Causality Analysis between Inflation, Budget Deficit and Money Supply: Empirical Evidence from Bangladesh

Abstract

Developing countries across the globe have always shared the misfortune of being unable to finance their proposed government expenditures using their public revenues. As a result, a budget deficit is a common feature of all underdeveloped nations, to which Bangladesh is no exception. Conventional economic notion asserts that rising gap between government’s expenditure and revenue creates pressure to enhance money supply in the economy which in turn may trigger the domestic rate of inflation. In addition, monetary policy tools are also referred to be ineffective in controlling domestic inflation. Thus, the objective of the paper is to identify the causal relationships between Inflation, money supply and budget deficit in the context of Bangladesh incorporating relevant data from 1980 to 2014. Granger Causality test and Vector Error-Correction Model approach was used to identify the long-run and short-run causalities between the variables. The results coincide with the conventional economic conjecture as a unidirectional causality is found to be running from budget deficit to inflation in the short-run while no causality is found between money supply and inflation in both the short-run and the long-run.