andthe currentscaled
public-sectordeficit. It is also influencedby real income
growth,its second lag, and the lagged monetizationof the
economy. The time trend and dummies have an impact
on inflation.Equation(8) suggests a positive relationship
between inflationand an appropriatelyscaled deficit. The
ECM's explainthe behaviorof inflationby revealingrela-
tively rapidreactions.This model closely matchesthe the-
ory model and appearsstatisticallysatisfactoryfrom the
diagnostictests except for the RESETF.
Parameterconstancyis also an importantstatisticalprop-
erty.To examineconstancy,recursiveleast squaresis used
because sequences of constancy tests yield tools for in-
vestigatingconstancyfrom the correspondingone-stepin-
novations.From the sequenceof innovations,Chow tests
can be constructedfor parameterconstancy[distributedas
F(1, t - k - 1) on the null]. Graphsprovidea convenient
way of portrayingevidenceaboutconstancy.Figure5 shows
plus or minustwice theirrecursivelyestimatedstandarder-
rors.Coefficientsvaryonly slightlyrelativeto theirex ante
standarderrors.Figure 5 also records one-step residuals
and correspondingcalculatedequationstandarderrorsfor
conditionalinflationequationwith 0 ? 2 estimatedstandard
errors.The equationstandarderrorvaries little. Figure 5
finally plots the breakpointChow (1960) statistic for the
inflationequation,whichremainsconstantover the sample
periodconsidered.
4.2 Nonconstancyof MarginalModels
Nonconstancyof the marginalmodels is relatedto the
conceptof superexogeneity,whichimpliesthatthe param-
eters of the conditionalmodel remainconstant,even while
those of the marginalmodelchange(i.e., the Lucascritique
does not hold). This subsectionestimatesmarginalmodels
for Ay, AB, andAh*. Becauseof the resultsin Section3.2,
the parametersof interesthere includejust the parameters
418 Journal of Business & Economic Statistics, October 1998

Constant = Trend = A2LP.1=

+ 2S.E.= ...... + 2S.E. = ..... 2SE =.
.9 - . 8 - .6
- , . ..... .
................... ,
"99.4 . ..3.

.3
9.004-

4.3 .
S..........
,':. ......... .........' . .. . ................. -.6
-. e99-

-.3 .-.912 -9
1975 1980 1985 1990 1975 1980 1985 1998 1975 1980 1985 1990

ABt = Ayt = Ayt-2=.

+ 2S.E.
=.. + 2SE. =... + 2SE.=
8 1

.6 - , .4 .8

-
.4 .69 -
.

.2 - --.4

-.2-.8 ..2

.
...... -1.2 .
.6 ... ?..

Ah 2 012 = - = -
Cl3'

6 .3 - 9
... .'9 .
.......

.3 - -.1 /
-.2......

-.4
-.3 -.3-

-.6 -.6 -.4

1975 1980 1985 1990 1975 1980 1985 1990 1975 1980 1985 1990

(a)

h- - Resi2StepW - CHOW
+22SE= .E.=..2 .. .. 1%crit= ......
.1

-.1 -." ".. ---

-.15 9
Metin:The RelationshipBetween Inflationand the Budget Deficitin Turkey 419

ReslStep= N4 CHOWs=_ 1%. crit=......

S2 S. E ......
1.5-

18 1.2
?0 .9 . .. .. .. . 1.2

.. .
. ..- ...t... . ..6.-
.09
........................

-.18

-.27 0
1975 1980 1985 1990 1975 1980 .985 1990
(a) (b)

ReslStep= N4 CHOWs= I_.% cr it=

+ 2-S. E.=.
.12- 1 -

-
.08 ..... ........... ........ . ..8
.04
.6
/
/4 1 .4

..1 ...........................

1975 1980 1985 1990 1975 1980 1985 1990

(C) (d)

ReslStep=_ N4 CHOWs= IV. cit= ......

+ 2*S. E.-=
.18 1- -

0..86

. ..4
-.06

-.18 .2 ... ....

1975 1980 1985 1990 1975 1980 t985 1990
(e) (f)

Figure 6. (a) One-Step Residuals From a Marginal Model for AB With 0 ? 2 Estimated Standard Errors; (b) Breakpoint Chow Statistics for a
Marginal Model of AB Normalized by Their One-off 1% Critical Values; (c) One-Step Residuals From a Marginal Model for Ay With0 f 2 Estimated
Standard Errors;(d) Breakpoint Chow Statistics for a Marginal Model of Ay, Normalized by Their One-off 1% Critical Values; (e) One-Step Residuals
From a Marginal Model for Ah* With 0 f 2 Estimated Standard Errors;(f) Breakpoint Chow Statistics for a Marginal Model of Ah*, Normalized by
Their One-off 1% Critical Values.

for dynamicsin the conditionalmodel. For each marginal reductionprocedure.The results are reportedin Table 4,
variable,we beganwith fifth-orderautoregression(includ- columns 4-6. For AB all lags matter.The residualsare
ing a constant,trend,and i1980) and applieda sequential nonnormal.Figure6, (a) and (b), graphsthe one-stepresid-
420 Journalof Business & EconomicStatistics,October1998

Table5. EncompassingTestStatisticsforEquation(8) ECM-PPP,andECM-UIPwere derivedfrom the monetary

and Metin's(1995) Equation(9)
sector,from purchasingpowerparity,and from uncovered
Nullhypothesis interest-rateparity,and d55 is a dummy variable,which
Metin(1995)
picks up a majoroutlierin 1955. Finally Ap, is consumer
Equation(8)
price index (CPI)inflationfor industrialcountries.Table5
Statistic Distribution Distribution reportsthe encompassingtest results.As shownin Table5,
Cox N(0, 1) -2.75 N(0, 1) -7.39 Equation(8) variancedominatesEquation(9) (.00487 vs.
Ericsson N(0, 1) 1.86 N(0, 1) 3.95 .0601). None of the encompassingtests reject (8), and all
6.79 14.71
Sargan
F
X2(6)
1.19
X2(9)
2.63
reject (9); the new model encompassesthe old one. (Note
F(6, 15) F(9, 15)
& .0487% .0601% that APtl was addedto (8) to calculatethe encompassing
tests.)
NOTE: T = 1954-1986.

REMARKS
5. CONCLUDING
uals andthe sequenceof breakpointChow statistics,which
show considerablenonconstancy,with possible breaks in This articleexaminesthe relationshipbetweenthe public-
1977 and 1984. sector deficit and inflation.System cointegrationanalysis
For Ay, the thirdand fifth lags matter.Statistically,the suggeststhree stationaryrelationships.Althoughweak ex-
model appearswell specifiedwith no rejectionsfrom the ogeneitydoes not hold for variablesconcerned(exceptAy),
diagnostictests available.Figure6, (c) and(d),plots the re- one is still ableto developa conditionalmodelfor inflation.
cursivelyestimatedequationstandarderrorsandthe break- In thatmodel,an increasein the scaledbudgetdeficitimme-
point Chow statistics.The marginalmodel of Ay appears diatelyincreasesinflation.Real incomegrowthhas a nega-
constant. tive immediateeffect and positive second-lageffect on in-
For Ah*, only the fifth lag matters.The equationis sta- flation.Monetizationof the deficitalso affectsinflationat a
tisticallysatisfactory,andit appearsconstant[Fig.6, (e) and secondlag. Thesedynamicsareconsistentwithinstitutional
(f)]. Becausethe conditionalmodelfor A2p is constantand and general knowledge of the economy.The conditional
the marginalmodel of AB is nonconstant,AB (at least) model of inflationis constantover the sampleperiod,even
appearssuperexogenousfor the dynamicparametersin the though several significantstructuralbreaksoccurreddur-
inflationequation. ing the period.Breaks includedthree devaluations,struc-
tural stabilization,and economic liberalizationprograms.
4.3 EncompassingImplicationsof the ConditionalModel As furtherevidenceof its specification,the new conditional
A congruentmodel should encompasspreviousempir- model of inflationencompassesthe inflationequationof
ical findingsexplainingthe same dependentvariable(see Metin (1995). The majorfindingfrom the new equationis
HendryandRichard1982, 1989;MizonandRichard1986). thatbudgetdeficits(as well as real incomegrowthanddebt
Considertwo rivalexplanations,denotedMl and M2. The monetization)significantlyaffect inflationin Turkey.
questionwas whetherM2 can explainfeaturesof the data
thatMl cannot.This can be a test of Ml, with M2 provid- ACKNOWLEDGMENTS
ing an alternativeto see whetherM2 capturesany specific I am indebtedto Neil Ericsson,David Hendry,and the
informationnot embodiedin Ml (see DoornikandHendry refereesfor helpfulcomments.EbruVoyvodahas provided
1994, p. 237). Severalvariantsof encompassinghave been valuableresearchassistance.
proposed-variance(Cox 1961),parameter(Hendry1983),
reduced-form(Ericsson1983), exogeneity (Hendry1988), APPENDIX:DATA
and forecast(Chongand Hendry1986). In this subsection
we compareEquation(8) with an inflationequationesti- This appendixdescribes the data, lists the definitions
matedby Metin(1995),using suchencompassingtests. The used, and gives theirunits and sources.The sampleperiod
model from Metin (1995) is is 1950-1987.
G, T: The budgetexpenditure(G) and the revenue(T) are
Apt = - .064 + 1.111Bt - 3.901A((G- T)/Y)t the generalbudgetexpendituresandrevenuesfromthe bud-
[.039] [.135] [.670]
get and final accounts,respectively(TL Billion). Ministry
+ 1.663Apv, +
.229AECM-Mt of Finance and Custom General Directorate of Account-
[.362] [.099] ing, Statistical Year Book of Turkey 1990, State Institute
- .272(ECM-UIP)t/2 + .074ECM-PPPt_1 of StatisticsPrimeMinistryRepublicof Turkey,TableNo.
[.093] [.044] 367, page 471.
+ .257d55t - .234Ayt, (9) G - T: The generalbudgetdeficitis the generalbudgetex-
[.020] [.166] penditureminus the general budget revenue-that is, the
primarydeficit,which excludesinterestpayments(TL Bil-
where R2 = .8973,& = .0601, DW = 2.072, AR(2,26) lion). The budgetdeficitdoes not includethe SEE'sdeficit.
= .55, ARCH: F(1,26) = 2.77, normality: X2(2) = 1.33, BecausereliablestatisticsaboutSEE'sdeficitsareavailable
and RESET:F(1, 27) = 3.74. In the work of Metin (1995), only afterthe secondhalf of the 1970s, the generalbudget
ECM representssectoralexcess demands,where ECM-M, deficitis thereforeused as a proxy for the total deficit.
Metin:The RelationshipBetween Inflationand the BudgetDeficitin Turkey 421

P: Price level is the CPI. The base year is 1980 (IMFIn- Journal of Monetary Economics, 7, 141-150.
ternationalFinancial Statistics,severalissues). Hein, S. E. (1983), "Discussion," in The Economic Consequences of Gov-
Y: Y is nominal GNP, divided by the GNP deflator(TL ernmentDeficits,ed. L. H. Mayer,Boston:KluwerNijhoff,pp. 75-85.
Billion).NominalGNP is obtainedfromIMFInternational Hendry,D. F. (1983),"Comment," EconometricReviews,2, 111-114.
- (1988), "The Encompassing Implicationsof FeedbackVersusFeed-
FinancialStatistics,severalissues. forwardMechanismin Econometrics,"OxfordEconomicPapers,40,
H: H is base money.The componentsof base money are 132-149.
currencyin circulation,vaultcash, legal reserves,andCen- Hendry,D. F.,andRichard,J.-F.(1982),"Onthe Formulationof Empirical
tralBank sight deposits(TL Billion).Reservemoneyis ob- Modelsin DynamicEconometrics," Journalof Econometrics,20, 3-33.
- 0(1989), "Recent in the Theoryof Encompassing,"
tainedfrom the databaseof the CentralBank of Turkey. Developments
in Contributions to Research and Economics: The Twentieth
Operations
Anniversaryof CORE,eds. B. CornetandH. Tulkens,Cambridge,MA:
[Received June 1995. Revised April 1998.] MIT Press,pp. 393-440.
Ho, L. S. (1990),"Government
DeficitFinancingandStabilisation,"
Jour-
nal of Economic Studies, 17, 34-44.
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