Budget deficit-inflation nexus in South Africa: VAR analysis

Abstract

The study uses the quarterly data covering the period 1980 - 2012 to empirically examine the impact of budget deficit on inflation in South Africa with the view to find the direction of causation and establish any cointegration existence. The study uses the Vector Autoregression (VAR) analysis coupled with the impulse response functions. Prior to getting the research results, the data is tested for unit root using the Augumented Dickey-Fuller (ADF) test and the Philips-Perron (PP) test. The Granger causality test is also conducted to establish the direction of causation between variables included in the model as well as the cointegration. The unit root test results reveal that inflation rate, budget deficit, money growth, import prices, foreign rate of interest and GDP growth are integrated of order zero and causality runs from budget deficit to inflation. There is also evidence of long run relationship between budget deficits and inflation in South Africa and the findings suggest that the VAR model produces sensible impulse functions and reveal that budget deficits are inflationary. The study shows that budget deficit contribute positively to inflation. The policy recommendations arising from the study are that the government should cut the size of its expenditures and to maintain the growth rate of money at the level which will not be inflationary.