The Debt-Inflation Dance: The Relationship Between Unexpected Government Debt Increases and Inflation

Abstract

This paper investigates the impact of debt shocks on inflation across developing and emerging economies in the post-pandemic economic landscape. It does so by utilizing panel regressions and a local projection method to explore the direct and temporal effects of unexpected increases in national debt, defined as debt shocks, on inflation. The dataset for this country includes 117 countries across 2010-2022. The results for the full sample of emerging and developing economies show a positive correlation between debt shocks and inflation. Specifically, a 10 percentage point increase in debt shock is associated with a statistically significant 24 basis point rise in inflation after one year. This relationship exhibits significant regional variation. The strongest inflationary response in Eastern European and Central Asian countries which exhibit a very similar trajectory to the full sample. These results highlight the important role of geographic, economic, and policy factors in the debt-inflation dynamic. These results underscore the need for tailored fiscal and monetary policies to address the inflationary pressures stemming from debt shocks for emerging and developing economies.