Fiscal Deficits and Inflation in Portugal: A Long Term Perspective

This paper examines the question whether fiscal deficits generate inflation from a long term perspective. Cointegration and Granger-causality tests with structural breaks are employed. Using long-run data for Portugal, we have shown that the price level and fiscal deficits, whether measured in amounts or as percentages of output, contain unit roots. Structural changes at various break dates do not affect their unit root processes. The price level and deficits ratios are cointegrated but the price level and deficit amounts are not. The price level and fiscal deficits as ratios of deficits to output move in an equilibrium relation in the long run. In the short-run, the error-correction model shows a feedback effect between them: higher deficit ratio raises the price level one period which in turn contributes to higher deficit ratio in the next period. Growth in deficits, whether measured by amounts or by deficit-output ratios, positively Granger-causes inflation for the whole period 1850-1985. The view held by demand oriented theories such as the traditional Keynesian, the new Keynesian, and the new classical schools appears to be supported by the lognterm data for Portugal: not only fiscal deficits tend to raise the price level, but their growth also tends to raise inflation. In addition, the Tanzi-Oliver effect is also confirmed in the error-correction model: rising prices worsen the fiscal deficits. Our results contradict both the supply-side economics and the Ricardian equivalence notion that fiscal deficits do not raise the price level or that an increase in fiscal deficits do not lead to inflation.