Inflationary effects of budget deficits: evidence from Zambia (1981-2016)

Abstract

Empirical and theoretical literature reveals that inflation is not only a monetary phenomenon. Budget deficits may be inflationary or not depending on the state of different transmission mechanisms which include the mode of financing budget deficits, institutional arrangements, the dominant regime, public indebtedness, the effect of budget deficits on private investment and aggregate demand, central bank independence, development of financial markets, public sector wages, exchange rate pass through and external shocks. With inadequate empirical evidence in Zambia, we are uncertain of the inflationary effects of budget deficits. The general objective of this study was to examine the relationship between budget deficits and inflation. The study specifically intended to determine the impact of budget deficits on inflation and to verify the causal relationship between the two variables. Using the Autoregressive distributed lag model for time series data ranging from 1981 to 2016, the results show that there is a significant positive relationship between budget deficits and inflation. The results also reveal that there is incomplete pass-through from budget deficits to inflation. The mean average lag time for complete adjustment to equilibrium after a shock is approximately 10.7 months. Results of the error correction based granger causality test show evidence of a unidirectional causality from budget deficits to inflation both in the shortrun and longrun. The results clearly indicate that a policy package that lowers budget deficits to sustainable levels would lower the inflation rate. Therefore, there is need for enhanced coordination between monetary and fiscal policy in Zambia. It is found that inflationary effects of budget deficits in Zambia are characterized by the Quantity Theory of Money and the Fiscal Theory of the price level. These theories may play an important role in the modelling and forecasting of inflation in Zambia. Key Words: Budget Deficits, Inflation, Granger Causality, Error Correction Model, Autoregressive Distributed Lag Model.