4. Inflation Performance

As we have shown earlier, different types of financing affect prices in different ways. The direct financing mechanism theoretically influences the inflation rate via monetary base expansion. Tbills (domestic borrowing) financing induces effects by crowding out for Investment and Net Exports i.e. indirectly. The result may vary with the exchange rate policy.

There is a choice of inflation indicators among consumer, producer prices or GDP deflator. CPI should react fast enough to changes in monetary policy. However, PPI seems to capture more of the exogenous shocks and imported inflation. The GDP deflator would be a good choice. Unfortunately, the latter is hard to estimate correctly, given the current availability of Ukrainian Statistics.

Figure 9. CPI Subindices December 1995 = 1 Source: State Statistics Committee. Calculations: ICPS

In evaluating the influence of deficit financing on inflation, the problem arises as to how to eliminate administrative and other exogenous shocks like the increases in household utilities in 1995-1998 and imported price shock of August 1998.

The utility shock could be clearly seen from the utilities prices graph that shows kinks in January 1996, April 1996, July 1996 due to administrative tariff adjustments to eliminate subsidies to households. There was also an adjustment in April 1999.

Figure 10. Budget Balance and Inflation % Source: State Statistics Committee. Calculations: ICPS

The part of the monetary base expansion due to fiscal imbalance could be approximated by the change in domestic credit of NBU to the government. In Figure 11, we can observe its lagged influence on inflation, with varying magnitude.

Figure 11. Change in NBU Credit to Government and Inflation mln UAH (left scale), % (right scale) Source: NBU. Calculations: ICPS

Until the begining of the crisis in August 1998, the central bank was able to neutralize the results of expansionary fiscal policy. Nevertheless the central bank's participation at the primary OVDPs auctions has changed its role from passive agent of the Ministry of Finance into active participant of the T-bills market.

As we have mentioned in the theoretical section, the NBU sometimes is able to increase it’s T-bills holdings without holding a large effect on money aggregates.The growth of budgetary liabilities at the central bank has not had a direct inflationary consequences due to the negative sterilization policy followed by NBU until the middle of 1998. The central bank was channeling money to government (by new TBills purchases) and simultaneously made the conversion for that part of Tbills withdrawn by non-residents from the market, decreasing the level of foreign reserves and keeping the monetary base rather stable.

4. Empirical Analysis

   1. Methodology

The purpose of this section is to empirically examine inflationary response to budget deficits, if any, when related variables, such as base money growth, exchange rate, domestic budget financing by NBU are taken into account. We test whether the price level is fiscal-dominantly determined¹⁰. We are also going to explore which part of the inflation variability is explained mostly by budget financing needs and which is influenced by other factors.

Rejection of the fiscal-dominancy hypothesis may be only implicit, because of possible cross-relationships that neutralize the direct effect of budget financing through monetary measures. Similarly, finding that the government balance affects prices itself does not directly imply that the impact of the monetary factors is lower or absent.

We chose the class of non-structural Vector Auto Regression (VAR) models for this analysis. Attempts to identify the components separately either in AR or structural specifications have failed in the sense that we obtain both poor econometric properties and weak economic inference. So we have tried to capture the mutual effect of variables associated with inflation to determine their net effect.

It may be interesting to impose additional restrictions and consider structural VAR, but it is hard to identify whether fiscal or monetary disturbances in the Blanchard-Quah (1989) decomposition should be considered permanent¹¹. Another candidate for the model specification, Vector Error Correction (VEC) model, was not supported by the cointegration tests¹².

Table 2. Data Used for the Estimation
Mnemonics13	Description	Unit	Source
CPI	Consumer Price Index		State Statistics Committee
MBASE	Monetary Base	Mln UAH	National Bank of Ukraine
EXRATE	Official Exchange Rate, period average	UAH/ USD	National Bank of Ukraine
MA_CLG	Net claims on Government	Mln. UAH	International Financial Statistics
GBAL	General Government Balance	Mln UAH	State Treasury

We have examined specifications with the following features:

• The price level tends to be the most endogenous variable while the others are considered more exogenous. The last exogenous, and hopefully the most powerful, is the fiscal deficit series or its transformations;

• The specification includes 5 variables: consumer prices (CPI), exchange rate (EXRATE), monetary base (MBASE), NBU net credit to government (MA_CLG), and budget balance itself (GBAL). The ordering of the variables is important in VAR analysis, so we sort out variables as follows: CPI, MBASE, EXRATE, MA_CLG, GBAL;

• The general VAR specification is:

where p_t is the transformed variables vector , p_t-i , are the lagged variables vectors, Xt are the explanatory variables, matrices A_i, B to be estimated.

We have examined the sample of monthly data for 1995:1- 2000:6. The results of quarterly regressions have shown significant loss in explanatory power, so we remained with the volatile but more responsive monthly frequency. Table 2 reports the sources of the data, whereas summary statistics of the original and transformed VAR series are presented in Appendix 1. Government balance is the general government balance, using national definition, and is negative for a deficit.