3. Policy Implications

The empirical estimation demonstrates the existence of complicated links between fiscal deficits, money, and inflation in Ukraine. We could hardly expect to find clear and linear structural coefficients that would provide policymakers with clear-cut recipes in the economy undergoing structural changes.

At the same time, the VAR analysis leads us to the tentative economic policy implications:

• although more possibilities, not just monetization, emerged to finance fiscal deficit in the second half of the 1990s (through T-bills market and from external sources), the fiscal imbalance still has a substantial inflationary impact. In our opinion, it suggests a lack of credibility in government debt management. Even if the government managed to attract funds from the public, economic agents do not trust the government would not be forced to reverse to monetization. Therefore the price level starts to grow in expectation of later monetization not far away. Financial crisis of 1998, when T-bills market fell, is the strongest example. It is crucial now to restore credibility to the government securities, for deficit to be less inflationary;

• cutting budget deficit is disinflationary, even more so when monetization share is falling. In the extreme case, a monthly 1% GDP decrease in budget deficit, all of which was previously monetized, subtracts 0.8% from annual inflation. If a non-monetized share of the deficit is eliminated, annual inflation is lowered by 0.4%;

• the monetary policy conduct in Ukraine largely depends a lot on a stance of the fiscal policy. The model suggests that in order to neutralize the inflationary effect of the fiscal expansion, the NBU need to decrease its credit to the government. However, previous experience shows, that it is hardly possible.

• inflationary inertia has a strong disinflationary potential. Once authorities manage to cut a monthly inflation rate by one 1%, the benefit is tripled over the year.

Finally, a note of caution should be made. The model we examined in this paper is not universal. For example, it fails to incorporate possible influence of real sector of the economy. Various exogenous shocks, like discrete administrative price increases certainly lower the explanatory power of the model. Therefore, as a forecasting tool the model might be used very cautiously.

5. Conclusions

The purpose of this paper was to evaluate the importance of budget deficit for inflation in Ukraine in the second half of the 1990s. We find that fiscal imbalance, apart from other, purely monetary factors, does affect the level of inflation determination. A monthly decrease of budget deficit by 1%GDP, all of which was previously monetized, leads to decrease of annual inflation by 0.8%. If a non-monetized part of the deficit is eliminated, annual inflation is lowered by 0.4%. Among the monetary factors, the monetization of the deficit seems to be the most inflationary. The dynamics of the National Bank’s claims to government (monetization) appear to be more tightly linked to the inflation than the monetary base and the exchange rate. Since the budget policy remains an important inflationary factor, the room for an independent monetary policy remains limited.