Current Debates on Public Finance

1. Introduction

One major issue that closely concerns both fiscal policy and monetary policymakers is expectations. The economic actors’ expectations play an important role to decision-makers. Because policymakers make decisions according to the economic actors’ expectations. Especially, inflation expectations are a guide for policy makers.

With the broad adoption of inflation targeting within the context of monetary policy, the idea of expectations has received increased attention (Kara & Küçük-Tuğer, 2010: 2725). For example, Turkey’s new monetary policy following the 2001 crisis stresses the need of managing public expectations in order to eliminate inertia in inflation dynamics by moving economic actors’ inflation expectations to a forward-looking perspective (Oral et al., 2011: 6). On the other hand, as is known that the inflation expectations are also shaped according to fiscal policy. According to the traditional view, monetary policy alone is not enough to ensure price stability, and an suitable fiscal policy is also necessary to control inflation (Lyziak & Mackiewicz-Lyziak, 2020: 296).

The first study emphasizing the importance of fiscal policy in ensuring price stability was conducted by Sargent and Wallace (1981). The authors developed their studies on the assumptions that monetary and fiscal policy dominate each other. In their studies, Sargent and Wallace (1981) argue that the monetary authority cannot control the monetary base and inflation forever under the assumption that fiscal policy dominates monetary policy. Indeed, the fact that budget deficits cannot be financed forever by borrowing causes principal and interest payments on bonds already sold to combat inflation to be financed, at least in part, by seigniorage, which requires the creation of an additional monetary base. According to the authors, in a monetizing economy, this practice sooner or later results in additional inflation (unpleasant monetarist arithmetic). In later years, this view was examined by many academics within the framework of the fiscal theory of the price level (Leeper (1991); Sims (1994); Woodford (1994); Cochrane (2001); Leeper and Yun (2006); Davig and Leeper (2007); Bajo-Rubio et al. (2009)). Within the framework of the fiscal theory of the price level, two different policy regimes have been put forward in the literature: the Ricardian regime (monetary dominant) and the non-Ricardian regime (fiscal dominance).⁴ In the Ricardian regime, the price level is determined by monetary policy, while in non-Ricardian regimes, the price level is determined by the government budget constraint (Oktayer, 2013: 54). For any given price level, the intertemporal government budget constraint under the Ricardian regime is satisfied by primary surpluses (Lyziak & Mackiewicz-Lyziak, 2020: 297). Monetary policy becomes passive and fiscal policy active in non-Ricardian regimes. Consequently, in the fiscal dominant regime, fiscal policies influence the price level (budget deficits and debt). As a result, it is critical to consider how the fiscal stance affects the level of prices.

The fiscal stance also affects inflation expectations. In their studies, Leeper and Leith (2016: 2314), when economic agents are aware that policymakers may favor inflation surprises in order to ease the debt burden, they boost inflation expectations as debt levels grow until this motivation is no longer present. Despite this, little is known about the connection between fiscal policy and inflation expectations, and this relationship is unclear. In his study, Webb (1986) concluded that inflation expectations depend on fiscal news for Germany. Celasun et al. (2004) found that an improvement in the primary balance significantly reduced inflation expectations for emerging countries. In their study, Cerisola and Gelos (2009) concluded that fiscal stance (proxied by the ratio of primary surplus to GDP) is effective in shaping inflation expectations for Brasil. In their weekly survey of inflation expectations, Galati et al. (2011) concluded that the government debt concerns triggered by the Greek financial crisis had some effect on short- and medium-term inflation expectations, albeit slightly, long-term expectations. Lyziak and Mackiewicz-Lyziak (2020) found that fiscal stance (proxied by the general government debt to GDP ratio) in 22 European countries affected the inflation expectations of consumer and professional forecasters.

Our aim is to analyze how government debt (as an indicator of fiscal stance) affects inflation expectations in periods when the economic actors’ expectations are different. The main purpose of this study is to better understand the dynamics of inflation expectations for fiscal policymakers. As is known, Turkey had low inflation and inflation expectations between 2006 and 2016. However, inflation increased and expectations deteriorated in the post-2017 period. Therefore, we can be divide inflation periods into two periods as single-digit and double-digit periods. Figure 1 presents box-plot graphs of the arithmetic averages of the expectation of 12 months ahead annual CPI (consumer price index) obtained from the Central Bank of the Republic of Turkey (CBRT) Market Participants Survey for two sub-periods.