The effect of budget deficit on inflation in Uganda

Abstract

This study investigates the effect of budget deficits on inflation in Uganda, analyzing the period from 1990 to 2023. The research employed the Autoregressive Distributed Lag (ARDL) model to explore both the short-run and long-run dynamics among budget deficits, inflation, lending rates, money supply, Gross Domestic Product (GDP) and exchange rates. The Bounds test for cointegration confirmed the existence of a long-term equilibrium relationship among the variables. In the short run, the study utilized the Error Correction Model (ECM) to assess the speed of adjustment back to equilibrium following a shock. The empirical findings revealed a significant and positive relationship between budget deficits and inflation, suggesting that persistent fiscal imbalances exert upward pressure on prices. This relationship held true in both the short and long run, reinforcing concerns about the inflationary impact of deficit financing. Moreover, the study identified a significant role of lending rates in shaping inflation dynamics, with higher lending rates correlating with reduced inflation. However, the effect of exchange rates on inflation was found to be more complex, with varying impacts depending on the time horizon and external conditions. These results imply that fiscal discipline is essential for maintaining price stability in Uganda. The study recommends that policymakers prioritize measures to contain budget deficits, such as enhancing revenue collection, curbing unnecessary expenditures, and fostering a conducive environment for economic growth. Additionally, the study underscores the importance of a stable and predictable macroeconomic environment, which could help in managing inflation expectations and promoting sustainable economic development.