Potency of Fiscal Variables in Inf lation Variations in Sri Lanka

Abstract

Although the monetary policy impact on inflation is deliberated intensively in economic literature, the fiscal policy impact has not gained much interest, particularly in the developing countries. The later issue is theorised as the fiscal theory of price level. This article examines the potency of fiscal factors relative to the money growth in inflation in Sri Lanka for an extended period 1965–2018, and also for the post-reform period 1977–2018. The inflationary impacts of public debt, budget deficit and public expenditure, in association with money growth and a few control variables are assessed rigorously. The results of the vector autoregression model estimations involving different combinations of these variables reveal that fiscal policy instruments are, in general, inflationary while no significant impact of money growth on inflation is found. Besides, the analyses of impulse response functions and variance decomposition of inflation corroborate that the external debt, budget deficit and public expenditure are potent factors amplifying inflation. The impacts of money and control variables are trivial. These findings are invariant over the samples and justify that an active fiscal and a passive monetary policy are operative. Managing the budget deficit and growing dependence on public debt is a critical policy issue in Sri Lanka. JEL Codes: E31, H63, C32