The relationship between fiscal deficit, money growth and inflation: The case of Zimbabwe

Abstract

The aim of the study is to investigate the relationship between budget deficit, money growth and inflation in Zimbabwe for the period 1980-2007. This study stands as a basis of building blocks for future policy analysis by reflecting errors of the past. The study employs Vector Auto Regression (VAR) model coupled with variance decomposition and impulse response functions to analyze the relationship. Before estimation is done the variables are tested for unit root using the Augmented Dickey-Fuller (ADF) test. The ADF test results reveal that budget deficit is integrated of order one whilst money supply growth and inflation are integrated of order two. The regression results reveal that there is a positive relationship between budget deficit and money growth and also a positive relationship between money growth and inflation. This supports the Sargent and Wallace (1981) hypothesis. The policy recommendations comprise of elements of both the fiscal policy and the monetary policy. The fiscal authorities should strengthen fiscal framework, display a high sense of transparency in the fiscal operations and enhance strategies for better government expenditure. Also the central bank should use a tight monetary policy to compliment fiscal policy.