Identifying the Relationships between Budget Deficit and Selected Macroeconomic Variables: A Study of Sri Lanka During the Postliberalization Era

Abstract A sustained sizeable deficit budget is problematic for Sri Lanka. Since 1980 to 2014, the Sri Lankan government budget deficit averaged 8.75% of GDP, and recorded the highest ratio of 19.2% of GDP in 1980 (Central Bank Annual reports, 1980-2014). This study examines the association with budget deficit and selected macroeconomic variables in Sri Lanka, using annual time series data for post-liberalization period; 1980-2014. The selected explanatory macroeconomic variables are inflation, interest rate, exchange rate, debt, and real GDP growth rate. Specifically, the study seeks to ascertain the relation-ship between selected macroeconomic variables and the budget deficit with a view to making appropriate recommendations to curb its negative effect to economy. The study carried 210 samples, and for examination of long-run relationship ARDL bounds test technique is applied, and short-run dynamic was examined using the ARDL Granger-Causality test. Further, Granger Causality test was carried out to determine the causality between selected variables and budget deficit, whether the impact were uni or bi- directional. The results revealed that there is a long-run relationship between budget deficit, inflation, interest rate, exchange rate, debts and real GDP growth rate in Sri Lanka. Further, in this study uni-directional relationship was confirmed between budget deficit and debts. The budget deficit cause debt. Additionally, a uni-directional relationship was also identified between budget deficit and inflation. The budget deficit cause inflation. Moreover, this study confirmed there were no uni or bi direction causality between other selected variables; Interest rate, Exchange, Real GDP growth rate and Budget deficit. Furthermore, the findings show that budget deficit has a meaningful effect on inflation, and debts. The paper recommended that the Sri Lankan government should take actions to control inflation to maintain price stability and to minimize the debts because the government is maintaining a sizable deficit budget since 1957. This research contributes to the idea that there are dimensional and dynamic factors involved between budget deficit and macroeconomic variables that require comprehensive knowledge to increase productivity, improve living standards, and ensure stability of the economic system. Keyword: Budget Deficit, Macroeconomic Variables, Granger Causality Test