Fiscal Policy Sustainability and Inflation in the Uk an Empirical Investigation

This thesis collects three interrelated chapters of empirical work, which are connected to each other in the sense of testing UK fiscal policy. The first chapter investigates whether the UK fiscal policy was consistent with an intertemporal budget constraint for a long period of time from 1955 to 2006. I find evidence of sustainability with three structural breaks, respectively occurring in the early 1970s, early 1980s and late 1990s. UK fiscal policy has been sustainable throughout the sample period except from 19731981 when a non-Ricardian regime applied. For the remaining periods correction of fiscal disequilibrium occurs through adjustments in public revenue rather than expenditure. Finally, I find evidence of non-linear fiscal adjustment, with UK authorities not reacting to relatively small deficits; but correcting exceedingly large deficits and any temporary surpluses relatively fast. The second chapter investigates whether the Fiscal Theory of the Price Level can deliver a reasonable explanation for UK inflation in the 1970s, a period in which the government greatly increased public spending without raising taxes and money growth was entirely endogenous. The implied model of inflation is tested in two ways: for its trend using cointegration analysis and for its dynamics using the method of indirect inference. I find that it is not rejected. I also find that the model’s errors indicate omitted dynamics which merit further research. Finally, when the model is extended to the data for the output gap and interest rates it is rejected for these further two variables. With a normalised Mahalanobis Distance of 5.1 overall and 3.3 for the data variances, this rejection is not so catastrophic that some re-specification could not possibly repair the model. But, perhaps not surprisingly, it indicates that the rather simple set-up of the model, while well able to capture the wide fluctuations of inflation in this unusual policy environment, cannot capture the behaviour of output and interest rates.