Fiscal Deficit Expansion and External Sector Imbalance in Nigeria: Implications for Monetary Policy

Abstract

The recent phenomenon of increasing deficit financing as a preferred fiscal instrument by resource-rich emerging economies calls for an understanding of an optimal level of deficit financing and the fleeting effects on aspects of international accounts, to allay external sector imbalances. This paper fills the void by using the Structural Vector Autoregressive (SVAR) framework to examine the interrelationship between fiscal deficit and external sector and the implications for monetary policy in Nigeria. In furtherance of the above, the study incorporates three key monetary policy transmission channels – money supply, interest rates and exchange rates – to the SVAR model, due to the vital role they play in the macroeconomy thus, establishing the effects of shocks from fiscal and current account deficits. Using data for the period 2000-2021, we found that a shock to fiscal deficit as a share of GDP causes a decline in current account deficit in the fourth period and vice-versa for a shock to the current account balance. However, there are no significant impacts in the first three periods. This implies a bi-directional causal relationship between fiscal deficit expansion and external sector imbalances. We further observe a detrimental effect of increase in fiscal deficit on interest and exchange rates. Quite saliently, our forecast analysis shows that Current account deficit is strongly influenced by exchange rate, while other variables are strongly exogenous. The ensuing policy implications and recommendations are noteworthy.