Fiscal deficit and inflation dynamics in Sri Lanka: an empirical investigation of causal relationships

Abstract

Introduction:

In Less Developed Countries, including Sri Lanka, the fiscal deficit has been blamed for much of the economic problems such as high inflation, debt, etc. During the last few decades, Sri Lanka has faced an upward trend in the general price level and expansion of its budget deficit. The relationship between inflation and fiscal deficit is important and controversial, one of the most widely debated topics among academics as well as among economics policy makers in both developed and developing countries. Good understanding of the dynamic relationship between inflation and fiscal deficit is important in policy planning. In-depth empirical analysis of dynamic linkages between these variables in Sri Lanka will provide useful directions for future research.

Several studies have examined the interrelationship between these variables related to developed countries and developing countries except for Sri Lanka. Fiscal based theories of inflation have been especially prominent in the developing countries’ literature (Alesina and Allen, 1991) Further, Metin (1998) argues that there is a positive relationship between the budget deficit and Inflation. Contrary to the above, Sahan and Bektasoglu (2010) have showed a negative relationship in some countries. Chimobi and Igwe (2010) find bidirectional causal relationships between both variables.

However, in Sri Lanka, this dynamic relationship has not received much attention in the literature. Very few studies have attempted to study about inflation determination. There exists no in-depth technical analysis on dynamic behavior and its statistical properties of the dynamic relationship in Sri Lanka. The current study intends to fill this gap in the literature and provide an in-depth analysis. This paper empirically tests whether the time path of the government budget deficit in Sri Lanka has an impact on inflation.