Are Fiscal Deficits Really Inflationary? An Investigation Into Ethiopia’s Experience

This study establishes long-run relations between budget deficits and inflation, while controlling for money supply owing to the justified links between deficits and money supply especially for developing countries. We employed time series data with temporal coverage of 1980-2018. Augmented Dickey Fuller has tested nonstationary for all series, but with all stationary at first difference. The Engle-Granger (1981) methodology for Cointegration tested long-run relation between budget deficits, money supply and inflation. Due to Laney and Willet (1983), the conventional least squares regression was adopted to estimate parameters of long-run equation. The results evidenced that fiscal deficits and money supply have been at the root of galloping inflation in Ethiopia. Besides, budget deficits have been the root cause of money supply growth in Ethiopia; while giving empirical support to the hypothesis that, governments of least developed countries resort to monetize large portion of their deficits. There is a need to reform the fiscal aspect of the government, if the mounting rate of deficits has to be lessened. Budgetary imbalances can be rectified through enhancement of domestic capital market and setting limits on central bank borrowing. Besides, it could be vital to expand the tax base as well as intensify efficiency of the existing tax system in the country.