1 Introduction
One of the principal goals of monetary policy pursued by Central Banks virtually in the entire world is price stability (Ekanayake
2013). Understanding inflationary dispositions and its determinants is therefore a critical issue and attracts interest from policy makers and the monetary authorities. Budget deficit is studied for Uganda because theoretically it could be a source of inflation especially with regard to how it is financed. In both the Keynesian and Monetarist frameworks, deficits tend to be inflationary. This is because, in the former, budget deficits stimulate aggregate demand, while in the latter, when monetization takes place, it leads to an increase in money supply, and ceteris paribus, increases the rate of inflation in the long run (Gupta
2013). Ideally, a positive shock to government expenditure should result in a supply-side response. However, if the increase in government expenditure generates demand pressure, this may cause inflationary tendencies.
However, evidence from the empirical studies provides mixed results. For example, Luis and Marco (
2006) find a strong linkage between inflation and budget deficits in emerging economies characterized by episodes of high inflation rates, but it holds less strongly in developed countries. They argue that budget deficits result in higher inflation rates for countries where the inflation tax base is smaller and that less impact is felt in countries that have greater levels of monetization. A similar result is found by Levin et al. (
2002) in a most recent study which analyzes 91 countries. They find a strong relationship between the budget deficit and inflation in countries that experienced high inflation and weak relationship in countries that experienced lower inflation (Levin et al.
2002).
A study by Muzafar et al. (
2011) on developing Asian countries reveals that, in the long run, budget deficits are inflationary in developing countries. This is considered to be the case because many developing countries rely on the Central Banks to finance their deficits through printing money, which may result in greater excess aggregate demand than in increased aggregate supply. In Sri-Lanka, Ekanayake (
2013) finds a weak relationship between the budget deficits and inflation. Interestingly, the relationship becomes stronger as the proportion of public expenditures allotted to wages increases. This implies that the inflation–deficit relationship is not only a monetary phenomenon, but that public sector wage expenditure is also influential in linking inflation and budget deficits.
In Pakistan, evidence from empirical studies provides mixed results. For example, studies by Shabbir and Ahmed (
1994) reveal a positive and significant relationship between budget deficits and inflation, and an indirect relationship between budget deficits and money supply. They further argue that inflation is not only linked to budget deficits, but that the deficit is primarily funded through bank borrowing and ultimately seigniorage. However, findings by Mukhtar and Zakaria (
2010) reveal a different picture for Pakistan; they do not find significant long-run connection between inflation and budget deficits. Instead, inflation is related to the money supply, yet no causal relationship is found between budget deficits and money supply. In Tanzania, Ndanshau (
2012) find no causal effect from budget deficits upon inflation; instead, Granger causality is observed running from inflation to budget deficits. On the other hand, in Nigeria, Oladipo and Akimbobola (
2011) find a unidirectional causation running from budget deficits to inflation.
Some scholars, however, do not find a significant evidence of the direction of causality between inflation and the budget deficit (Viera
2000; Cevdet Akcay et al.
2001). This implies that neither inflation nor budget deficit Granger causes the other. On the other hand, other studies find bidirectional causation between deficits and inflation (Aghevli and Khan
1978; Marbuah and Mali
1997). These proponents were actually testing the Olivera–Tanzi effect which argues that the budget deficit does not only lead to inflation, but inflation also provides a feedback through lags in tax collection which leads to a reduction of real tax revenue and further leads to an increase in the budget deficit hence self a strengthening phenomenon (Tanzi
1991).
In Uganda, however, less effort has been made to study the connection between the budget deficit and inflation despite the fact that the country has been running deficit budgets over the years. This has been attributed to the low revenue mobilization compared to the increasing expenditure requirements. For example, in 2012, total revenue was at 17.2% of GDP compared to the expenditure requirements of 20.6% of GDP in the same period (MoFPED
2013). The economy therefore has been typified by relatively high budget deficit and inflation for a prolonged period of time. The few studies that have been conducted have also provided mixed results for the case of Uganda. For instance, Bwire and Nampewo (
2014) examined the association between money creation, inflation and the budget deficit in Uganda over the period 1999Q4 to 2012Q3. Using vector error correction model (VECM) and a pairwise Engle–Granger causality test, a long-run relationship between the budget deficit, money supply, inflation and the nominal exchange rate was found to hold. However, their results showed that only money supply Granger causes inflation in the short run. Although results of Granger causality tests revealed a unidirectional causality running from inflation to the budget deficit, no statistically significant causation was found from the budget deficit to inflation or from the budget deficit to money supply in the short run.
In a supposedly related study (Alani
1995), the author analyzes the relationship between government deficits, money supply and inflation in Uganda using Quarterly data from 1985Q2 to 1993Q2. Applying Ordinary Least Squares (OLS) to the data set, the study revealed no association between budget deficit and inflation, although a short-run causation running from money supply to inflation was revealed. Most empirical studies in Uganda have majorly concentrated on the effects of the budget deficit on the exchange rate and the sustainability of the government deficit (Bagonza
2004; Birungi
1995; Alani
1995; Brownbridge and Kirkpatrick
2000). Most of these studies have been using single equation models where inflation is treated as an endogenous variable and the budget deficit as an exogenous variable among other variables using ordinary least squares (OLS) estimation technique. However, this approach rules out the possibility of bidirectional causation.
This therefore forms the basis of this study. This study contributes to the literature by examining the budget deficit–inflation nexus for Uganda, using annual data for the period 1980–2016. The ECM and Granger causality approaches were employed to investigate the interrelationship between the budget deficit and inflation. A chief uniqueness of this study in the context of the budget deficit–inflation nexus literature is in the use of a rich dynamic approach that allows the short-run adjustments and long-run equilibrium relationships to differ. The debate concerning the relationship between budget deficit and inflation is still inconclusive. This study contributes to the debate for the case of Uganda since most of the studies have concentrated on the unidirectional causation running from the budget deficit to inflation (Bagonza
2004; Birungi
1995; Alani
1995; Brown bridge 2000).
Therefore, this study examines the nexus between budget deficit and inflation as well as their direction of causality in Uganda using annual time series for the period 1980–2016.
2 Literature review
There is an extensive deliberation regarding the budget deficit and the inflationary effects in the fiction of economic theory. Throughout the Keynes era, the classical economists attached strong value to a balanced budget, even though they did not analyze its bearing on the price levels. Apart from classical economists, Keynes saw the fiscal imbalances and the budget deficit mechanisms as amassed national demand (Levin et al.
2002). The underlying reason is that when budget expenditures upsurge, aggregate demand curve responds by shifting right, leading to an increase in both prices and production assuming aggregate supply is inelastic or perfectly elastic (Gupta
2013).
In the monetarist point of view, money supply drives inflation. If monetary policy is accommodative to a budget deficit, money supply continues to go up for a long time. Aggregate demand increases as a consequence of this deficit financing causing output to increase above the aggregate level of output. Growing labor demand increases wages, which in turn leads to a shift in aggregate supply in a downward direction. After some time, the economy returns to the natural level of output. However, this happens at the expense of permanent higher prices. According to the monetarist view, budget deficits can lead to inflation but only to the extent that they are monetized (Hamburger and Zwick
1981).
According to Olivera–Tanzi effect, the nexus between budget deficit and inflation exhibits a two-way interaction. That is, not only does the budget deficit through its impact on money aggregates and expectations produces inflationary pressures, but high inflation also has a feedback effect pushing up the budget deficit. Basically, the process works due to significant lags in tax collections. The problem lies in the fact that the time of tax obligation’s accrual and the time of actual tax payment do not coincide, with the payment usually made at a later date. We may therefore have the following self-strengthening phenomenon. Persistence of budget deficit props inflation which in turn lowers real tax revenues, a fall in the real tax revenue then necessitates and further increases in the budget deficit and so on. In economic literature, this is referred to as the ‘Olivera–Tanzi effect’ (Olivera
1967).
The debate of Sarget and Wallace under the neoclassical theory enlightens the discussion on the relationship among the budget deficit and inflation. They discuss two types of the coordination between the monetary and the budget authorities which is effective in controlling the inflation. In the first type of the coordination in which the monetary authorities are dominant, monetary authorities announce the monetary base growth and budget policy. In the second type of coordination, in which the budget authorities are dominant, budget policy sets its budget and announces the amount of money needed for monetary authorities through seigniorage and bond sales (Sargent and Wallace
1981)
The new classical economists oppose the misperception part of the theory and assert that such an assumption is inconsistent with the rational expectation theory. That is, the demand for goods is based on expected present value of the future taxes (Catao and Terrones
2001). Budget policy can influence the price level through aggregate demand changes; it should change the expected value of the future taxes, which occurs by altering the sounding. In this sense, budget deficits and taxation have equivalent effects on the economy hence the term the ‘Ricardian equivalence theorem’ (Catao and Terrones
2001). That is, there is no change in national saving, since an increase in private saving as faced by an equivalent decline in public saving. Because national savings, in turn, investment and aggregate demand do not change, one can argue that the budget deficit does not affect price levels.
Just like the theoretical literature, evidence from empirical literature concerning the direction of causality is also inconclusive. Some studies have found a unidirectional relationship running from the budget deficit to inflation and vice versa. While others have found a bidirectional relationship, some have actually found no relationship between these two variables. Some have found a unidirectional relationship running from the budget deficit to inflation, and these support the traditional approach to budget policy (Luis and Marco
2006; Hamburger and Zwick
1981). However, most of these studies have been using single equation models where inflation is treated as an endogenous variable and the budget deficit as an exogenous variable using ordinary least squares (OLS) estimation technique. Yet, such approach rules out the possibility of bidirectional causation. Recent studies of Ndanshau (
2012) and Ekanayake (
2013) used the cointegration and error correction model (ECM) but also concentrated on whether the budget deficit leads to inflation and ignored the aspect of feedback which can be done by making inferences using the short-run and long-run Granger causality within the framework of the VECM model. This forms the basis of this study.
3 Theoretical framework
The theoretical framework adopted by this study is borrowed from Solomon and Wet (
2004) and Bwire and Nampewo (
2014). This model links reactions of the government deficits to inflation as was developed by Aghevli and Khan (
1977,
1978). According to Bwire and Nampewo (
2014), for the case of a developing country like Uganda, the main sources of budget financing, excluding grants, are summarized in Eq. (
3.1) below. Grants are excluded because they are not reliable sources of government revenue; grants solely depend on donor discretion, and may, as a result, present potential risks of financial vulnerability.
$$Gt + \frac{Dt - 1}{Pt}\left[ {1 + rt - 1} \right] = Tt + \left( {\frac{Mt - Mt - 1}{Pt}} \right) + \frac{Dt}{Pt} + \Delta R$$
(3.1)
where
Gt is the total government expenditure at time (
t),
\(\frac{Dt - 1}{Pt}\left( {1 + rt - 1} \right)\) is the discounted value of the real stock of accumulated government debt in the previous period with maturity value in the current period (
t),
\(Tt\) is the tax revenue at the current time (
t),
\(\frac{Mt - Mt - 1}{Pt}\) is the change in money supply or seigniorage revenue,
\(\frac{Dt}{Pt} = {\text{Captures domestic and external}}\)
This specification follows the one used by Catao and Terrones (
2001) and is widely supported in the literature over the conventional scaling of the budget deficit to GDP. According to Catao and Terrones (
2001), scaling the budget deficit by money supply is theoretically sound, and would measure the inflation tax base and capture the nonlinearity factor in the specification. This study, therefore, adopted the conventional measure of scaling the budget deficit by GDP. Rearranging Eq.
3.1 in terms of budget deficit given the purpose of the study, the final model for estimation is expressed in Eq.
3.2.
$$\pi = f\left( {\frac{\text{FD}}{m}, {\text{M2}}, {\text{TB}}, {\text{GDP}}, {\text{NER}}} \right)$$
(3.2)
where
π = Inflation, M2 = Money supply Growth, TB = Trade Balance, GDPG = Gross Domestic Product Growth, NER = nominal exchange rate. Letting Consumer Price Index (CPI) denote
π as a measure of inflation, budget deficit (BD) denote the term
\(\left( {\frac{\text{FD}}{m}} \right)\) as a measure of budget deficit as a percentage of GDP Eq.
3.2 was transformed into the following;
$${\text{CPI}} = f\left( {{\text{BD}}, {\text{M2}}, {\text{TB}}, {\text{GDPG}}, {\text{NER}}} \right)$$
(3.3)
8 Conclusion
The main conclusion from this analysis is the existence of the long-run relationship among inflation, budget deficit and money supply. This was thus an indication of granger causality in at least one direction among the variables. However, the impact of trade balance and NER was taken as exogenous. A long-run stationary relationship between the budget deficit, money supply, inflation, trade balance and the exchange rate has been found to hold for Uganda. Normalizing the only relation for the annual change of CPI reveals that all variables in the model had a positive and significant long-run association with inflation. It implies that increases in the ratios of the budget deficit to GDP, M2/GDP, and depreciation in the exchange rate should each lead to a long-term increase in inflation. Results of Granger causality tests reveal unidirectional causality running from budget deficit to inflation and from money supply to inflation in the short run. No statistically significant causation is found from inflation to the budget deficit or from the budget deficit to money supply in the short run. From such analysis, it can be seen that inflation is not only caused by monetary factors but by budget factors as well.
Authors’ contributions
SK is the main author of the manuscript, and he initiated the research idea, undertook literature review, developed the theoretical framework, collected and analyzed the data from the different sources. EB is a co-author of this manuscript. He approved the research idea, supported the theoretical underpinning of the research paper, undertook quality assurance and supported the empirical data analysis and generation of policy implications. Both authors read and approved the final manuscript.