The impact of public debt on inflation: a case study of Sri Lanka

Abstract

Introduction

Inflation is one of the key macroeconomic indicators of a country. It is the continuous rise in the general price level of commodities. Maintaining a low rate of inflation is one of the major macroeconomic objectives. There are two types of inflation in the economy. Those are Demand-Pull Inflation and Cost-Push Inflation. Demand-pull inflation occurs when aggregate demand for goods and services rises more rapidly than aggregate supply. One potential shock to aggregate demand might come from a central bank that rapidly increases the supply of money.

Public debt is one of the major economic issues threatening the countries which are facing fiscal deficits. Public debt includes domestic and external debt. Domestic debt is a fundamental tool used by governments to finance internal and external deficits. Domestic debt is derived from different sources such as central bank, commercial banks and non-bank financial institutions. Among these three sources, borrowing from the Central Bank and non-bank financial institutions (NBFIs) carry a serious effect of inflation due to increase in money supply. If the NBFIs invest by purchasing government securities and face a shortage of liquidity, they have no option but to turn to the central bank. Also there would be no inflationary effect in the case where government borrows directly from commercial banks. When the debt is utilized efficiently it enhances productive capacity and economic growth through development related projects. Contrastingly when the debt is not effectively utilized and managed, it creates problems for the economy. Here we can sum up it that there is a direct relationship between domestic debt and inflation.

There is a significant literature which has identified the relationship between domestic debt and inflation. These include the direction from public debt to inflation, where public debt has a significantly positive effect on inflation while in the opposite direction inflation has a significantly negative effect on public debt (Bon, 2015). According to previous studies, Ahmad et al. (2012) have found that the volume of domestic debt and domestic debt servicing have significantly positive effects on price level. Harmon (2012) has found a weak positive relationship between the public debt and inflation while links between public debt – GDP growth as well as public debt – interest rates are negative. Also Lopes et al. (2014) have found public debt having a positive impact on inflation. Martin (2015) has also found a positive relationship between public debt and inflation. However, according to the literature review these findings are mixed up. It means that an exact relationship between public debt and inflation has not been identified. This motivated me to do the quantitative analysis between these two variables.