Budget Deficits and Inflation: The Case of Sri Lanka

This paper explores the relationship between budget deficits and inflation in Sri Lanka using three approaches: the Granger causality test, Auto Regressive Distributed Lag (ARDL)/Bound test, and ARDL long run cointegration coefficients analysis with time series data for the time period of 1957-2016. Three statistical procedures are also exploited in the study, namely, Toda-Yamamoto (1995) Granger causality test, ARDL/Bound test procedure developed by Pesaran and Shin (1999) and Pesaran et al. (2001), and ARDL Error Correction Model. Moreover, four model specifications are formed that are distinguished by two budget deficit indicators, namely, the budget deficit scaled by narrow money (BDMI), which was developed by Catao and Terones (2003), conventional budget deficit indicator, which is the budget deficit as a per cent of Gross Domestic Product (BDGDP), and two inflation indicators, namely the Consumer Price Index (CPI) and GDP deflator. The findings of the study are statistically significant at acceptable levels (p=10%, p=5%, and p=1%). The results suggest a unidirectional causality coming from the budget deficits to inflation in Sri Lanka and the existence of a long run cointegration with high magnitudes, which interprets that a one percentage point change in natural logarithms of BDM1 and LNBDGDP, will result in a 1.5-2.5 per cent change in inflation in Sri Lanka as measured by natural logarithms of Colombo Consumer Price Index (LNCCPI) and Gross Domestic Product Deflator (LNGDPD). Further the study concludes that the importance of maintaining low budget deficits in view of reaching inflation targeting in Sri Lanka.