Effect of budget deficits on economic growth

Department Development Economics
Nigus Temare
Seminar papers presentation
MASTER OF DEVELOPMENT ECONOMICS
Seminar Paper on the Effect of Budget Deficit on Economic Growth:
In the Case of Ethiopia:
By

BY: NIGUS MSC IN ECONOMICS 11/02/2021 2
Seminar : The Effect of Budget Deficit on Economic Growth
Overview
 Introduction
 Objectives
 Research Gaps
 Literatures
 Methodology
 Result
 Conclusion and Recommendation

CHAPTER ONE
INTRODUCTION

Introduction
• Budget is the amount of money reserved for a particular institution, activity, or
time-frame; this is a component of the financial plan. It can be either deficit or
surplus depending on planning. Keynes (1936), budget deficits were viewed as
positive instruments to shore up aggregate income to stimulate all sectors to
spend more.
• However, the linkage between budget deficit and its relative contribution to
economic growth is a controversial issue from both theoretical and empirical
perspectives.

Cont.…
• According to Keynesians BD stimulates high personal savings and, in part,
high consumer demand and economic growth.
• The neoclassical economist argues that budget deficit harms economic growth,
and they believe that this relationship is negative.
• Ricardian economists argue that there is a neutral connection between the
budget deficit and economic growth.

Cont.…
• The budget deficit is linked to the fiscal policy of the government; it
has implications for the monetary policy as well. Example:-
• To maintain the stability of the prices in the economy when governments
run a budget deficit, central banks must conduct restrictive monetary
policy.
• But such limitations lead to a reduction in private investments and
private final consumption, in particular consumption of durable
goods.

Cont..
• unless the extent of the budget deficit and its financing is not managed prudently, it
has negative consequences, on macroeconomic stability.
• In Ethiopia, the level and financing of the budget deficit are designed to promote the
desired macroeconomic goals such as controlling inflation, boosting private
investment and growth, and maintaining external credit worthiness.
• Budget deficit financing comes from two sources. These are:
 tax revenue and
 central government debt

Statement of problems
• A deficit policy plays a vital role in assisting countries to achieve macroeconomic
stability, poverty reduction, income redistribution, and sustainable growth.
• most governments use the budget as an effective tool in achieving their economic
objectives. This means that a large and accumulating budget deficit may not
necessarily be a bad policy objective if such deficits are effectively utilized to
enhance economic growth.
• There is no theoretical as well as empirical consensus among economists and
researchers on the issue of the relationship between budget deficit and economic
growth.

Cont..
• There was no enough research on this issue in Ethiopia particularly after the
downfall of the Dregs regime in 1991.
• The study aims to contribute to the reconciliation of the effect of budget deficit
on economic growth in Ethiopia. It employed the most famous econometric
procedure of the ARDL approach which is developed for this purpose and
recently applicable in wide ranges.

Objectives
• The main objective of this study is to investigate the effect of budget deficit
on economic growth in Ethiopia. Based on this basic objective, the study
addresses the following specific questions:
 To analyze the trend of the budget deficit and economic growth;
 To analyses the linkage between budget deficit and economic growth

Significance of the study
 The study helps to identify the relationship between budget deficit and
economic growth in the case of Ethiopia.
 It helps future researchers as a source of literature review.

CHAPTER TWO
LITERATURE REVIEW

Theoretical Framework
• Budgets are considered a very useful tool of control applied by companies.
It can help set developmental policies in the country.
• It is black and white about the earnings and spending of an organization. It
can be either deficit or surplus.
• Budget Deficit results in situations where the expenditures of the country
exceed its revenues, earned from the taxes and other sources (Fatima et al
2012).

Cont..
• There were three schools of thought concerning the economic effects of budget deficits. These are:
 Neoclassical economists: This school of thought also assumes that the market will always be at
equilibrium in all periods. They argue that budget deficits have detrimental effects on the economy and
thus advocate for a balanced budget at all times.
The Ricardian: They believe that government deficits have no impact on key macroeconomic
variables. Hence, there is a neutral connection between the budget deficit and economic growth.
Keynesian economists: They are of the idea that budget deficits are good due to their multiplier
effects on the economy. Increased government spending stimulates aggregate demand which leads to
the employment of idle resources and thus increases output.

The Keynesian economies believed that there is a direct relation between these two
series /budget deficit and economic growth/, while the new classical economies
argued that there exists a negative relationship.
On the other hand, the Ricardian equivalence hypothesis perceived that there is a
neutral relationship between budget deficit and economic growth. In this regard,
(Osoro, 2016) analyze the relationship between budget deficit and economic growth
in Kenya using time series data from 1980 to 2014 and he was employed Ordinary
Least Squares (OLS) as a method of estimation. He found that there a positive
relationship between budget deficit and economic growth but as the budget deficit
increases, the impact on growth decreases.
Empirical Literature

Cont…
On the contrary, studies conducted by (Fatima etal, 2012) using a similar
model that identifying the effects of budget deficit on economic growth in
Pakistan. They found a negative impact of budget deficit on the economic
growth.

Cont.…
 In general, a lot of empirical studies were carried out on the effect of budget deficits
on the economy using a different model in different countries and concluded by
agreeing with the Keynesians proposition that the positive effects of budget deficit on
economic growth.
 On the other hand, some empirical studies with different models concluded and
agreed with the Neoclassical economists that budget deficits harm economic growth
and development. Besides, some empirical studies that support the Ricardian
equivalence hypothesis, agree that budget deficits do not have any impact on
economic activities.

CHAPTER THREE
Methodology

Data Type and Source
 We used secondary time series data and it covered a period from 1994 to 2020.
 The main source of this data was from
 World Bank development indicators
 Ministry of Finance, and
National Planning and Development Commission of Ethiopia

Methods of Data Analysis
To analyse the data we used both
Descriptive Analysis and
Econometric Models Analysis

Econometric Models
 Testing for Unit Roots
Identify the nature of time series data whether it is stationary or non-stationary
(trend).
Stationary : means having constant mean and variance over time.

Model
𝑅𝐺𝐷𝑃 = 𝑓 𝐵𝐷, 𝐺𝑂𝑉, 𝐼𝑁𝐹, 𝑇𝑅𝑂
𝑅𝐺𝐷𝑃 = 𝛽0 + 𝛽1𝐵𝐷𝑡 + 𝛽2𝐺𝑂𝑉𝑡 +𝛽3 𝐼𝑁𝐹𝑡 + 𝛽4𝑇𝑅𝑂𝑡 + 𝜀𝑡 where
RGDP : real gross domestic product and it is our outcome variables.
GOV : total government expenditure as a share of gross domestic products
BD : the budget deficit as a share of a gross domestic product
INF : inflation rate
TRO :Trade openness as a share of Gross domestic products
𝜀𝑡: error terms

Cont..
 Autoregressive Distributed Lag test
 It has a lot of advantage over the Johansen approach to co-integration.
 It is applicable to determine the long and short-run relationship when variables
are integrated into a different order, I (0) and I (1), or having the same order of
integration.
It is relatively more efficient in the cases of a small data finite
It is also suitable when there is a combination of endogenous and exogenous
variables

Cont.…
 The ARDL representation of the effect of budget deficit on the economic growth
model is specified as follows:
∆𝑅𝐺𝐷𝑃𝑡
= 𝛼0 + 𝛽1∆𝑅𝐺𝐷𝑃𝑡−1 + 𝛽2∆𝐵𝐷𝑡−1 + 𝛽3∆𝐺𝑂𝑉𝑡−1 +𝛽4 ∆𝐼𝑁𝐹𝑡−1 + 𝛽5∆𝑇𝑅𝑂𝑡−1
+ 𝛼1𝑖
𝑝
𝑖=1
∆𝑅𝐺𝐷𝑃𝑡−𝑖 + 𝛼2𝑖
𝑞
𝑖=0
∆𝐵𝐷𝑡−𝑖 + 𝛼3𝑖
𝑞
𝑖=0
∆𝐺𝑂𝑉𝑡−𝑖 + 𝛼4𝑖
𝑞
𝑖=0
∆𝐼𝑁𝐹𝑡−𝑖
+ 𝛼5𝑖
𝑞
𝑖=0
∆𝑇𝑅𝑂𝑡−𝑖 + Vt
where
α1 − α5 and β1 − β5 are the short-run and long-run elasticity’s, respectively

Cont..
The short-run dynamic parameters may be obtained by estimating the error correction representation of
the ARDL model.
∆RGDPt= α0 + α1i
p
i=1
∆RGDPt−i + α2i
q
i=0
∆BDt−i + α3i
q
i=0
∆GOVt−i + α4i
q
i=0
∆INFt−i
+ α5i
q
i=0
∆TROt−i + δECMt−1 + Vt
where, ECM: error correction which used to estimate the speed at which the outcome variable return
to equilibrium

Result
 Summary of all the variables

Cont.---
 Trend Analysis of Budget Deficit and Economic Growth

Cont.…
 The economic growth grew from 3.2 percent in 1994 to 12.4 percent in 1996.
 In 1998 the economy was more decline due to the Ethio- Eritrea war .
 since 2004 it showed an upward increment but show fluctuation trend in 2016
due to rainfall shortage which mainly affect agriculture then economic growth.
 In 2020 was due the pandemic effect of covid 19.
 As a result, the relationship between the budget deficit and economic growth is
observable. Years of high economic growth were usually followed by years of
low deficits, and vice versa.

Econometrics Analysis
 The first thing for analysis time series model is determining the maximum lag of variables. The maximum lag
length is automatically selected depending on the Akaike information criterion , final prediction error etc..
 We get that the maximum lag length is one for our variables.
 We also test the Stationary
The hypothesis to be tested is:
Ho: The variable has a unit root
H1: The variable doesn’t have a unit root

Cont.…
 The results of ADF test statistics show that four of the variables are non-
stationary in their levels but stationary after taking first difference. And one
variable is stationary at level.
 These allow us to apply ARDL Model.

Long run ARDL Bounds Tests for Co-integration
The hypothesis for testing the long run relationships.
Ho: The long-run relationship does not exist
H1: The long-run relationship does exist
Bounds test for co-integration analysis

Cont..
 The results of the bounds tests confirm the existence of a level relationship
among the variables, the F-statistic is above the upper bound at all levels of
significance. We reject the null in favour of alternative hypothesis.
 So the next stage involves estimating the long-run and short-run coefficients of
each ARDL model. which presented in the table below.

Cont.…
 The result shows that all variables are statically significant at 5% level of
significance. It shows that a 10 percent increase in the budget deficit, in the
long run, would lead to a 0.6 percent decrease in real GDP, holding all other
factors constant.

Short run relationships
 The result presents the short-run relationship between budget deficit and
economic growth in the table below is that :
 The coefficient of the error correction term (ECM) is negative and highly
significant at 5 percent level.
 It indicates a rate of adjustment to the equilibrium at 25 percent per annum in
the next period in case of a shock to economic growth in the current period.

CHAPTER FIVE
CONCLUSINON AND RECOMMONDATION

CONCLUSINON
 The main objective of this study was to explore the effect of budget deficit on
economic growth in Ethiopia.
 To achieve study’s goal, the study used time series secondary data, and the
data were pull out from the World Bank development indicators, Ministry of
Finance, and National Planning and Development Commission of Ethiopia as
source.
 The data lies between 1994 year up to 2020 period.

Cont.…..
 The paper has employed the Autoregressive Distributed Lag co-integration technique
to govern the long and short-run relationship between budget deficit and economic
growth.
 The study considered real economic growth as outcome variables and budget deficit
as a share of a gross domestic product by means of its interest is the explanatory
variable.
 Similarly, the paper looked at other explanatory variables such as inflation rate, total
government expenditure, and Trade openness as a share of Gross domestic products.

Cont..
 The findings of the study after modeling and analysis shows that there is a
negative relationship between budget deficit and economic growth in Ethiopia
and this result is consistent with the neoclassical economist schools of thought.
 Based on the dynamic growth model, the study concludes that in the long run,
budget deficit affects economic growth negatively.
 This shows that a 10% percent increase in the budget deficit would lead to a
0.6 percent decrease in economic growth, holding all other factors constant

Cont..
 Besides, the inflation rate is affecting the economic growth negatively
and significantly whereas, government expenditure and trade openness
affect the economy positively and statistically significant in the long run.
 Nevertheless, the analysis in the short-run depicts that the budget deficit
is positive but statistically insignificant.
 This indicates that budget deficit changes have no immediate effect on
economic growth.

Cont..
 The fact is that the government spends mostly on long-term projects in
sectors like education, construction of roads, and other infrastructural projects
whose impacts are not observed in the short term,
 while inflation rate and trade openness shape negatively and positively in the
short run respectively

Recommendations
 The study recommends that Ethiopia should adopt and implement policies that could
reverse the brief budget deficit leading to reduction of economic growth but rather,
put the economy on a sustained path of growth and, development in the medium to
long term.
 The optimal levels of governments’ expenditure should be determined to avoid
deficits and encourage as the impetus to economic growth through increased capital
expenditure.
 The government can decrease unnecessary expenses to reduce when there is a budget
deficit.

Cont..
 In addition, the Ethiopian government could increase its revenue base by
implementing appropriates tax policy and a good administration system.
 Formulating and implementing suitable policies to encourage the rich to pay
their shares of taxes, offering incentives for taxpayers is also crucial,
 The motives will bring about that the rich the change in their attitudes and tax
evasion will be eliminated
 this, in turn, creates more revenue sources to increase the income and reduce
dependence on developed countries

Thank You!!!

Effect of budget deficits on economic growth

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