The inflationary effect of the budget deficit: Does financial sector development matters?

This study aims to examine the budget deficit-inflation relationship, considering financial sector development and broad money supply as moderating and mediating variables. For this purpose, polled mean group, mean group, and dynamic fixed effect estimation techniques are employed. However, following the Hausman (1968) slope homogeneity test statistic, the pooled mean group estimator results are accepted as the main results. Hence, the pooled mean group estimation result reveals that the budget deficit is inflationary. In addition, GDP per capita, the effective exchange rate, financial sector development, regulatory quality, and the interaction term of the budget deficit and financial sector development are significant determinants of inflation. The study further examines the role of the broad money supply as a mediating variable in the budget deficit-inflation relationship. To this end, the structural equation model is estimated and post-estimation mediation effect tests are performed. Finally, both the structural equation model results and the mediation effect tests confirmed a partial mediation effect of the broad money supply on the budget deficit-inflation relationship.