Effect of fiscal deficit and money supply on inflation in Uganda (2007–2020)

Abstract

The main objective of this study was to investigate the effect of fiscal deficit and money supply on inflation in Uganda employing secondary quarterly data for the period 2007 to 2020 obtained from the Ministry of Finance, Planning and Economic Development and Bank of Uganda. The study used an Autoregressive Distributed Lag (ARDL) approach to estimate both the long-run and short-run effects of fiscal deficit and money supply on inflation and the Granger causality test was applied to test for causality effects among the main variables of the study. The variables that were examined in this study included inflation rate, fiscal deficit, money supply, interest rate, exchange rate, gross domestic product and terms of trade or trade openness. The long-run results showed that the money supply and fiscal deficit had a positive and statistically significant effect on the inflation rate. This implies that a 1% increase in fiscal deficit and money supply leads to about 0.33%, 0.28% increase in the inflation rate, respectively at a 5% level of significance. On the other hand, short-run coefficients of fiscal deficit and money supply were found to have a positive and significant effect on the current inflation rate at 5 percent level of significance, the error correction term results showed adjustment toward equilibrium by about 67% within a quarter. The Granger causality tests revealed that there exist a unidirectional causality running from fiscal deficit to the inflation rate, as well as a strong evidence of unidirectional granger causality flow from money supply to the inflation rate. Therefore, both the fiscal deficit and the money supply can cause inflation in the economy and an increase in the price level. Based on the results and findings of this study, the main conclusion is that the fiscal deficit and money supply had positive and statistically significant effects on the inflation rate. Therefore, the study recommended, when applying the fiscal and monetary policies to foster the economy, however, the government of Uganda should be careful about the fiscal deficit and money supply and implement monetary policy by reducing and setting interest rates, printing money, and setting bank reserve requirements to achieve price stability. The government should also reduce fiscal deficits and spend just what is available and apply fiscal policy to raise revenue through taxation.