An Empirical Analysis on the Relationship between Fiscal Deficit and Inflation in Nigeria

Abstract

The implications of fiscal deficits on key macroeconomic variables have led to a large body of literature examining the question of whether economies with large and persistent fiscal deficits have high inflation rate. In line with this argument, this research work examines the long-run relationship between fiscal deficit and inflation in Nigeria using Autoregressive distributed lag (ARDL) approach to cointegration on a time series data spanning from 1970 to 2011. It further examines the nature and direction of causality between the two variables. The ARDL result reveals that there is insignificant long run relationship between fiscal deficit and inflation. There is also no significant relationship between exchange rate depreciation and inflation. However, there is a positive and significant long-run relationship between interest rate and inflation. On the direction of causality, uni-directional causalities running from fiscal deficit to inflation and also from inflation to interest rates were evident, while no causality between inflation and exchange rates was recorded. The study therefore, concludes that the sustained fiscal deficit maintained over the years is not the cause of inflation. Rather, interest rate is the main cause of inflation, as such policies targeted at inflation control could be best achieved if geared towards reducing interest rate.