The Impact of Government Expenditure on Inflation: Evidence from Sri Lanka and India

Abstract

This study analyses the impact of government expenditure on inflation in Sri Lanka and India from 1977 to 2019, using ARDL Co-integration, Bounds test, Error Correction version of the ARDL model and the Granger Causality test, while employing inflation, government expenditure and interest rates as study variables. Results for both Sri Lanka and India reveal a statistically significant and a positive relationship between government expenditure and inflation in the long run: A 1% increase in government expenditure tends to increase inflation by 0.0793% and 4.6469% for Sri Lanka and India respectively. The coefficient of the Error Correction Term for both countries carry a negative sign and are statistically significant, indicating an adjustment towards equilibrium at a speed of 63.8% and 93.94% respectively, one period after exogenous shocks. Granger causality test indicates a unidirectional causality stemming from government expenditure towards inflation only in the case of Sri Lanka. This highlights Sri Lanka’s need to manage its public expenditure and its impact on money supply in order to achieve price stability. It is advisable for fiscal as well as monetary policy makers to work closely so as to control inflationary pressure on the economy resulting from rising government expenditure.