The effect of Government budget deficit on monetary aggregates and the foreign sector. The case of Ethiopia

Macroeconomic effect of government budget deficit

Research Paper (postgraduate), 2013

18 Pages, Grade: Very good




1. Introduction

2. Literature Review
2.1 Research Gap
2.2 Model Specification
A. The Money Supply Equation
B. The Price Equation
C. The Real Effective Exchange Rate Model (REER)
D. The Model of Current Account Balance

3. Estimation result

4. Discussion

5. Policy Recommendations

6. References


By: Tewolde Girma

Affiliation: FDRE Policy study and Research center


The main objective of the study is to examine the effect of budget deficit on monetary aggregates and the foreign sector of Ethiopia using the Vector Error Correction Model over the period 1970/71 to 2010/11. Estimation result shows the existence of fairly significant relationship between fiscal deficit, monetary aggregates and the foreign sector in Ethiopia. Budget deficit is at the root of monetary expansion. Monetary expansion intern contributes positively to rising inflation and overvalued exchange rate. The Inflation and overvalued exchange rate intern contributes to the low performances of the foreign sector through adversely affecting export incentive. Fiscal deficit for small open economy like Ethiopia is also sign of stimulated domestic import demand, because government not only spends on goods and services produced in domestic economy. Thus, the result is in favor of the twin deficit hypothesis therefore fiscal restraint bucked by export diversification will improve the performance of the foreign sector and status of inflation.

Key words : fiscal deficits, real effective exchange rate and current account and vector error correction.

1. Introduction

There is high level of consensus among many economists ,central bankers and policy makers that one of the fundamental objective of macroeconomic policy in both developed and developing world is to sustain high economic growth without distorting the macroeconomic balance (both internal and external) (Tanzi,1994). In an effort to escape sever poverty in developing countries like Ethiopia the role of government in the economy is indispensable because government engages on building roads ,different power generating plants ,communication facilities ,schools and health facilities however government is constrained by under developed financial sector ,high informal sectors ,erratic nature of the tax collection (Adunya,1997) and ,(Yemane,2008) This in turn enlarge the gap between government expenditure and revenue receipt then leads to large and persistent budget deficit which is possibly linked to monetary expansion ,inflation, reduced competitiveness of domestic producers (appreciation of real exchange rate ) and eventually runs to trade and current account deficit.

The problem of persistent foreign sector deficit, inflation and exchange rate appreciation in Ethiopia is a reflection of the overall economic development and macroeconomic policies of the country. Therefore, a brief review of some macroeconomic variables will provide information about the nature of the economy and the possible relation of the successive government budget deficit with monetary aggregates and the performance of the foreign sector.

During the imperial regime expenditure and revenue including grant is more or less balanced; inflation is also not a series problem except on uncertain occurrence of drought and war (supply side factors), furthermore, the official exchange is comparable to the parallel exchange indicates the no sign of over valuation of the real exchange rate and the foreign sector also had experienced occasional two years trade balance/Current account surplus. For instance, over the period 1970/71-1973/74, total government revenue (including grants) as a ratio of GDP averaged at 6.01 percent, while the ratio of government expenditure to GDP averaged 6.88 percent. The resulting budget deficit amounted only 0.87 percent of GDP (MoFED ,2011).

The military regime achieved a remarkable growth in revenue collection. However, due to higher growth in government expenditure the Derg period was characterized by the worsening budget deficit. Between 1974/75 and 1990/91, the ratio of total government revenue and total government expenditure to GDP averaged at 11.5 percent and 16.83 percent respectively. Thus, the ratio of budget deficit to GDP averaged at 5.43 percent. The growing deficit was financed by large through borrowing from the central bank and external loans, which had nearly equal share in deficit financings and is inflationary (MoFED, 2011). While our export only bills 50.07 percent our cost of import. This is again backed by the non coincidence of the values of the parallel and official exchange rate. The parallel rate was about 136 percent higher than the official rate in 1975/76 and it further climbed up to a 222 percent in 1990/91. If we are to assume that the parallel market rate represents the true value of the currency, then the Birr was clearly artificially overvalued, this in turn adversely affect the performance of the foreign sector. Thus, this indicative of the fact that successive budget deficit through its effect on inflation (it over valuates the exchange rate) linked to foreign sector (NBE, 2011).

Over the post reform period, especially after the advent of Ethiopian millennium, government revenue showed a considerable growth and also dependence on domestic mode of financing declined. Between 1991/92 and 1997/98, the ratio of the total government revenue and total expenditure to GDP averaged at 11.7 and 18.31 percent respectively resulting an average 6.61 percent budget deficit to GDP ratio. Over, the two years of Ethio-Eritrean border conflict, the ratio of total government expenditure, revenue, and deficit jumped to an average of 24.96 percent, 15.0 and 9.96 percent respectively. While, over period 1999/00 - 2010/11 total expenditure and revenue on average account about 22.26 and 14.27 percent of GDP. The deficit gap is 7.99 percent of GDP. In addition, the highest overall budget deficit in modern history of Ethiopia scored in 1999/00 and 2002/03 which is 11.65 and 11.96 percent of the GDP respectively. While our export bills only 25.7 percent of our cost of import. Hence despite an effort in improving revenue and excessive flow of grant, the gap is not considerably bridged. This was one among the important sources of monetary expansion (MoFED, 2011).

Monetary aggregates have been important indicator of macroeconomic performance as they are interrelated with fiscal, external sector and monetary policies of the country. Over the study (1971-2011) ratio of money supply to GDP (measure of monetary deepening) significantly increased. Ethiopia also experienced high inflation following government move towards less conservative monetary, fiscal policy and aggressive public investment (Kibrom ,2008).For instance during, 2003/04 up to 2010 annual inflation average was 15.4 percent for Ethiopia, which is higher than the sub-Saharan Africa average of 8.8 percent (IMF, 2011). Money supply grows on average of 18.34 percent per annum and the current account of country recorded sustained deficit amounting to 17 percent of the GDP over the 1997/98-2006/07 and, the non coincidences of parallel and official exchange is also indication of over valuation our exchange rate, which adversely affects export incentive (MoFED, 2011). Furthermore, Dependence of our economy on foreign aid, grant, and borrowing enables the agenda of looking the impact of successive budget deficit on macroeconomic variable as determinant to keep the economy at equilibrium. Grant and aid dependence on the free will of donators’, hence economic planning which depends on grant and aid is fully uncertain, especially in case of economic crises. Foreign borrowing also increases our indebtedness and leads to currency crises which have depressing effect on Current account balance. For instance, over the last 40 years grant on average shares around 16% of domestic revenue, in addition the growth and transformation plan indicates around 70 percent of expenditure for infrastructure and industrial development will expected to be obtained from external and domestic borrowing while the rest 30% will be from own sources of development enterprises (GTP, 2010)

Therefore, successive trade and current account deficit, rising inflation and dependence of our country on foreign aid and borrowing enables the agenda of looking the impact of budget deficit on macroeconomic indicators as detrimental to keep the economy at equilibrium

The present study, therefore answer the following research questions:

i. Is their fairly significant relationship between monetary and fiscal aggregates in Ethiopia?
ii. Is the twin deficit hypothesis holds for Ethiopia? Or is fiscal restraint improves the performance of the foreign sector?

2. Literature Review

From theoretical perspective the effects of budget deficit on the external and monetary sector is explained by Mundel -Fleming Model, Keynesian absorption model and Ricardian Equivalence hypothesis (REH) with mixed results. According to the Mundel -Fleming model, successive budget deficit increases the disposable income or financial wealth of the consumer this in turn increases aggregate demand , hence import increase ( domestic supply of goods and services is inelastic in the short run ) which leads to depreciation of currency which in turn increases the export and the net effect is ambiguous. On the other hand the Keynesian absorption theory advocates that budget deficit increase domestic absorption and import increases eventually this will reduce the surplus or increase the deficit in the trade balance. The REH postulates that the increase in aggregate demand that results from a rise in government deficit spending will be offset by a decrease in aggregate demand due to the fall in private sector spending. As a result, there will be no net change in aggregate demand. Since the changes in government deficit spending have no net effect on aggregate demand or the excess demand for credit, therefore, budget deficits should be uncorrelated with the stock of money, price, exchange rate and trade deficit (Sachs and Lorraine ,1993).

Empirical evidences in both developed and developing countries have also showed mixed results on the effect of budget deficit on country’s stock of money, inflation, exchange rate and current account balance. This means that empirical studies have not resolved the debate over the impacts of successive budget deficit on external and monetary sectors of nation and there have been contradicting results. Over all the extent to which these large deficits have affected macroeconomic performance or real economic activity is a highly debatable issue: depending on the definition of the deficit, how it is financed, and components of government expenditures and the original setting of the economy. However, they unambiguously argue monetization as source of financing deficits is inflationary (Sargent and Wallace ,1981).

2.1 Research Gap

As far as my knowledge is concerned previous literatures highly concentrate on determinants of the two of the behavioral equations (inflation, and the current account balance) on individual bases. (Shibeshi, 1994) also tried to see the relationship between budget deficit, money and inflation with the use of OLS over the period (1976-1991). However, this paper combines four behavioral equations using VAR model in order to explore the transmission mechanism of effect budget deficit to the external sector. In addition previously done paper take trade balance as measure of the external sector, however trade balance doesn’t fully represents the foreign sector because it only takes in to account the net income from trade in goods but the current account balance include both net income from trade in goods and services, private transfers . The treatment of trade balance as measure of the foreign sector also ignores an important transmission mechanism which is the effect of budget deficit on real exchange rate which is linked trough expansion in money supply. Thus, this paper unlike the others uses the real effective exchange rate and current account equation to represent the foreign sector, modified the model with adding equation and using VAR over the period (1970/71-2010/11) .

2.2 Model Specification

In order to examine the macroeconomic impact of budget deficit on monetary aggregates and the foreign sector the study combined, four behavioral equations, i.e the money supply, price, real effective exchange rate and the current account equation are individually estimated. The monetary aggregate is represented by the first two equations, while the last two are used to represent the foreign sector. To do so credit counterpart approach to money stock determination, different synthesis of inflation, real exchange rate models and the balance of Payment theories (monetary approach to balance of payment ), are merged together through the use of Keynesian approach to budget deficit as bench mark. Furthermore researcher referred (Korsu, 2005), and (Chaundary and Ghulam, 2005) in which both use simultaneous equation. Thus, the study is based on the model developed by (Korsu, 2005) with modification to account for specific behavior of our economy and estimation techniques.

A. The Money Supply Equation

According to (Shibeshi ,1994), in Ethiopia monetary policy is accommodative to fiscal policy, so it is better to use the credit counterpart approach to money supply determination in order to take in to account the role of fiscal factors in determining the money supply. Furthermore, the credit counterpart approach implicitly takes in to account the foreign sector. Accordingly, money creation is the result of change in non bank private sectors lending to public sectors, change in bank lending to the non bank private sector, public sectors purchases of foreign currency, and change in bank sectors net claim on foreigners (Patinkin, 1972).

Where the change in money supply given as:

illustration not visible in this excerpt

Where, MS stands for money supply, BD for budget deficit, NGT for net government transfer, D: for public debt and CTP stands for outstanding total bank advances to the private sector. To the extent that domestic financial sector is not developed the omission of private sectors lending to the public or government is not this much troubling. Hence change in money supply is function of government budget deficit, debt management policy and credit expansion (loan disbursement to the private sectors). However, the equilibrium money supply also depends on factor affecting the Money demand which is real income (RGDP) and interest rate (R).

Thus, the empirical model of money supply can be:

illustration not visible in this excerpt

Quantity of money (MS) available in the economy is a function of budget deficit (BD), bank lending to the private sectors (CTP), gross reserves (GR), real income (RGDP) and interest rate (R). Therefore, huge government budget deficit, increasing bank lending to the private sector and gross reserve expected to exert upward pressure on stock of money circulated in the economy while an increase in interest rate reduces money supply and the effect of real income is inconclusive.


Excerpt out of 18 pages


The effect of Government budget deficit on monetary aggregates and the foreign sector. The case of Ethiopia
Macroeconomic effect of government budget deficit
Bahir Dar University
Economic Policy analysis
Very good
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
612 KB
government, ethiopia, macroeconomic
Quote paper
Tewolde Girma Hailemikael (Author), 2013, The effect of Government budget deficit on monetary aggregates and the foreign sector. The case of Ethiopia, Munich, GRIN Verlag,


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