Regime Effects of Fiscal Deficit Financing and Inflation Dynamics in Ghana

Abstract

Fiscal deficit financing is confirmed in both theoretical and empirical literature to often lead to higher-than-expected inflation. The unsustainable regime of fiscal deficit financing in Ghana over the years had contributed to price instability in Ghana. Previous studies on deficit financing-inflation nexus in Ghana concentrated completely on linear and symmetric relation while ignoring the effect of regime of fiscal deficit financing on inflation. This study investigated the regime of fiscal deficit financing and its effects on inflation dynamics in Ghana over the 1980-2018 period. The Theory of Fiscal Price Level (TFPL) was adopted as the theoretical framework for the study. The TFPL highlighted the macroeconomic consequences of fiscal dominance over monetary policy actions and how it impacts on price stability due to the financing of government fiscal deficit in a country. The study employed Markov-Switching Regime Dynamic Model (MSRDM) to investigate the regime effects of fiscal deficit financing on inflation. The study revealed the presence of two fiscal regimes in Ghana and that the regime of fiscal deficit financing remained persistent over the study period. The paper further found that fiscal deficit financing had a stronger effect on inflation dynamics in Ghana in the higher regime of fiscal deficit financing while its impact on inflation in the lower regime of fiscal deficit financing remained relatively subdued. The paper recommends that the government of Ghana should adopt fiscal policy actions that could lead to the achievement and maintenance of fiscal sustainability and consolidation consistent with a low inflation regime going forward.