The Short-Run Relation between Growth and Inflation in Latin America: Reply

Abstract

Sebastian Edwards uses a new, money variable-based on the addition of the contemporaneous fiscal deficit to my autoregressive money growth equations -to argue that 1) in Brazil and Chile there is no significant relationship between unexpected money growth and output growth, 2) unexpected money growth has different estimated effects on output in Colombia, Peru, and Mexico, and these effects substantially exceed those estimated in Brazil and Chile, and 3) thus my 10 percent rule for the effect of unexpected money growth on output growth does not hold. In addition, Edwards incorporates the terms of trade in his output equations and finds they are important in the case of Chile and Mexico.' Finally, Edwards takes issue with my use of lagged inflation to explain output. Edwards and I use somewhat different data, not only in terms of sources, but also Edwards often uses M2 rather than Ml in reporting his best results. However, Edwards' and my basic results are broadly similar (compare his Table 1 and my original Tables 1 and 4). This is encouraging, and in general makes it seem not worth quibbling over the differences in data. However, there is one difference which affects the results that I will discuss later. The inclusion of the fiscal deficit in the money growth equation is a key difference in our work. As I pointed out in my earlier article, fiscal and monetary policy often are closely related in Latin America. Thus it is not surprising that Edwards finds the deficit (divided by lagged money) is a significant factor in explaining money growth. However, the point is not to explain money growth, but to estimate a relationship which the public could have been using to predict how much money, and thus nominal aggregate demand, has grown since the last observation on the money stock.2 It strains credulity to assume that, in Latin America, the budget deficit could be used by the public to estimate money growth contemporaneously. Data on the cash deficit usually are available publicly only with a long lag. Moreover, many alternative versions of a deficit, involving creative accounting methods, are reported. For example, for many years in Colombia, the reported deficit, which is available with about a one-quarter lag, treated both the unspent portion of the budget and the accounting profits from the revaluation of the local currency value of exchange reserves as income; procedures which caused great confusion inside as well as outside the government. Despite such problems, the cash deficit still might be useful as a monetary growth predictor; for example, it may be correlated with some other easily available contemporaneous indicator of money growth. However, its usefulness can best be judged from a comparison of the results when the deficit is used only as the money growth predictor to determine unexpected money (a constrained equation) with those obtained when it is used as an additional independent variable (an unconstrained equation), a test Robert Barro has suggested in another context. *World Bank. The views and interpretations expressed in this article are my own and should not be attributed to the World Bank, its affiliated organizations, or to any individual acting in their behalf. 'Edwards also uses the seemingly unrelated regression technique to take into account possible interrelationships in the error terms across countries. Judging from the reported t-statistics, this procedure did not improve the fits greatly. 2Surprisingly, the deficit is not significant in explaining domestic credit in Mexico. This result and the estimated negative relationship between Edwards' domestic credit series and output suggest a problem in the domestic credit variable.

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