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ANNEXII

# FISCAL DEFICITS AND MACROECONOMIC CONSISTENCY

# A. Introduction

1. Fiscal deficits could be financed through external borrowing, domestic borrowing or/and monetization, that is, creation of base money. Each of these optiom as important macroeconomic consequences. The most frequently discussed of these consequences in applied macroeconomic analysis is the crowding out of private investment which could occur if the budget is financed through domestic borrowing. Often reference is also made to the potential inflationary effect of monetizing the deficit. By this is usually meant the potential impact of increasing the money supply on the demand for goods and services. However, at a given level of output, an increase in the money supply would only raise inflation if it exceeds what individuals would normally hold, other things being equal. Similarly, at a given level of inflation, a money supply increase would only be "excessive' if it exceeds what individuals would normally hold as output increases, other things being equal. Accordingly, the level of inflation and the demand for financial assets limit the extent to which the fiscal deficit can be financed through monetization. One corollary is that there may be a unique "financeable fiscal" deficit which is consistent with a macroeconomic policy package which sets targets for inflation, external borrowing, domestic borrowing and output growth.

2. This Annex explores this issue in the context of Kenya. It uses a simple framework which links the financing of fiscal deficit to domestic borrowing, the interest rate, the inflation rate, output growth rate and the real exchange rate. This approach draws on the methodology developed by Anand and van Wijnbergen (1989) and Catsambas and Pigato (1989) but includes disaggregated behavioral equations for money demand.

3. The' Annex begins by reviewing definitions of the budget and then selects the onerationA concept as the one most suited for determining the financeable deficit. Next, a budget constraint is specified and manipulated to obtain an accoundng idendty which includes money creation, inflation and borrowing. Tbe specification also captures the role of the inflation tax and seignorage in deficit financing. Linkages are then made to selected policy targets, the behavior of money demand and the conditions for consistency between fiscal imbalances and selected macroeconomic objectives.

4. After sketching and discussing the integrated framework, the section assembles data from Chapter 3 to evaluate the consistency of fiscal performance with other macroeconomic parameters.

# B. The Budget Constraint and Macroeconomic Targets

_5._ The operational, primary and cash deficits are three measures of fiscal imbalance. The oerational deficit is expressed in real terms and excludes the inflation component of interest payments by the government. The rationale for using real values is the view that interest payments by the government may contain an inflation premium which is not regarded as income by the recipients but as a restoration of inflation-induced capital losses. In consequence, the inflation component of interest receipts would not be spent, at least not fully, and therefore would not (fully) translate into a claim on resources. The primary budget goes a step further and focuses on the noninterest component of the budgetary accounts. Hence, this concept is useful for analyzing the impact of curren fiscal policy on aggregate demand, since the interest paid on debt is only the result of ps