Relationship between Macro-Economic Variables and Budget Deficit

Few are the econometric studies which have examined the relationship between budget deficit and microeconomic variables-interest rate, exchange rate, inflation and money supply. This study analyses empirical relationship among interest rate, exchange rate, inflation, money supply and budget deficit in Nigeria over a period of 31 years from 1981 to 2012. The data were sourced from the World Bank Statistics (2013). In order to clarify whether exchange rate, money supply, interest rate and inflation rate cause budget deficit or vice versa, a vector autoregressive model is developed. Moreover, Granger causality technique is used to assess the direction of causation. The results show that bilateral causal relationship in the long run from exchange rate to budget deficit and from budget deficit to exchange rate while there is no causation between interest rate, money supply and inflate rate. The study recommended that the presence of a causal link between exchange rate and budget deficit has implications of great importance on development strategies for developing countries in the world such as Nigeria. The findings provide evidence to support the exchange rate-led budget deficit hypothesis. Thus, exchange rates are important in contributing to economic growth via budget deficit. Inflation and interest policy should be implement as they are capable of reducing budget deficit in Nigeria by more thousands percentage index. Fiscal policy measures can be changed and checked in tax rate, government consumption and public expenditures.