Macroeconomic effects of budget deficits in Uganda: a VAR-VECM approach

Abstract

This paper investigates the relationship between budget deficits and selected macroeconomic variables for Uganda between 1999 and 2011 using Vector Error Correction Model (VECM), pairwise granger causality test and variance decomposition techniques. Results indicate that the variables under study are cointegrated and thus have a long run relationship. VECM results reveal unidirectional causal relationships running from budget deficits (BD) to current account balance (CAB), inflation to BD, BD to lending interest rates, and no causal relationship between gross domestic product (GDP) and BD. The Pairwise Granger Causality test results reveal unidirectional causal relationships running from BD to CAB, BD to GDP, inflation to BD, and a bi-directional causal relationship between the CAB and GDP. Variance decomposition results show that, variances in CAB and GDP are mostly explained by BD followed by lending interests while variance in lending interest rates is mostly explained by inflation followed by GDP. Variances in the Inflation are mostly explained by variance in lending interest rates followed by CAB. The results from the study clearly show that budget deficits in Uganda are responsible for widening current account deficit and raising interest rates. Fiscal and monetary policy actions are therefore needed to contain and reduce the deficit in order to minimize its effect on the current account and lending interest rates.