Dynamic Effects of Fiscal Deficit Financing on inflation in Ethiopia: Markov Regime-Switching Model Approach

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2024-06-08

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A.A.U

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Ethiopia’s rapid economic growth over the past two decades has been accompanied by a persistent fiscal deficit and soaring inflation, which raised concern about the sustainability of the growth path in the face of inflationary pressure. Thus, examining the relationship between inflation and fiscal deficit financing has drawn substantial attention from researchers and scholars, as financing budget deficits is confirmed both in theoretical and empirical literature to often lead to higher inflation. This study examines the dynamic effects of fiscal deficit financing on inflation in Ethiopia using a Markov regime-switching model (MRSM) approach to capture the nonlinear relationship between fiscal deficit financing and inflation. The Fiscal Theory of Price Level (FTPL) was adopted as a theoretical framework in this research. FTPL is a macroeconomic postulation that highlights the consequences of the dominance of fiscal policy activities over monetary policy and its effect on price stability due to the government's deficit financing. The maximum likelihood estimation (MLE) method has been used to estimate the model for the time series dataset spanning the period from 1980 to 2022. The paper revealed the presence of two fiscal regimes in Ethiopia and the inconsistency in the regimes of fiscal deficit financing over the study period. The findings of this study further indicate that fiscal deficit financing has a stronger impact under the higher regime of deficit financing, whereas, in the lower regime of fiscal deficit financing, the impact of financing government budget deficits on inflation over the study period remains muted in Ethiopia. Keeping other things constant, budget deficit financing increases inflation by 0.9230973 (92%) under a high regime of fiscal deficfinancing, while in a low regime of fiscal deficit financing, deficit financing causes inflation to rise by 0.0867 (8.67%) in Ethiopia. Furthermore, the system stays in State 1 with a transition probability of 36.8% and in State 2 with a transition probability of 55.9%. Therefore, this paper commends that the government of Ethiopia should follow a consolidated fiscal policy that broadens revenue sources for the public sector, tightens the fiscal gap, and ensures fiscal sustainability with low regime deficit financing and a reasonable level of inflation.

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