Causality Analysis between Inflation, Budget Deficit and Money Supply: Empirical Evidence from Bangladesh

Developing countries across the globe have always shared the
misfortune of being unable to finance their proposed government
expenditures using their public revenues. As a result, a budget deficit is a
common feature of all underdeveloped nations, to which Bangladesh is
no exception. Conventional economic notion asserts that rising gap
between government’s expenditure and revenue creates pressure to
enhance money supply in the economy which in turn may trigger the
domestic rate of inflation. In addition, monetary policy tools are also
referred to be ineffective in controlling domestic inflation. Thus, the
objective of the paper is to identify the causal relationships between
Inflation, money supply and budget deficit in the context of Bangladesh
incorporating relevant data from 1980 to 2014. Granger Causality test
and Vector Error-Correction Model approach was used to identify the
long-run and short-run causalities between the variables. The results
coincide with the conventional economic conjecture as a unidirectional
causality is found to be running from budget deficit to inflation in the
short-run while no causality is found between money supply and inflation
in both the short-run and the long-run.

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