Budget Deficit and Its Financing: Exchange Rate, Interest Rate, and Inflation Trilemma in Ghana, a Co-Integration Approach

Abstract

The study employed annual data from the year 1982 to 2017 to investigate the relationship exchange rate, interest and inflation, have with the budget deficit in Ghana. It also used monthly data from the year 1990 to 2017 to establish the long run distribution of inflation and the exchange rate in Ghana. The Autoregressive Distributed Lag (ARDL) co-integration technique, the Error correction parameterization of the ARDL model, impulse response function of the Vector Autoregressive model, and Markov transition probabilities were used in unveiling these dynamics. The study established co-integration between budget deficit and exchange rate as well as with the inflation. It, however, suggests no co-integration between the budget deficit and the interest rate. The result showed that there exists statistically significant negative long-run relationship between the budget deficit and the exchange rate. The speed of adjustment estimated by the error correction model for exchange rate, and inflation in relation to the budget deficit shows that changes in the budget deficit cause the inflation to adjust faster than the exchange rate Furthermore, upon the establishment of these long-run relations, Markov transition probabilities was used in estimating the long-run stationary distributions of inflation and exchange rate. It was realized that in the long run there is a 56.45 % chance that inflation rate will lie between 10% and 20%, inclusive in Ghana whereas the Cedi in the long run has a 87.76 % chance of depreciating against the US dollar. The study predicts the long run distribution of the exchange rate to occur in 20 months’ time whiles the inflation rate will have 316 months’ time-horizon