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The Impact of Inflation on Budgetary Discipline

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  • Joshua Aizenman
  • Ricardo Hausmann

Abstract

This paper investigates budgetary rules for an economy characterized by inflation and volatile relative prices. We view the budgetary process as a limited contingencies contract between the treasury and the ministers. The budgetary process allows a minister, whose realized real budget falls short of a threshold, to ask for a treasury, the minister obtains the extra funds needed to meet the expenditure threshold level. The contract sets both the projected budget and the threshold real expenditure that justifies budget revisions. We identify the efficient contract and show that for significant state verification costs and for low volatility, the contract is non contingent (i.e., a nominal contract). For volatility significant enough the contract becomes state contingent -- it reduces the initial allocation [i.e., the projected budget,] and reduces the threshold associated with budgetary revisions. Both adjustments imply that in volatile economies the projected revenue understates the realized budget hence the average budget error is positive. As volatility increases, the contract converges to a full ex-post indexation. Hence, one of the costs of inflation is that nominal contracts lose their disciplining role in determining the real allocation. Instead, the economy shifts towards more costly arrangements like ex-post indexation, where discipline is accomplished by constant monitoring The last part of the paper uses the data from 12 Latin American countries to test the model's predictions. Our tests confirm that in an inflationary environment the planned budget is under-predicting the realized one -- higher inflation increases the budget error and the average budget error is positive.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5338.

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Date of creation: Nov 1995
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Handle: RePEc:nbr:nberwo:5338

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  1. Ball, Laurence & Mankiw, N Gregory, 1994. "Asymmetric Price Adjustment and Economic Fluctuations," Economic Journal, Royal Economic Society, vol. 104(423), pages 247-61, March.
  2. Alesina, Alberto & Hausmann, Ricardo & Hommes, Rudolf & Stein, Ernesto, 1999. "Budget institutions and fiscal performance in Latin America," Journal of Development Economics, Elsevier, vol. 59(2), pages 253-273, August.
  3. Cantor, Richard M, 1988. "Work Effort and Contract Length," Economica, London School of Economics and Political Science, vol. 55(219), pages 343-53, August.
  4. Guy Debelle & Owen Lamont, 1996. "Relative Price Variability and Inflation: Evidence from US Cities," NBER Working Papers 5627, National Bureau of Economic Research, Inc.
  5. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  6. Sheshinski, Eytan & Weiss, Yoram, 1977. "Inflation and Costs of Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 44(2), pages 287-303, June.
  7. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  8. Edwards, Sebastian & Tabellini, Guido, 1991. "Explaining fiscal policies and inflation in developing countries," Journal of International Money and Finance, Elsevier, vol. 10(1, Supple), pages S16-S48, March.
  9. Townsend, Robert M., 1988. "Information constrained insurance : The revelation principle extended," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 411-450.
  10. Calvo, Guillermo A. & Kaminsky, Graciela L., 1991. "Debt relief and debt rescheduling : The optimal-contract approach," Journal of Development Economics, Elsevier, vol. 36(1), pages 5-36, July.
  11. Benabou, Roland, 1988. "Search, Price Setting and Inflation," Review of Economic Studies, Wiley Blackwell, vol. 55(3), pages 353-76, July.
  12. Aizenman, Joshua, 1984. "Optimal wage re-negotiation in a closed and open economy," Journal of Monetary Economics, Elsevier, vol. 13(2), pages 251-262, March.
  13. Stanley Fischer, 1981. "Relative Shocks, Relative Price Variability, and Inflation," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(2), pages 381-442.
  14. Calvo, Guillermo A & Guidotti, Pablo E, 1993. "On the Flexibility of Monetary Policy: The Case of the Optimal Inflation Tax," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 667-87, July.
  15. Guidotti, Pablo E. & Vegh, Carlos A., 1993. "The optimal inflation tax when money reduces transactions costs : A reconsideration," Journal of Monetary Economics, Elsevier, vol. 31(2), pages 189-205, April.
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Cited by:
  1. Bilin Neyapti & Secil Ozgur, 2007. "The Effects Of Fiscal And Monetary Discipline On Budgetary Outcomes," Contemporary Economic Policy, Western Economic Association International, vol. 25(2), pages 146-155, 04.
  2. Ernesto Talvi & Carlos A. Vegh, 2000. "Tax Base Variability and Procyclical Fiscal Policy," NBER Working Papers 7499, National Bureau of Economic Research, Inc.
  3. Bilin Neyaptý & Secil Ozgur, 1999. "The Effects of Fiscal and Monetary Discipline on Budgetary Outcomes : The Case of the European Union," Departmental Working Papers 996, Bilkent University, Department of Economics.
  4. Brückner, Markus & Gradstein, Mark, 2011. "Government Spending Cyclicality: Evidence from Rainfall Shocks as an Instrument for Cyclical Income," CEPR Discussion Papers 8622, C.E.P.R. Discussion Papers.
  5. Talvi, Ernesto & Vegh, Carlos A., 2005. "Tax base variability and procyclical fiscal policy in developing countries," Journal of Development Economics, Elsevier, vol. 78(1), pages 156-190, October.
  6. Magazzino, Cosimo, 2011. "The nexus between public expenditure and inflation in the Mediterranean countries," MPRA Paper 28493, University Library of Munich, Germany.

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