Korea's outstanding economic performance during the last two decades has been accompanied by an enormous inflow of foreign capital on the one hand and by an excessive expansion of money supply on the other. The excessive liquidity and government budget deficits have created inflationary pressure on the economy.
The objective of this thesis is to examine to what extent government budget deficits have influenced monetary growth and high rates of inflation since 1962. Also a survey of various theories and hypotheses that have been offered to explain the effects of fiscal deficits on inflation is presented.
Using a money supply function and test equation of the rate of inflation, originally developed by Niskanen, we find that about 23%-29% of deficits appears to have been monetized. Although this result is partly significant, there is sufficient evidence supporting the notion that budget deficits have had a considerable impact on the rate of inflation.
One of the major contributions of this thesis is the introduction of new testable equation which examines the relationship between deficits and price level. The empirical evidence of the suggested model is consistent with the result of Niskanen's. According to the suggested model budget deficits appears to have contributed more than 2.5% to the inflation rate.
Furthermore, the monetarist argument that budget deficits themselves are not inflationary but that the excessive money supply stemming from large budget deficits is the major inflationary factor has been critically examined and tested by the estimated money supply function. However, our test result of the monetarist proposition not unambiguous depending on the budget deficits data compiled by the Bank of Korea and Economic Planning Board.
In addition to the investigation of the impact of government budget deficits on the monetary expansion and the consequent effect on inflation, the thesis deals with two important policy issues associated with government budget deficits. First, the thesis compares and evaluates the effects of three methods of financing budget deficits within the IS-LM framework: (a) increasing revenues through taxation, (b) printing money, and (c) borrowing from the private sector through the open market operations. Second, the Ricardian equivalent theorem and the non-equivalent theorem are discussed in some detail to see what impact the two different methods of deficit financing, tax and bond, have on the allocation of resources.
