Za Unit Root Da Prevzemam

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Empirical Studies in Social Sciences 6th International Student Conference,Izmir University of Economics, Izmir Turkey

A PANEL COINTEGRATION ANALYSIS OF BUDGET DEFICIT AND

INFLATION FOR EU COUNTRIES AND TURKEY

FULL PAPER

Fatih SAHAN

Marmara University/ Department of Economics

Marmara University Goztepe Campus, 34722, Kadiky, Istanbul

0090 538 3950143

[email protected]

Yunus BEKTASOGLU

Marmara University/ Department of Economics

Marmara University Goztepe Campus, 34722, Kadiky, Istanbul

0090 554 8881718

[email protected]

ABSTRACT

This paper aims to analyze the empirical relationship among budget deficit and inflation for Turkey and

European countries. According to theory, fiscal imbalances result in inflation problem as 1990s experience of

Turkey has shown. The major outcome from the empirical studies indicated strong evidence that a budget deficit

financed through monetarisation and a rising money supply could lead to inflation. The inflationary effect of

budget deficits depends on the means by which the deficit is financed and the impact of that on aggregate

demand. In this paper, budget deficits and inflation relationships are studied by utilizing the Larsson et. al. testapproach for Turkey and other sixteen European countries, including Czech Republic, Hungary, Poland, Austria,

Belgium, Greece, Denmark, France, Germany, Italy, Holland, Norway, Slovakia, Spain, Sweden and England

over the period 1990-2008, annually. Apart from the traditional studies, this paper investigates the relationship

by using panel data cointegration analysis. Firstly, LLC test, IPS test and Hadri test are employed to test thepresence of unit roots among series. After that, cointegration analysis is done. Our results will point out the fact

that budget deficit and inflation has long run positive relationship in some of the countries, while it has negative

relation in other countries. At the end of this analysis, we will try to understand if there is difference tendency

towards to budget deficit-inflation relation among developing and developed countries.

Key Words:Budget Deficit, Inflation, Panel Data, Cointegration Analysis

JEL Classification: C23, E31, H62
mailto:[email protected]:[email protected]


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1. Introduction

The impact of fiscal policies on inflation has been widely discussed since 1990s. After the

studies done for closed economies in 1990s, in 2000s the fiscal theory of price level was being debated

within monetary unity of European countries framework. In the discussion of this monetary systems

sustainability, the public finance phenomenon has gained importance. In the Maastricht criteria

(Maastricht treaty, 1992), while defining the basic conditions to enter euro area for the new entries, the

finance of fiscal deficits is prioritized by European countries. Therefore, one can argue that the FTPL

has been dominating the literature recently.

It is argued that the monetization of deficits is the fundamental reason for the high inflation

problems in developing countries. Turkey, as a developing country, experienced extremely high

inflations during 1990s. The underlying reasons for such a tremendous amount of inflation can be

miscellaneous. However, to large extent, economists concluded that the main cause of inflation is high

budget problems. The restriction of government to central bank resources which is implemented with

the liberalization program of 1980s, made governing authorities focus on domestic debt financing.

That is, the government avoided compensating the deficits through corresponding money supply.

Meanwhile, the domestic banks became the major source of domestic debt financing that resulted in an

increase in the assets of banking system. Thus, the interrelationship of budget deficit and inflation is a

vital point for Turkish economy, despite the fact that the direction of relationship is uncertain.

The basic purpose of this paper is to analyze this relationship between price level and fiscal

imbalances. The paper unfolds firstly by giving a theoretical framework for that relationship. In the

following part, a brief literature review is provided. In the third part, empirical evidence from EU

countries and Turkey is stated by using panel cointegration analysis. In the last part, the results of

empirical study and its compliance with the theory is discussed.

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2. Theoretical Framework

2.1. Budget Deficit and Inflation Relationship in General

The term of budget deficit can be defined as the difference between budget revenue and

budget expenditure. Budget revenue includes three important components which are tax revenue , tax-

exempt revenues and private revenues. The most important component of the budget revenue is tax

revenue. However, budget expenditure involves four important elements that are current expenditure,

investment expenditure, real expenditure and transfer payments. Current expenditure is a kind ofexpenditure which is related to nondurable goods. It is usually used for short term expenses.

Investment expenditure is stated as expenses related to investment and efficient use of resources.

Transfer payment is an unrequited payment that has an indirect effect on GDP. Real expenditure

consists of production factors and production expenditure. If budget deficit shows the disharmony and

imbalance between revenue and expenditure, both the revenue and expenditure side of budget should

be analyzed in detail.

It is notable about budget deficits that there is a significant difference between developed and

developing countries about budget balances. Most developed countries dont have budget deficit

problem because of their strong fiscal structure. In developed countries, low level of foreign

indebtment prevents the debt payment to be burden on the budget. Moreover, most developed

countries have a trade surplus due to having more export than import. On the other hand, developing

countries usually have high inflation, lower per capita income compared to developed countries, high

current account deficit and high public expenses. All these progresses cause increases in budget deficit

and deterioration of macroeconomic stability. Developing countries have four different ways to

finance their high budget deficit which are printing money, running down foreign exchange reserves,

borrowing from abroad and domestic markets.

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As stated above, developing countries have more budget deficit problems compared to

developed countries. The reasons of budget deficit can be stated as unstable public revenue, low

degree of economic development, low acceleration of public revenue, deficient government auditing

and the regulatory role of government in the economy. Countries which have low degree of economic

development, have high level of budget deficit owing to three important reasons which are high

spending pressure, deficient tax revenue and low private savings. High employment cost is very

crucial problem of public economy in developing countries and these governments dont have any

chance to reduce it. Also, deficient public revenue leads to increase in budget deficit. In developing

countries, private saving level is so low and deficits are financed by borrowing which cause to

borrowing-interest spiral by increasing budget deficit more.

In general, inflation has raising effect on budget deficit by raising nominal interest rate.

According to Fischer Effect; nominal interest rate consist of real interest rate and expected inflation

rate. If the inflation expectation increases, it causes to rising nominal interest rate which leads to the

public debt to go up. Interest payment covers the big part of public payment in developing countries. If

interest rate increases because of inflation, it leads to raise interest payment as well as budget deficit

by causing the Debt/ GDP ratio to increase. Thus, high interest rate and interest payment lead to

instability between budget and public deficit acceleration and tax revenue acceleration. Budget and

public deficit always increase faster than public revenue so budget deficit increase as well.

In spite of the positive relationship between inflation and budget deficit as stated above, in

some cases inflation and budget deficit move in reverse direction. Inflation tax is important for this. If

inflation tax is higher than normal level, as inflation increase people avoid holding money because the

cost of holding money is high. Thus, real monetary base tends to decrease as inflation tax

correspondingly. Holding money would be a costly activity. Inflation tax would be a type of tax

revenue which makes the budget deficit decline. Another type of negative relation between inflation

and budget deficit occurs because of public borrowing stocks. If borrowing is not indexed to the

inflation, as the inflation rise the real value of public borrowing stocks would decline. As the public

borrowing stock fall, budget deficit is expected to decrease.

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2.2. Budget Deficit and Inflation Relationship in Different Economic Thoughts

There is a considerable debate on budget deficits and its inflationary effects in economic

theory literature. In the preceding period of Keynes, the classical economists gave importance to a

balanced budget, yet they didnt analyze its impact on price levels. Apart from classical economics,

Keynes saw the fiscal imbalances and budget deficits as internal components of aggregate national

demand.(Corsetti and Roubini,1997:27) The underlying reason is that when budget expenditures

increase, aggregate demand curve responds it by shifting right, leading to an increase in both prices

and production.(Assuming aggregate supply is not perfectly elastic/inelastic) The increasing nominal

income will come up with rising transactional demand for money, which is compensated by

speculative demand for money, i.e. increasing real interest rates.(Anusic,1991) In the Keynesian

economic thought, the budget deficits can be tolerable in the crisis times. Moreover, Keynes saw the

budget deficits as an indicator of the impact of fiscal policy on aggregate demand. Thereby, due to the

fact that the budget deficit can affect economic performance, it has been perceived as an endogenous

factor. (Blanchard and Fischer, 1989). As a result, in Keynesian theory, because the main aim of the

governments is to sustain high overall economic performance in the long run, the budget deficits can

be acceptable to some degree. (Altnta, et.al.,2008)

In the neoclassic theory, the debate of Sargent and Wallace enlightens the discussion on the

relationship among fiscal imbalances and inflation. Sargent and Wallace discuss two types of the

coordination between monetary and fiscal authorities which is effective in controlling the inflation. In

the first type of coordination in which the monetary authority is dominant, monetary authorities

announce the monetary base growth and fiscal policy sets its budget by considering the revenue

created by monetary policy. In the second type of coordination, in which the fiscal authorities are

dominant, fiscal policy sets its budget and announces the amount of money needed for monetary

authorities through seignorage and bond sales. (Sargent and Wallace, 1981) The second type of

coordination provides insight to inflation problem which is led by fiscal imbalances, since the fiscal

authorities sometimes demand more revenue than tolerable amounts and this creates inflation. This

argument has been debated widely in the literature. The fiscal view of inflation has been especially

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prominent in developing country literature which has long recognized that less efficient tax collection,

political instability and more limited access to external borrowing tend to lower the relative cost of

seignorage and increase dependence on inflation tax. (Catao and Torrentes, 2003) Thus in the

neoclassic theory the effect of fiscal theory is significant especially in developing countries.

In the neo classical approach, increasing budget deficit, which is compensated by borrowing

instead of taxes, results in incrementing private sector wealth, consumption and aggregate demand, in

turn. Nevertheless, this rising wealth is accompanied with a misperception by private sector about

which the budget deficit will be paid by taxes in the future. Buiter (1983) argues that if deficits are

financed by printing money, this will fuel inflation. If they are financed by borrowing this will put

upward pressure on interest rates, leading to "crowding out" of interest sensitive spending. As this

kind of financing arises the real interest rates, the neoclassical theory suggests that increasing budget

deficit can lead crowding out of investment and capital.

The new classical economists oppose the misperception part of the theory and asserted that

such an assumption is inconsistent with rational expectation theory. That is, the demand for goods is

based on expected present value of the future taxes. Fiscal policy can influence the price level through

aggregate demand changes; it should change the expected value of the future taxes, which occurs by

altering the spending. In this sense, budget deficits and taxation have equivalent effects on the

economy-hence the term, "Ricardian equivalence theorem."(Barro, 1989) i.e. there is no change in

national saving, since an increase in private saving as faced by an equivalent decline in public saving.

Because national savings, in turn, investment and aggregate demand do not change, one can argue that

the budget deficit doesnt affect price levels.

As we can see from miscellaneous economists from different economic schools, the financing

of fiscal deficits has a key role in inflationary effects of them. To this end, the type of deficit is can be

either bond-financing or monetization. In case of monetization, as monetarist approach puts forward,

the price levels are directly affected. In addition, if the deficits are financed by borrowing, i.e. selling

bonds, then the interest rates must be lower than the monetary base growth to prevent the unexpected

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inflationary effects. Thus, one can assert that budget deficits are an important policy tool to be taken

into account in inflation targeting policies.

3. Literature Review

The relationship between budget deficit and inflation is a very common debate in economic

literature. Lots of economists have analyzed the relationship among these two variables for years by

using different countries, different econometric technique and different time period. While some

economists found negative relation, most of the economists found positive relationship betweenbudget deficit and inflation. Some of these studies are ordered below with their critical results.

Fischer (1989) analyzed the budget deficit-inflation relationship in different countries . He

found that the countries with high inflation have strong relationship among inflation and budget

deficit. Fischer noted that high inflation has reducing effect on tax revenue which is known as Tanzi-

Olivera Effect. Also, high rate of inflation increases budget deficit by declining seignorage revenue.

Hondroyiannis and Papapetrou (1997) studied on the direct and indirect effect of budget

deficit on inflation in Greece and found the result that budget deficit has an indirect raising effect on

inflation. However, they also stated that an increase in inflation results in an increase in budget deficit.

Cardoso(1998) worked on the relationship between budget deficit and inflation in Brazil by

following Patinkins(1993) study. He found reverse relationship between budget deficit and inflation

in Brazil.

Kvlcm(1998) analyzed the long run relationship among budget deficit and inflation in

Turkish Economy between the years 1950-1987. At the end of his study, he concluded that a change in

budget deficit cause to change in inflation on the same direction. He also highlighted that this budget

deficit-inflation spiral is one of the most important problems of Turkish Economy.

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Tanzi (2000) researched the tax revenue and budget deficit relation in Latin American

countries. He emphasized that even though the tax revenue rises, the budget deficit and public deficit

also increase. He stated that this imbalance results from the deficient and inefficient social programs.

Egeli(1999) studied relations among inflation tax, budget deficit and public spending. His

result was reverse relation among inflation tax and budget deficit. He also stated that increasing public

spending leads to increase in budget deficit. Egeli concluded that this disequilibrium results from

governments wrong policies such as using borrowing in order to finance the deficit.

en (2003) analyzed the relations among tax revenue and inflation. en stated that high

inflation cause to decrement in tax revenue in crisis time. Low level of tax revenue cause to tax loss

which leads to high budget deficit. He also interrogated the time of tax collection. He concluded that

short term tax collection is better than long term tax collection. In the long run the real value of tax

revenue tends to decline because of high inflation.

Catao and Terrones (2000) worked on the relationship between inflation and budget deficit by

using data from different countries. The result that they reached is being weak relationship in

developed countries and being strong positive relationship in developing countries.

Yabal, Baldemir and Bakml (2004) made a study about imbalance between public spending

and public revenue in Turkey. They highlighted that the government finances budget deficit by using

short term advance money. It also results in the money supply to increase which results in inflation to

go up. They concluded that high budget deficit leads high inflation in Turkish Economy.

Solomon and Wet (2004) made a research on Tanzania. They found a strong positive

relationship between inflation and budget deficit. They stated that budget deficit has a significant

effect on inflation. They also concluded that developing countries should give more importance to

inflation because inflation tends to be affected from many economic shocks such as high budget

deficit. According to them inflation should be controlled by efficient fiscal policies.

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4. Econometric Methodology

After considering relevant theory and reviewing literature, it is time to give empirical

evidence to test the consistency of the theories with the real world. To this end, firstly the series should

be taken logarithms and differenced to avoid spurious regression problem that means that regressing a

non-stationary variable on a deterministic trend does not yield a stationary variable.(Harris, 1995:20).

4.1. Panel Unit Root Test

As the involvement of macroeconomic applications in the panel data analyses has been

growing recently, the Dickey-Fuller and Augmented Dickey-Fuller tests are required to be extended

for testing stationarity in panel data analysis. When dealing with panel data, because the procedure is

more complex, the ADF and DF tests can result in inconsistent estimators. Thus, the stationarity of the

series should be tested by using three different types of tests, namely LLC (Levin,et.al.,2002), IPS

(Im,et.al., 2003) and Hadri(2000).

In the analysis, firstly the LLC test is employed to test the stationarity. Levin et. al. model

allows heterogeneity of individual deterministic effects and heterogeneous serial correlation structure

of the error terms assuming homogeneous first order autoregressive parameters.(Barbieri,2004) In

addition the model provides two-way fixed effects, one of which comes from the term iand the other

one emanates from t. . Moreover, these two parameters allow for heterogeneity, as the coefficient of

lagged Yi is limited to be homogenous through all individual units of the panel.

LLC model tests the hypothesis of non-stationarity, i.e. the presence of unit roots. That is,

H0: 1 = 2 = 3 .....= = = 0

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H1: 1 = 2 = 3 .....= = < 0

There are two major shortcomings of the LLC test. Firstly, it relies on the assumption of the

independence across units of panel where a cross sectional correlation may be present.(Barbieri,2004)

Secondly and more importantly, Autoregressive parameters are considered to be identical across the

panel in this model.

Im, Persan and Shin (2003) broadened the LLC test to overcome the second limitation of it by

presenting a more flexible and computationally simple test structure that permits the to differ

among individuals, i.e. by allowing heterogeneity. The IPS test made the estimation for each of the i

section possible. As a result their model is such that;

Im et. al. tests the null of non-stationarity. That is;

H0:i = 0 for all i

H1: i < 0 for i= 1, 2,..,N1

i = 0 for i= N1+ 1,,N

This alternative test clarifies that a fraction of the panel can have unit roots. This is the

contrasting point of IPS to LLC. The IPS model is constructed under the restrictive assumption that T

should be the same across individuals. That is to say, there should be a t-barstatistic which is the

mean of ADF t-statistics for testing i = 0 for all i such that

1/N =

i

n

it

1

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That is, ti converges to a statistics denoted as tiT which is presumed to be iid and has finite

mean and variance. (Asteriou, 2005) Finally, it is significant to note that this procedures are relevant in

balanced panels and it is based on collecting test statistics.

Hadri (2000) test is distinctive from other two tests mentioned above for testing the absence of

unit roots, i.e. variance of the random walk equals to zero. He proposes a parameterization which

provides an adequate representation of both stationary and nonstationarity variables and permits an

easy formulation for a residual based Lagrange-Multiplier (LM) test of stationarity. (Brabrieri, 2004)

In his model, the disturbance terms are hetoroskedastic across i. He provides a LM where the series

are stationary (elik,et.al.,2008), such that;

where ,

4.2. Panel Cointegration Tests

Although differencing the data is a useful transformation in preventing the spurious regression

problem, it also causes the loss of the long term information that the series include. At this point,

cointegration analyses, which provides such an analysis that even though the series themselves may

contain stochastic trends (i.e. non-stationary), they will nevertheless move together over time and the

difference between them will be stable (i.e. stationary) ,(Harris,1995:22) employed to examine the

long-term relations between the variables. The cointegration tests are implemented through two main

tests, namely Pedroni (1997,1999 and 2000) and Larrson et.al. (2001).

Pedroni(1997) concentrated on the homogeneity of the two simple variables in his first

analysis. Nonetheless, it has some limitations. Thus, in the second study, he analyzed multi regressors

models. The good feature of this test is that it allows both cointegration vectors to vary and

heterogeneity in the errors across cross sectional units.(Asteriou, 2005) As a result, Pedroni(1999)

developed seven test statistics to test the null of no cointegration between two variables.;

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1.Panel v statistic

1

1

2

1,

2

11

1

2/32

,

2/32

=

=

T

t

tii

N

i

TNVeLNTZNT

2.the panel statistic

( )=

=

=

=

T

t

ititii

N

i

T

t

tii

N

i

TNeeLeLNTZNT

1

,1,

2

11

1

1

1

2

1,

2

11

1

,

3. the panel t statistic (Non-parametric)

( )=

=

=

=

T

t

ititii

N

i

T

t

tii

N

i

TNTtNeeLeLZ

1

,1,

2

11

1

2/1

1

2

1,

2

11

1

2

,,~

4. The panel t statistic (parametric)

( )=

=

=

=

T

t

titii

N

i

T

t

tii

N

i

TNTtNeeLeLSZ

1

*

,

*

1,

2

11

1

2/1

1

2*

1,

2

11

1

2*

,

*

,

~

5. the group statistic(parametric)

( )=

=

=

T

t

ititi

T

t

ti

N

i

TNeeeTNZTN

1

,1,

1

1

2

1,

1

2/1

1,~2/1 ~

6. The group t statistic (non-parametric)

( )=

=

=

T

t

ititi

T

t

tii

N

i

TtNeeeNZN

1

,1,

2/1

1

2

1,

2

1

2/1

1,

2/1 ~

7. The group t statistic (parametric)

( )=

=

=

T

t

titi

T

t

tii

N

i

TtNeeeSNZN

1

*

,

*

1,

2/1

1

2*

1,

2*

1

2/1*

,

2/1 ~

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Larrson, Layhagen and Lthgren (2001) constructed their model on Johansens (1988)

maximum likelihood estimator tests on residuals, i.e. a panel extension of VAR cointegration analysis.

This model permitted to avoid from unit root tests on residuals, widening the unique cointegrating

vector assumption. (Asteriou, 2005) The construction of this test statistic is similar to Im,Pesaran,

and Shin (2003) and hence the test statistic is given by a suitably centered and scaled version of the

cross-sectional average of the individual trace statistics (Wagner and Hlouskova, 2006) As a

consequence, the model is represented such that;

The Larsson et.al, model is based on the estimation of the above model separately for each

cross sectional unit by employing the maximum likelihood models to compute the trace for each. To

this end the null and alternative hypothesis will be;

where p is the number of variables we adopt to test cointegration among them.

We can evaluate the Larsson et. al. process in two phases. First, after the computation of trace

statistics, the rank trace statistic LRNT should be calculated by taking the average of N cross sectional

units. Second, the LRNT statistics is used to calculate YLR by adopting the formulation below. As it

can be realized, one can say that when YLR is greater than the critical value of 1.96, it moves to the

upper cointegration vector number by rejecting the one it has. (elik,et.al., 2008)

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5. Empirical Findings

In this study, the budget deficit and inflation are investigated for 16 European Countries,

namely Austria, Belgium, Czech Republic, Denmark, France, Germany, Greece, Hungary, Italy,

Netherlands, Norway, Poland, Slovak Republic, Spain, Sweden, United Kingdom, and Turkey. As

noted, the countries are selected from both developed and developing countries. Since, Turkey wants

to converge to European Union countries; it is useful to examine budget deficit and inflation

relationship in EU countries and Turkey.

The data are drawn from OECD stat extracts. For budget deficit statistics, the government

lending/borrowing statistics are used and they are divided into gross domestic product to understand

the real meaning of those deficits for that country. For inflation data, consumer price index for each

country is adopted. In overall analysis, the panel data set is employed.

5.1. Panel Unit Root Tests

As a precondition for panel cointegration tests, panel unit root tests, including LLC(2002), IPS

(2003) and Hadri (2000), are implemented as individual intercept and intercept and trend for budget

deficit (BD) and inflation (P) data. LLC process tests the common unit root process under the null of

non-stationarity. Table 1 show that the presence of unit root could not be rejected. Nevertheless, when

one takes the first difference of the variables, it can be noted that both of the variables have unit root in

not only individual intercept case, but intercept and trend situations, as well.

IPS test has the same null hypothesis of having unit roots as LLC test. However, it assumes

individual unit root process as stated above. This test also indicated a positive result in testing the

presence of unit roots of series just like the LLC tests results.

In addition to the previous tests, Hadri test is also implemented. Apart from the previous tests,

this test has a distinctive null hypothesis which claims the stationarity of the series. In the level case,

the null of having no unit roots is rejected and after taking first differences, this hypothesis approached

to not rejecting this null hypothesis as table 2 points out.

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As a result, these outcomes obtained from panel unit root tests allowed us to go on to

cointegration tests.

5.2. Panel Cointegration Tests

After assuring the same integration level for both of the series and performing panel

unit root tests, it is possible to continue with cointegration tests.

Table 1. Panel Unit Root Tests- Level Case

Variable SituationCommon Unit Root Individual Unit Root

LLC Hadri IPS

BD/GDP

Individual-0,99905

(0,1584)

6,83418

(0,0000)

-0,81201

(0,20849)

Individual

Intercept and

Trend

2,15481

( 0,9844)

5,51930

(0,0000)

0,41295

( 0,6602)

Inflation (P)

Individual1,78507

(0,9629)

7,01099

(0,0000)

-6,68613

(0,0000)

Individual

Intercept

and Trend

21.1715(1,0000)

8,88533(0,0000)

1,17610(0,88502)

Table 2. Panel Unit Root Tests- 1st Differenced Case

Variable Situation

Common Unit Root Individual Unit Root

LLC Hadri IPS

BD/GDP

Individual-5.36934

(0,0000)

2,29595

(0,0108)

-5,97775

(0,0000)

Individual

Intercept

and Trend

-6,45968( 0,0000)

6,44716

(0,0000)

-6,07663

(0,0000)

Inflation (P) Individual 11,7538

(1,0000)

5,3842

(0,0000)

-9.53613

(0,0000)

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Individual

Intercept

and Trend

-179,185

(0,0000)

7,40287

(0,0000)

-53,3361

(0,0000)

* In the analysis, Modified-Swartz criterias automatic selection of lags is used. The numbers in brackets

represents probabilities and the others represent critical statistics.

5.2.1. Pedroni Test

Pedroni computed seven statistics to test the null of no cointegration among series. For these

series, the critical value is -1,64 except v-statistic which has 1,64. Thats to say, when the test statistic

is lower then -1,64, (greater than 1,64 for v-statistic), then the null hypothesis is rejected. Table 3

reports these seven statistics for budget deficit- inflation relationship. As it can easily be understood

from the table, there is not a strong cointegration between two variables in both individual intercept

and individual intercept and trend situations. On the other hand, the table 3 points out a remarkable

cointegration between two variables.

Table 3. Pedroni Panel Cointegration Test

Individual Intercept Individual Intercept & Individual Trend

Panel v statistic

0,505010

( 0,3068)

0,103243

( 0,4589)

The panel statistic-0,652150

( 0,2572)

0,282895

(0,6114)

The panel PP statistic-4,355230

(0,0000)

-6,516146

(0,0000)

The panel ADF statistic-4,124920

(0,0000)

-6,499010

(0,0000)

The group statistic 2,035258(0,9791)

2,477789(0,9934)

The group PP statistic-0,832295

(0,2026)

-4,154713

(0,0000)

The group ADF statistic -1,022074(0,1534)

-4,658355

(0,0000)

*The statistics are computed with 0,05 significance level

5.2.2. Larsson et. al. Test

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After utilizing Pedroni test, Larsson et. al. test is carried out to test cointegration. As it is

analyzed the 17 countries one by one by applying Johansen cointegration test, 10 of 17 countries

accept the hypothesis test which claims that there is no cointegration. These countries are Austria,

Belgium, Denmark, France, Germany, Italy, Netherlands, Norway, Spain and U.K. As it can be seen

from these results, in developed countries usually there is no cointegration between these two

variables. However, developing countries such as Czech Republic, Greece, Hungary, Poland, Slovak

Republic, Sweden and Turkey reject the hypothesis.

On the other hand, 15 of 17 countries also accept the hypothesis test which assumes there is at

most one cointegration. Furthermore, Greece and Poland reject the hypothesis that there is at most one

cointegration. When we combined the results obtained from two hypothesis tests, we can conclude that

mostly in developing countries such as Czech Republic, Hungary, Slovak Republic, Sweden and

Turkey there is cointegration. They have long run relationship between inflation and budget deficit.

As a result, Larsson et. al. test indicates that there is no certain cointegration between these

two variables. That result confirms the outcome of Pedroni test. Moreover, this test shows another fact

that developing countries are more likely to have cointegrating series of price level and fiscal

imbalances.

Table 4: Larsson et. al. Test Results

Countries r=0 r=1

Austria 0.3557 0.7318

Belgium 0.1594 0.6467

Czech Republic 0.0131 0.0580

Denmark 0.3436 0.2908

France 0.4989 0.9741

Germany 0.0851 0.2768

Greece 0.0000 0.0391

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Hungary 0.0007 0.0739

Italy 0.1888 0.5582

Netherland 0.2717 0.3858

Norway 0.2423 0.6676

Poland 0.0062 0.0255

Slovak Republic 0.0300 0.3552

Spain 0.4937 0.4600

Sweden 0.0010 0.1984

Turkey 0.0004 0.7398

U.K. 0.6989 0.8722

YLR 0.0000 0.1402

Significance Level 0.05 0.05

N 17 17

6. Conclusion

In this study, 17 countries were selected by employing panel data in order to test long run

inflation and budget deficit relation by using cointegration tests. Panel data were obtained by selecting

annual consumer price index and budget deficit/GDP data between 1990-2008. Firstly, unit root test

were applied in order to test series stationarities. After testing unit root of series, cointegration tests

were applied. Pedroni cointegration test resulted in that there was not a clear cointegration between

series in the long run. In addition, Larsson et. al. test showed that there is difference among

developing and developed countries since it has been implemented one by one. As a result of Larsson

et. al. test, while developed countries have no long run relationship between inflation and budget

deficit, in contrast, in most developing countries, cointegration exists between these variables.

In this study, we also focused on Turkey and other sixteen European countries in order to

compare them. Turkey has a long term relationship among inflation and budget deficit between 1990-

2008. Larsson et. al. test proved this conclusion. However, although in some developing countries,

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cointegration between inflation and budget deficit exists, generally there is no cointegration between

inflation and budget deficit, i.e. our test result pointed the fact that there not a standardized

relationship between budget deficit and inflation in the long run. It changes with respect to the

development level of countries or structural features of the economies.

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