Government behavior and inflation in Turkey an interpretation based on two alternative approaches

Abstract

In this study, two alternative forms of government behavior are proposed and their connections with the inflationary process in Turkey are analyzed using post-1980 data. The theory of optimal seigniorage predicts that if government's aim is to minimize the welfare costs of financing a given amount of revenue needs by taxation and seigniorage, the optimal fiscal policy for the government is to increase ordinary income tax rates and inflation together. Using a model developed by Trehan and Walsh (1990), we showed the testable restrictions of the theory of optimal seigniorage on data: both the tax rate and inflation must be nonstationary series and the two series must be cointegrated. Post-1980 Turkish data, however, did not support these predictions of the optimal seigniorage theorf. As an alternative, we used a deficit-oriented approach developed by Bruno (1989), and Bruno and Fischer (1986 and 1990). This approach investigates the connections between the fiscal fundamentals and inflation and models the inflationary process as the failure of the government to correct the fundamentals. Our findings were consistent with the predictions of this alternative view: the inflation being shaped by the fiscal and monetary fiindamentals. Our results can be interpreted as a demonstration of the non-optimality of the inflationary process in Turkey and as an indication of the increased fragility of the economy.