This paper investigates the validity of the hypothesis that suggests there is a link between fiscal deficits and inflation in developing countries and further explores this link in the absence of public sector wage expenditure.
Sri Lanka, a developing country with a persistent fiscal deficit, a large public sector and increasing inflation, has been chosen for the empirical study. An auto-regressive distributed lag (ARDL) model is employed in the analysis, using annual data from 1959 to 2008.
The results suggest that, in the long run, a one percentage point increase in the ratio of the fiscal deficit to narrow money is associated with about an 11 percentage point increase in inflation. This link becomes weaker in the absence of the public sector wage expenditure. The overall inference is that inflation is not only a monetary phenomenon in Sri Lanka and public sector wage expenditure is a key factor in explaining the deficit-inflation relationship.