1

CHAPTER 1

1.1 INTRODUCTION

Many economists argue that inflation is strictly a monetary phenomenon and that
inflation occurs when the rate of growth of the money supply is higher than the growth
rate of the economy. This is the conventional monetarist linkage from the creation of base
money to inflation when the central bank issues money at the rate that exceeds the
demand for cash balances at the existing price level. The increased demand in the goods
market pushes up the price level as the public tries to get rid of its excess cash holdings.
It is the contention of these economists that the central bank can eliminate the link
between budget deficits and inflation by refusing to monetize the deficit. Higher deficit
policies may lead to inflation if the deficit is financed through money creation though
they may also increase price level even if the deficit is financed through the sale of
bonds. But the rate might not be as high as it would be the case with money creation. The
government borrowing requirement will increase the net credit in the economy, drive up
the interest rates resulting into crowding out of private investment. The reduction in the
growth rate of the economy will lead to a decrease in the amount of goods available for a
given level of cash balances and hence the increase in the price level.
Since the 1980’s, there has been a growing consensus on the importance of
macroeconomic stability and much emphasis was placed on price stability and exchange
rate stability. Price stability in South Africa remains the overriding long-term objective
for monetary policy. However, budget deficits seem to disturb the economy in that they
lead to inflation if monetized. Budget deficit occurs if the government is forced to spend
beyond its tax revenue. In order to clear the deficit the government needs to either borrow
or create money, but under certain conditions (e.g. in a growing economy) creation of
money leads to seigniorage revenue. Leeper (1991) describes a situation where fiscal
deficits imply that inflation will eventually occur as the one where there is an active fiscal
policy and a passive monetary policy. Such a situation is also described as a fiscal
dominance. With fiscal dominance, an increase in government debt will eventually
require an increase in seigniorage. A contractionary monetary policy aimed at producing
 2

lower inflation will initially lower seigniorage revenue and requires that additional debt
be issued. This ultimately leads to higher inflation. If the fiscal authority does not adjust,
the monetary authority will be forced eventually into producing higher inflation.
The loss of public confidence in monetary or exchange rate targeting regimes has
forced banks to look for a credible nominal anchor. In this context, many countries have
recently adopted explicit inflation targeting as their monetary policy regime. South Africa
is following this example, as the reserve bank puts in place as rapidly as feasible a formal
inflation targeting framework. Price stability in any economy depends solely on the
central bank independence and the financial market development. If the central bank is
not independent enough to block out the external forces that would compel it to create
money so as to finance the deficit, then the country is likely to experience high inflation.
This therefore suggests that inflation management lies in the hands of the reserve bank
(central bank) and the financial market.

1.2 BACKGROUND
Global consumer price inflation accelerated very little in the year 2003 and this
brought some concern regarding the rise in the budget deficit and the international oil
prices. Almost all countries experience the problem of high budget deficit associated with
high inflation. It is in rare cases that a particular country will have a balanced budget. If
government’s spending exceeds its revenue, the resulting deficit has to be financed either
through borrowing or through issuing of money. Borrowing by the government is limited
by the public’s capacity or willingness to hold additional government debt and monetary
expansion leads to inflation.
The South African Reserve Bank (1996) has attributed the slow-down in inflation
during the first half of the 1990s to the consistent application of conservative monetary
policy since the late 1980s and the impact of the drawn out recession of 1989-1993 on
inflation expectations and wage settlements. These factors were supported by the relative
price stability in South Africa’s main trading partner countries and a somewhat more
stable exchange rate of the Rand. During the past four decades inflation in South Africa
seldom entered the moderate range, defined by Dornbusch and Fischer (1993) as
persistent annual rates of price increases ranging between 15 and 30%. Table 1.2
 3

provides a comparison of inflation rates in South Africa and its main trading partners.
The table shows that the inflation rate in South Africa remains considerably higher than
the inflation rates of the country’s main trading partners.

TABLE 1.2: INFLATION IN SOUTH AFRICA AND ITS MAJOR TRADING

PARTNERS

Country Average annual rate(%)

1980-1990 1990-1998
South Africa 14.8 9.1
Trading partners
Germany 2.5 2.4
United Kingdom (UK) 5.8 2.9
United States of America (USA) 4.2 2.7

Source: World Bank (2001a, 2001b)

Inflation is expressed as the annual percentage change in the consumer price index
(CPI). Inflation was relatively low until the early 1970s, averaging 2.5% during the
1960s. It subsequently accelerated and entered the double-digit range in 1973. During the
1970s, the average inflation rate was 10.3%. After a period of relative stability around a
level of 11% in the late 1970s, inflation rose again in the early 1980s. The 1980s were
characterised by high, but relatively stable rates of inflation ranging from 11.5 to 18.6%.
The average inflation rate for the decade was 14.7%. Inflation subsided significantly in
the early part of the 1990s. After peaking in 1986, the rate of inflation began decreasing
and in 1993 it dropped to beneath 10%. It subsequently decreased further to 5.2% in
1999. On average, consumer prices rose by 9.3% during the 1990s. Money supply and
budget deficit were seen to be increasing in those years. As budget deficit increased
money supply also increased, which might provide an indication that the deficit was
monetized and that resulted into inflation.
 4

1.3 STATEMENT OF THE PROBLEM

South Africa’s huge budget deficits to finance its numerous public sector
undertakings and persistent high inflation rates in the last two decades have only created
massive poverty and a potentially explosive socioeconomic environment. The country’s
dismal economic performance raises in the minds of domestic policy makers as well as
foreign advisors the basic question of how to control inflation and thereby bring back the
economy into track. The relationship between the two variables (budget deficits and
inflation) now brings us back to the classic policy debate between the Keynesians and the
monetarists. The former would argue for drastic reduction in South Africa’s budget,
whereas the monetarist would emphasize on stringent control over the country’s money
supply.
South Africa experienced a massive budget deficit, high growth rates of money
accompanied by high rate of inflation. It is believed that the high rate of inflation that was
experienced in 1967 was due to the increased level of budget deficit. GDP also fell by 2
units from 4 percent (IFS, 2004). Each economy tries to establish a balanced fiscal policy
as one of its macroeconomic policy conducts. If South Africa continues to register some
increments in the budget deficit it will continue to have a high rate of inflation and a
target range will not be reached. An inflation rate of 5.2 percent was registered in 1999
with the deficit standing at 2.8 percent, but in the following year inflation was 5.3 while
budget deficit was at 5.4 percent (IFS 2004). Policy makers view deficit and inflation as
hazardous to the economy if the latter happens to be persistent. But if the deficit remains
unchecked it impedes on the flexibility of policy making and consequently hampers
economic growth. Thus eliminating large budget deficit is a necessary condition for
achieving price stability. What then should the fiscal and monetary authorities do to
maintain price stability while trying to get rid of the budget deficit? High inflation is not
desirable because it reduces the purchasing power of money. It is therefore the aim of this
study to find the impact of monetizing of the budget deficit on inflation.
 5

1.4 OBJECTIVES OF THE STUDY

This study broadly aims at investigating the relationship between budget deficit,
money growth and inflation in South Africa over the period 1975-2003. Specific
objectives are:To investigate the causal direction between inflation, money growth and
budget deficit and to evaluate the relationship between inflation and budget deficit
inflation and money growth.

1.5 HYPOTHESES TO BE TESTED

The hypotheses to be tested are stated as follows

There is a positive relationship between inflation and budget deficits as small
deficits can help to control inflation and avoid balance of payment problems.
There is also a positive relationship between inflation and money growth as for the
classicalist point of view and the moneratist’s formulation.

1.6 JUSTIFICATION OF THE STUDY

Maintaining budget discipline sends signal that the central government is the one
on control. The pattern or trend in government spending as a percentage of GDP and the
level of spending are critical factors in creating a stable environment for development.
The South African monetary authority, the Reserve Bank in its actions on the monetary
policy to maintain economic stability in the economy.
Several factors have influenced the choice of South Africa. First, very little
empirical investigations have been done with respect to the link between these three
variables and because of the developed nature of the financial market as compared to
other African countries. Moreover, existence of developed financial markets in South
Africa makes it relatively easier to carry out a study of this nature. The study will provide
knowledge towards understanding the relationship between budget deficit, money growth
and inflation in South Africa.
 6

1.7 OUTLINE OF THE STUDY

Chapter 2 provides discussions on the theoretical framework. It outlines different

theories of inflation. The chapter also provides empirical review. The regression model is
presented in chapter 3. Chapter 4 presents the empirical results from the regressions and
gives an interpretation of regression results. Chapter 5 summarizes, concludes and
highlights policy implications emanating from the findings of the study.
 7

CHAPTER 2

2.0 LITERATURE REVIEW

This section discusses the related literature on the subject. We explore both the
theoretical and empirical literature. Under the theoretical literature we explore how the
respective variables enter the model, thus helps to determine the main determinants of
inflation. The empirical literature provides a summary of existing studies on the subject.
The theoretical literature section demonstrates how money growth and budget deficits
affect inflation.

2.1. THEORETICAL LITERATURE

The tax cut and the attendant increase in the deficit have two major stimulative
effects. First, the tax cut increases disposable income. Second, if the deficit is increased,
there is an increase in net private sector financial assets. This follows from the
equilibrium condition

I +G = S +T (2.1.1)
which can be written as
G −T = S − I (2.1.2)
where I is investment, G is government spending, S is national saving and T is the
tax revenue.
G − T is the government deficit. The stimulative effect of the tax cut and deficit
increase is represented by an upward shift of the IS curve. The expansionary effect of the
shift in IS curve will depend on whether the LM curve shifts or not. The movement of the
LM curve will depend on how the deficit is financed. If additional reserves provided to
the commercial banks are created, the money supply increases and the LM shifts to right,
adding to the expansionary effect of the deficit. This ultimately leads to a rise in the
general price level (Branson, 1989)
 8

Each government has its budget constraint; it has to pay its bills just like
individuals households do. It enjoys the two options of paying its bills. It raises revenue
by levying taxes or going into debt by issuing government bonds. Ways of financing
government spending are well defined by an expression known as the government budget
constraint: which states that government budget deficit (BD) which is equal to the excess
of government spending (G) over tax revenue (T) must equal the sum of changes in the
monetary base ( ∆MB ) and the change in government bonds held by the public ( ∆B ) .
Algebraically, we can write:
BD = G − T = ∆MB + ∆B (2.1.3)
The government’s constraint reveals two facts. If the government deficit is
financed by an increase in bond holding by the public, there is no effect on the monetary
base and hence on the money supply. But if the deficit is not financed by increased bond
holdings by the public, the monetary base and the money supply increase. This boils
down to inflation if the quantity theory holds. Financing a persistent deficit by money
creation will lead to a sustained inflation (Mishkin 1997). If it is temporary, it would not
produce inflation. In the period when the deficit occurs, there will be an increase in
money to finance it, and the resulting rightward shift of the aggregate demand curve will
raise the price level. This tells us that a deficit can be a source of a sustained inflation
only if it is persistent rather than temporary and if the government finances it by creating
money rather than by issuing bonds to the public.
Unlike Mishkin’s presentation, Metin (1999) assumes that all public debt takes
the form of non-interest bearing money. The public sector budget identity is then
G − T = ∆H (2.1.4)
or
G −T ∆H
=
PY PY
(2.1.5)
where G is the public sector expenditure, T is the public sector revenues, Y is the real
income, P is the price level and H is the base money. In a steady state growing economy,
it follows that
 ∆H ∆P ∆Y 
∆( H * ) = ( H * ) − − 
 H P Y 
 9

∆H
= − H * (∆P + ∆Y )
PY
(2.1.6)

Where ∆ is the difference operator; H*, ∆P and ∆Y are scaled base money ( H PY ) ,
inflation and the growth rate of real income respectively. It is assumed that the long run
income elasticity of money is unity. Then the simplified constraint is
G −T
∆( H *) = − H * ( ∆P + ∆Y )
PY
(2.1.7)
When solved for ∆P we have
∆P = c + α1 B − α2 ∆Y

(2.1.8)
 G −T 
Where B is the scaled budget deficit   , c is the constant term interpretable as the
 H 

inertial inflation rate and α1 and α2 are slope coefficients associated with the scaled
budget deficit and the income growth. This now states that inflation is explained by base
money, budget deficit and real income growth.
Sargent and Wallace (1981) proposed an analytical framework, where seigniorage
assumes the central role for deficit finance. This proposition views the relation basically
as a game between the fiscal and the monetary authorities. Under the assumption that the
fiscal authority is the first to make a move, the monetary authority is left with a difficult
choice in order to balance the intertemporal budget. It either loses its policy in the short-
run to avoid high inflation in the long-run, or tightens its policy today at the expense of
an inevitable future increase in inflation. The budget deficit increases and eventually may
become unsustainable. In sum, a fiscal dominant regime implies unavoidably a positive
intertemporal correlation between deficits and inflation, with causation running primarily
from deficits to inflation (Sargent and Wallace 1981)
Another approach argues that the main channel is the effect of inflation on the real
value of the stock of debt and on the real interest rate. While Sargent and Wallace (1981)
saw their approach as an economic policy game between fiscal and monetary authorities,
Keynes (1971) regarded this approach as a social game between rentiers and workers.
 10

Society does not tolerate ever-increasing taxes, and therefore, other ways such as
inflation must be considered to reduce the accumulated stock of debt. According to this
analysis, causation runs from budget deficits to inflation.
Other less referred channels can be identified and one of them is the wealth effect,
a demand side effect which was introduced by Patinkin (1965). This postulates that the
rise in the real value of the stock of bonds increases perceived private wealth and
therefore spending, leading to inflation. There may also be a supply-side effect through
the cost of factors; a deficit caused by an increase in certain public expenditures may
augment the demand for scarce resources, increasing their cost. These two effects may be
regarded as non-monetization effects of the deficit. The wealth effect was denied by
Barro’s Ricardian Equivalence proposition. Barro (1979) focused on the positive
relationship between expected inflation and budget deficits. The moneratist hypothesis is
well supported by the Ricardian equivalence hypothesis. With fixed time paths of
government spending and money creation, any bond-financed change in current taxes
implies changes in future interest payments to be made by the government. If these are to
be financed by lump-sum taxes, and if the government and private agents face the same
market interest rates, then the change will have no effect on a representative private
agent’s intertemporal budget constraint. Under such conditions, then a bond-financed
change in taxes will have no effect on the agent’s supplies and demands and consequently
no effect on the price level. Ricardian equivalence states that bond-financed deficits are
noninflationary. According to this hypothesis higher inflation expectations imply higher
real interest rates and therefore higher debt service cost.
Theories of money do state the relationship between money and the price level.
We will therefore turn to some different theories of money. First we start with the
classical theory of money, which dates back in the eighteenth century or even earlier. The
main tenet of this school is Irvin Fisher. In this school a simple equation or identity is
used to show the relationship between money supply and the price level. Such theory is
referred to as the quantity theory of money. It implies that the general price level (P) in
the economy depends on the supply of money (M). The more the quantity of money we
have, the higher will be the price level. What is advocated in this theory is that inflation is
caused by a rise in money supply. It was from the analysis of historical experience that
 11

the influence of money on prices was deduced. Among those who concentrated on the
link between money and the price level was Jean Bodin. He attempted to explain the
revolution which swept through Europe after the Spanish introduced greater quantities of
gold and silver into that continent from the American colonies in the sixteenth century.
Fisher as in Laidler (1993) used a simple analysis with a simple identity. His
remark regarding the effect of money on commodity prices was deduced from that
identity, which arises from the act of exchange. An act of sale or exchange must
encompass both the purchases and sale with two parties in a transaction. The total value
of all purchases are equal to the average stock of money (M) multiplied by the average
number of times that money stock was turned over (V) or spent for goods and services. In
this way, MV represents the total purchases made during a certain period of time
(Makinen, 1977). This must be equal to the volume of transactions (T) multiplied by the
price level (P). Thus the identity can be written as:
M sVT ≡ PT

(2.1.9)
As for Fisher the value of transactions (T) was difficult to measure, and the
quantity theory was formulated in terms of aggregate output. T is assumed to be
proportional to Y such that T = αY . If α = 1 , then T = Y ,thus the equation of exchange
now becomes
M sVT = PY

(2.1.10)
Fisher’s view that velocity is fairly constant in the short-run transforms the
equation of exchange into the quantity theory of money. Because the classical economists
thought that wages and prices were completely flexible, they believed that the level of
aggregate output (Y) produced in the economy during normal times would remain at the
full employment level, so Y in the equation of exchange could be treated as constant in
the short-run (Mishkin,1997). This therefore implies that if M doubles, P must also
double in the short-run because V and Y are constant. For the tenents of this theory, this
theory provides explanation of movements in the price level, movements in the price
level result solely from changes in the quantity of money.
 12

The long-run effect of an increase in money supply helps in defining the

inflationary process under the classical school. The increase in money supply is assumed
to come about via the commercial banking sector. Given that the excess reserves of these
banks increase, the bank keeps on lending out the reserves by buying bonds and
supplying new money to the market for loanable funds. This process of buying bonds by
commercial banks helps us remember how such banks create money. The increase in the
supply of loanable funds will then drive down nominal interest rate. The lower rate will
make it profitable to undertake additional investment previously perceived as
unprofitable. It will also force individuals to save less and consume more of their income,
thus leading to an excess of intended investment over intended saving.
The increase in consumption (C) and investment (I) therefore have to force up the
commodity prices in relation to the rise in money supply (M) as real output (Y) is fixed
according to the classical theory. Disequilibrium will then be observed in the system, and
to maintain equilibrium nominal wages have to increase as rapidly as possible in order to
keep the real wage unchanged. As long as banks continue to make money, inflation will
persist and aggregate demand will rise. However, once money creation halts, the nominal
rate of interest will again be equal to the natural rate and the system will be back to
equilibrium. In this way with V and Y as constant with respect to M, then the quantity
theory must hold:

P = f (M )

An increase in money supply simply leads to inflation as pointed out by Sloman

(1997). This is the classical’s view of inflation formulation using the quantity theory of
money. The final conclusion of the classicals is that the end result of monetary expansion
is the increase in the price level and interest rates. But other variables in the system will
be unaffected. Thus, money is seen to be neutral (Snowdon 1994). In this whole analysis,
we see money as one of the variables influencing inflation.

The classical theory, with its model was later rejected by one of the great
economists, John Maynard Keynes. This rejection was known to be the Keynesian
revolution. In his book titled “The General theory of Employment, interest and money”
 13

(1936), Keynes rejected the classical assumption that markets do clear. Disequilibrium
could persist and unemployment would continue. Such disequilibrium could be seen both
in the labour market and in the financial markets. In the labour market, because of the
rigidity in wages, wage cuts would not solve the problem of deficient demand. But rather,
the problem would persist because individuals would reduce their consumption
expenditure, while firms would reduce their demand for labour as inventories would be
accumulating. In the financial market, on the other hand, neither savings nor investment
would be responsible to changes in interest rates. It is in fact, believed that the expected
business cycle determines investment in the future while the level of disposable income
determines savings. This according to Sloman (1997) suggests that in both the labour
market and the financial market, disequilibrium would persist.

Keynes also rejected the quantity theory on two grounds. He denied the idea that
money supply increases would lead to increases in prices. He said, extra income (M) will
not all go into expenditure, but some might be held by the individuals. In that way, the
average speed at which money circulates (V) may be slowed down, which means that the
V in the equation of exchange MV = PY may vary and not necessarily remain fixed.
Again, it was argued that increases in money supply might lead to increases in real output
and leave prices (P) unchanged. These arguments were raised to refute Say’s Law, which
stated that supply would create its own demand. Keynes also pointed out that unregulated
markets could not ensure sufficient demand. The use of demand management policies to
smooth out the fluctuations in the trade cycle was to be from the government. We now
turn and examine the difference between cost and demand driven inflations.

Keynes emphasized inflation as a situation of excess demand and as a result of an

autonomous increase in costs (Ball 1973). We therefore have what is termed demand and
cost push inflation. The former is associated with the rightward shift of the aggregate
demand (AD) curve in the AD-AS model. Exogenous increases in the nominal money
stock, consumer spending, investment spending, government spending and export
demand are demand factors. Among these factors, we will discuss only those that are of
interest to this study. A deficit is experienced in an internal economic situation where
government purchases exceed net taxes. In this case, government may create spending
 14

power or put some previously idle funds to use. The additional demand caused by
government spending means that an already over heated economy experiences a fresh
value of price increases (Fourie 1982).

Cost push factors are those which cause an upward shift of the AS curve. These
include increases in nominal wages or wage rates, profit margins, import prices and
reduced productivity. With this particular case also, we will consider only those variables
which are part of our analysis. The increased desire for leisure versus real income or
pressure for higher wages in a highly unionized economy are causes of cost push
inflation. This has the effect of raising output price, which is made up of input cost and
profit margins. There is also cost push inflation that can come from outside the domestic
economy. In the early 1970’s, one such particular shock came out of the creation of the
OPEC (Oil and Petroleum Exporting Countries) cartel and enormous increase in oil
prices it managed to achieve (Fourie, 1982). Imported inflation may also bring
inflationary effects if foreign trade plays a greater part in a particular country. That is,
channels in the price levels abroad must necessarily affect the domestic price level. As
such, exchange rate depreciations imply higher import prices. Both the supply shock and
the imported inflation have the effect of increasing the input costs for the firm, which are
passed on to consumers as increased prices for the finished products. Thus, increases in
prices of imported inputs have a positive effect on domestic prices. This therefore
justifies the inclusion of import prices into our analysis. The Keynesian ideology on the
other hand would argue for the inclusion of the government fiscal deficit, oil prices (a
proxy for imported prices) as variables causing inflation in South Africa.

The orthodox monetarist school, whose chief advocate was Friedman came to
develop the monetarist theory which started with extension of the quantity theory of
money (Friedman, 1959, Friedman and Schwartz, 1963). This theory maintains that
inflation is “always and everywhere a monetary phenomenon”. This means that whenever
money supply increases, the end result of that is the rise in the general prices.
 15

2.2. EMPIRICAL LITERATURE

The study tries to investigate the role budget deficit and money growth play in the
inflationary process in South Africa. The interrelationships between these variables have
been at the heart of the monetary economics literature (Ozman, 2003). Budget deficits are
inflationary in the monetarist framework only to the extent that they are monetized. This
section reviews the existing studies which tried to explore the link between budget
deficits, money growth and inflation.

In South Africa studies in inflation were carried out but none of them seemed to
mention any contribution of the budget deficits on the inflationary process. One of those
studies is by Strydom (1976) which was concerned with aggregate demand pressure or
monetary expansionary effects on prices. He views inflation as the by-product of a
struggle over income distribution in which entrepreneurs and wage earners fight to
pressure or increase their share of the national income. He notes that inflation is
generated via the institutional aspects of the economy. The estimation results of that
study revealed that the variables that were included in the model were statistically
significant, that is, they bore expected signs. The import prices parameter indicated the
total effects of the foreign sector on the domestic price level. Its effect was more direct
than other magnitudes. The manipulation of that magnitude via the exchange rate policy
had severe effects on the domestic price level.

Apart from Strydom (1976) study, other studies were undertaken in other
countries to test the macroeconomic effects of money growth and fiscal budget deficit on
inflation. These studies are mainly for the United States and the European countries.
They appeared to have inconclusive results because some supported the hypothesis while
others did not and leaves the question as to what factors economies can target to reduce
inflation. One empirical study is by Dweyer (1982). He tested the leading explanations
for the positive link between the level of prices and the government deficits. He found no
 16

significant evidence to support the idea that inflation is caused by the deficits. Darrat
(1985) focused on the link between federal deficits and inflation by relating the rate of
change of prices to money supply, deficits and lagged inflation rate. His conclusion was
that both the monetary growth and the federal deficits significantly influenced inflation.
Federal deficits bore a stronger and more reliable relationship to inflation than monetary
growth.

Akcay, Ozmucur and Alper (1996)’s study whose main aim was to gain an insight
into which the channels through which the deficit has been operating in Turkey both in
the post world war II era and in the post-liberalization era where bond-financing has been
an addition source of deficit financing was done to establish the existence of a stable long
run relationship between deficits, money growth and inflation. The short-run dynamics of
inflationary process were also analyzed. Their study employed the vector autoregressive
and vector error correction specifications. The cointegration analysis revealed that there
were two cointegrating vectors, though the coefficients of deficits and money growth had
negative signs. The negativity of the coefficient of GNP implied that an increase in the
GNP ratio seemed to imply a lower inflation rate at steady state and an increase in growth
of money was associated with lower long-run inflation rate. Akcay, Ozmucur and Alper
(1996), however, stated that any linear combination of those two cointegrating vectors
was also a legitimate candidate for characterizing the long-run relationship among the
three variables and one such combination gave the cointegration relation as money
growth and deficits being exogenous variables. The coefficient of deficit was stated as
1.59. under such cointegration relation, money neutrality was assumed. This therefore,
revealed that a one unit increase in the deficit GNP ratio under money neutrality would
increase the long-run inflation by 1.59 units. The negative coefficients indicated that
excess inflation entered the error correction mechanism for inflation with a negative
coefficient. If there was excess inflation, that excess was corrected towards the long-run
equilibrium next period by an amount that is given by the weighting coefficient.

The monetarist explanations of inflation have followed the classic study of

hyperinflation by Cagan (1956) in stressing that changes in money that in some sense
cause changes in prices. In that Cagan (1956) model, there came a question of
 17

unidirectional nature of that model. Sargent and Wallace (1973) suggested that it was
more appropriate to look at causation between money and prices as running from both
sides. Frenkel (1977) and Jacobs (1977) also came with the same suggestion. But in their
studies, they emphasized that a common explanation for increases in the money supply
that led to inflation was due to government’s fiscal operations. Apart from these studies,
other studies like that conducted by Aghevhi and Khan (1978) have recognized that the
increase in the money supply might not be independent of inflation. They introduced the
idea that inflation occurs in a widening of fiscal deficits financed through the banking
system, more especially by the central bank. If budget deficits were experienced,
financing them through money creation would result in the increase in inflation. The
purpose of Aghevli and Khan’s (1978) study was to examine the link between increases
in money supply and inflation in four developing countries, Brazil, Colombia, Dominican
Republic and Thailand. Their study first showed that the variables in question were
linked in a two-way relation and found a link in the form of reactions of the government
fiscal deficits to inflation. The conclusion drawn from that study was that the financing of
the deficit through money creation increased money supply and hence inflation. The
control of inflation required deliberate action by budgetary authorities if the monetary
policy was not to be excessive.

Darrat (2000) reconsidered the inflationary effects of budget deficits after

Hondroyiannis and Papapetrou (1997) had denied any direct impact of the deficit on
inflation. He pointed out some problems associated with the Hondroyiannis and
Papapetrou (1997) results that prices were second-difference stationary but when
undertaking the cointegration test dealt with first difference. The second problem of the
Hondroyiannis and Papapetrou (1997) results was that they performed the cointegration
test in a bivariate setting that included only money and prices, whereas their primary
focus was presumably on the role of deficits in the inflationary process. Darrat (2000) re-
examined the cointegration relationship among money, prices and deficits using the
Johansen-Juselius cointegration approach and found that the cointegrating vector by HP
was misspecified. His empirical results reported that, besides money growth, higher
budget deficits had also played a significant and direct role in Greek inflationary process.
 18

Ozman and Koru (2003) investigated the interrelationships between budget

deficits, money growth and inflation in Turkey. they use a trivariate system containing
money growth, budget deficits and inflation. The first equation was where inflation was
regressed on money and deficits as being weakly exogenous and the other remaining
equations, money growth and deficits were the dependent variables. Their test results
strongly supported the quantity theory of money, that any change in the quantity of
money will change prices as well and causation was running from both sides. Choudhay
and Parai (1991) also investigated the role of huge budget deficits in Peru’s near
hyperinflation. That study used the rational expectations macro model of inflation to find
out the effect of the anticipated budget deficits on inflation rates by using quarterly data
of Peru for the period 1973:1 to 1988:1. The study found a positive relationship between
budget deficits and inflation with money growth acting as an intermediate. Their
concluding remarks were that Peru’s huge budget deficits as well as high rates of money
growth did have significant impact on the high inflation rates during 1973 to 1988.

Neyapti (2003) in his simple model investigated the relationship between budget
deficits and inflation with the view that the nature of this relationship depends on the
characteristics of the monetary and financial institutions. The main hypothesis of that
study was that budget deficits were inflationary when both the central bank was not
independent enough and the financial market not developed enough to contain
inflationary expectations. His empirical results supported the stated hypothesis and
suggested that budget deficits had a significant positive effect on inflation. The results
also suggested that the effect was largely attributed to low degrees of central bank
independence and financial market development. Money growth was also seen to be
positively related to inflation and this therefore supported Friedman’s view that money
was always and everywhere a monetary phenomenon.

The literature review shows that different studies conducted earlier for different
countries have produced different results, in which case some studies suggest that there is
positive relation between budget deficit, money growth and inflation. While some do not
support that positive relationship. The critiques were revealed in relation to those mixed
results and more appropriate techniques were suggested by other researchers.
 19

CHAPTER 3

3.0. METHODOLOGY

In order to analyze short-run dynamics and long-run relationships among budget

deficits, money growth and inflation, we make use of the Autoregressive Distributed Lag
(ARDL) model and the Error Correction Mechanism specifications in this study. The
application of the ARDL is adopted from Henry and Richard (1983) because this method
helps us to consider the behavior of the variable over time and that the effect of the
exogenous variables on inflation is spread over a period of time. The causality test is also
conducted to find the direction of causation between the variables. This involves the
bivariate causal test.

3.1. DATA DESCRIPTION

The study uses time series quarterly data for the period 1975 to 2003. Most of the
data variables were on quarterly basis, while the data on wage rates is on annual form
and was interpolated using the Spline Line interpolation method because it does not have
overshooting behaviour of linear interpolation. The variables are consolidated budget
deficits, which is expressed as ratio of Gross Domestic Product (GDP), percentage
change in the Reserve Bank money (M2)1, inflation rate which refers to the growth rate of
the consumer price index. The other variables are wage rate, foreign rate of interest which
is an average of interest rates of South Africa’s major trading partners (United States of
America, United Kingdom and Germany) and the import prices, which captures the
imported inflation. The data for the analysis was sourced from the International Financial
Statistics (IFS) various issues and data on wage rates was sourced from Statistics South
Africa.

1
M2 which is currency in circulation plus demand deposits plus savings, and time deposits
 20

3.2. MODEL SPECIFICATION

The connection from deficits to inflation is somehow a difficult one to establish

for certain reasons. First, empirical studies trying to capture the link between budget
deficits and inflation are bound to produce results that are quite sensitive to the choice of
the model being used when one considers the number of possible versions that can be
constructed. Most of those studies used the inflation model, while a few used a trivariate
system. In view of the discussions above and the adaptation to be followed, the linear
regression equation to be estimated takes the following general:

In f = f ( B D, M S, IM P, G D P,W A G, r * In fla ,gM S la,gD u m m ie

)s
+ + + − + + + +

(3.2.1)

Where Inf is the inflation rate proxied by Consumer Price Index (CPI), MS the
money growth, BD fiscal deficit as a percentage of GDP, WAG changes in unit labour
costs, IMP the import prices, GDP growth of real GDP, Inflag lagged value of the
dependent variable and MSlag is the lagged value of the money growth.

3.3. ANALYTICAL TECHNIQUES

3.3.1. Causality test

Since one of our objectives is to test the causal link between budget deficits and
inflation, we will have to do such test using a special test called Granger causality test. In
the bivariate case, the standard Granger causality test amounts to testing whether past
values of a variable Yt , together with past values of another variable X t , explain the
current change in X t better than the past values of X t alone do. A failure to reject this
 21

null hypothesis leads to the researcher to conclude that Yt Granger causes X t . This
process is repeated interchanging the two variables. The Vector Autoregressive bivariate
regressions of the form below will be estimated:

n n
BD t = ∑α1i BD t −i + ∑α 2i Inf t − j + µt
i =1 j =1

(3.3.1.1)

k k
Inf t = ∑λ1i Inf t −i + ∑λ2 j BD t − j + δ t
i =1 j =1

(3.3.1.2)

Where BDt represents the budget deficit and Inft, the inflation rate. µt and δt
are the white noise terms. Using general-to-specific approach, the lag length is chosen
such that serial correlation is eliminated between the error terms. The following presents
all possible causal relationships:

k k

a) Unidirectional causality from Inft to BDt exists if ∑α j =1

2j ≠ 0 and ∑λ
j =1
2j =0

k k

b) Unidirectional causality exists from BDt to Inft if ∑ λ2i ≠ 0 and ∑αj =1

2j =0
i =1

k k

c) Bidirectional causality between BDt and Inft if ∑ λ2 j ≠ 0 and

j =1
∑α
j =1
2j ≠0

k k

d) No causality is established between BDt and Inft if ∑α 2 j = 0 and ∑λ 2j =0

j =1 j =1

The results of the Granger causality test are sensitive to the lag lengths.
Employing arbitrarily chosen lag lengths, although a common practice, gives rise to
economic problems in that choosing a less than optimal lag order may lead to a bias,
whereas, applying a more than optimal lag order may lead to a loss of efficiency (Ansari
1994). To avoid these problems we use the Akaike Information Criterion (AIC) and the
 22

Schwatz Information Criterion (SIC) to determine the optimal lag length for each series
by estimating an equation of an autoregressive form choosing a lag order as the optimal
lag which minimizes the AIC and SIC. The optimal lag is the lag that minimizes the AIC.
Knowing the direction of causation will help the policy makers as to which variable to
target first.

3.3.2. STATIONARITY

For establishing a meaningful (as opposed to spurious) relationship between

budget deficit, money growth and inflation, the variables must satisfy stationarity
condition. A series is said to be stationary if its mean and variance are constant over time
and the value of covariance between two time periods depends only on the distance or lag
between the two time periods and not on the actual time at which the covariance is
computed (Gujarati 1995). Differencing variables when they are stationary is likely to
cause a loss of valuable information about the long-run relationship between the
variables. The most commonly used methods are those adopted from Dickey and Fuller
(1979) and the Augmented Dickey-Fuller (ADF). The Dickey-Fuller (DF) test involves
running three regressions, one without drift, the second one with drift and the third with
drift and trend. The equations are:

Without drift

X t = ρX t −1 + ε t

(3.3.2.1)

The null hypothesis is that H 0 : ρ = 1 as opposed to H 1 : ρ < 1 . An alternative way of

writing the above equation is

∆X t = ( ρ −1) X t −1 + ε t
 23

= δX t −1 + εt
(3.3.2.2)

In this particular case the null hypothesis is that δ = 0 , suggesting that there is unit root
or the process is non-stationary.

The equation with drift is

∆X t = α + δX t −1 + ε t (3.3.2.3)

With drift and trend

∆X t = α + βt + δX t −1 + ε t (3.3.2.4)

An improvement to the above method is the Augmented Dickey-Fuller test. Such test is
presented below.

n
∆X t = α + βt + δX t −1 + ∑ λi ∆X t −1 + ε t
i =1

(3.3.2.5)

Its advantage over the DF test is that it allows for the presence of the deterministic
trend and drifts to be tested. This means that with the addition of the lagged difference
terms, serial correlation is corrected in the residuals. Just like in the case of the DF test,
the ADF test also involves three test specifications, one without drift, second with drift
and the last with both the drift and the trend. One experiments with different
specifications because the correct one may not be known. Specifications are as follows:

n
∆X t = α + βt + δX t −1 + ∑ λi ∆X t −i + ε t
i =1
n
∆X t = α + δX t −1 + ∑ λi ∆X t −i + ε t
i =1
n
∆X t = δX t −1 + ∑ λi ∆X t −i + ε t
i =1

(3.3.2.6)
 24

Where X is the variable under consideration, ∆ is the first difference operator, t

is a time trend, n is the number of lags and εt is a white noise random error term. The
number of difference terms to include is determined through the use of the Akaike (1974)
and Schwatz (1978) information criteria. An appropriate lag length would the one that
minimizes either AIC or SIC. These are not the only procedures recommended. Several
authors have presented sequential procedures with the “general to specific” framework
for testing unit root if the data generating process is not known.

If the null hypothesis, that δ = 0 , is not rejected the variable series contains a unit
root and is non-stationary. An appropriate lag length is the one that reduces or eliminates
autocorrelation, that is, we choose k such that serial correlation is eliminated. Few series
are likely to be stationary at level form, and if not stationary, we proceed to the first and
second differences to ensure that a series is stationary. This process of differencing a
series X t a certain number of times before it becomes stationary is referred to as the
order of integration. If found to be stationary at level form, then it is said to be integrated
of order zero denoted as X t ~I(0) and if differenced d times before becoming stationary,
then it is integrated of order d denoted X t ~I(d). Thus any time we have an integrated
time series of order one or greater, we have a non-stationary series. Though DF/ADF
tests are very common, they are found to have a drawback in that their power is likely to
be low for series where moving average terms are present or where the disturbances are
heterogeneously distributed. An alternative unit root test, Phillips-Perron (PP) test
(Phillips 1987, Phillips and Perron 1988) will also be conducted to ensure the stationarity
of the data series as this test uses non-parametric correction to deal with any correlation
in the error terms.

3.3.3. COINTEGRATION AND ERROR CORRECTION MODEL

After establishing the stationarity condition of the series, we then make use of the
Johansen (1988) and Johansen and Juselius (1990) approaches to examine the test of a
long-run equilibrium relationship among the variables. This involves testing for
cointegration among the variables. One alternative of testing for cointegration is by use of
the error terms obtained from the regression. The error terms thus obtained can be tested
 25

for stationarity, if stationary then there is long run relation between the variables. In this
study we will employ the Johansen approach because the Engle-Granger method is
somehow criticized on special grounds. Engle-Granger (1987) assumes one cointegrating
vector, but there is a possibility that more than one cointegrating vectors may be obtained

After establishing the long run relationship between inflation and the explanatory
variables, we will then turn to examine the short-run dynamics of the relationship. For
this purpose, following Engle and Granger (1987), an error correction model is
developed. The error correction mechanism allows long term components of variables to
obey equilibrium constraints, while short-run components have a flexible dynamic
specification. The idea is simply that a proportion of the disequilibrium from one period
is corrected in the next period. It involves estimating the model (4.2.1) in the first
difference form and adding an error correction term as an explanatory variable. In our
case the error correction model to be estimated is as follows:

n n n n n
∆Inf t = β 0 + ∑ β1 ∆BD t −i + ∑ β 2 ∆MS t −i + ∑ β3 ∆GDPt −i + ∑ β 4 ∆WAG + ∑ β5 ∆rt*−i +
i =0 i =0 i =0 i =0 i =0
n n

∑β ∆IMP
i =0
6 t −i + ∑ β 7 ∆Inf t −i + β8 EC t −1 +ν
i =1

(3.3.3.1)

Where the respective variables are of the same order of integration but those with
order zero will cointegrate with high power, while those integrated with order one will
low power. The value of n is chosen using the AIC and the SIC. EC is the error correction
component and V is the random error term. The error correction term (EC) is the lagged
values of the error term that has been derived from the regression model. If the
coefficient of EC is negative and statistically significant, it tells us what proportion of the
disequilibrium in inflation is corrected in the next period.

3.3.4 REGRESSION SPECIFICATION ERROR TEST (RESET)

 26

In addition to the above named tests to be undertaken, a Reset test (Ramsey, 1969)
will also be conducted to ensure the absence of specification error. This test involves
some steps, which may be stated as follows:

Λ
From the chosen model, obtain the estimated Inf, that is Inf

Introduce the estimated Inf in some form as additional regressor(s)

The hypothesis under the Ramsey Reset test is that the model is misspecified. If the F
value obtained is statistically insignificant at a particular level of significance, one can
accept the hypothesis that the model is misspecified. But if the test reveals that indeed the
model has been misspecified, it will not tell us the source of the misspecification and for
this reason, we will ignore it and proceed.

3.3.5. BREUSCH-GODFREY LM TEST

ich helps to find if there is serial correlation in residuals. Under this test, the LM is given
as:

LM ( H ) = (TSS − RSS ) (TSS n) = nR 2

Where TSS is the total sum of squares, RSS is the residual sum of squares and n is the
sample size. The null hypothesis is that there is no heteroskedasticity and under this
hypothesis, LM(H) is approximately Chi-Square ( χ2 ). If the null hypothesis is rejected,
there is heteroskedasticity.

3.3.6. NORMALITY TEST

We will also test whether the residuals are normally distributed or not. The most
commonly used method is the Jarque-Bera(1987) test. The Jarque_Bera (J-B) test uses
the fact that the normal distribution has a characteristic set of moments. It works by
comparing the sample versions of the coefficient of excess skewness and the coefficient
of kurtosis. The JB is given as,
 27

[
JB = n S6 +
2 ( K − 3) 2
24
]
Where S represents skewness and K represents kurtosis and n is the sample size.
In large sample, JB follows a chi-square distribution ( χ2 ) . The null hypothesis is that
the residuals are normally distributed and the decision criterion is that if the value of the
JB is significant, then we reject the null hypothesis.

CHAPTER 4

EMPIRICAL ANALYSIS

4.1 INTRODUCTION

This chapter discusses the estimation results of the study. The reliability of the
results is done on both a priori criterion as well as on statistical test criterion. The
reliability of a priori criterion is determined by the principles of economic theory and
refers to the sign of the coefficient of economic theory, that is the marginal values. If the
estimate turn up with the wrong signs or magnitudes, they are rejected, meaning that the
observations are not the true representatives of the data. On statistical criterion, the
statistical theory aims at evaluating statistical reliability of estimates of parameters. The
tests normally used include the t-ratios, coefficient of determination (R2) and many more.
The reliability of data is based on the probability value. If the probability value is above
10 percent, the estimate is question is considered insignificant.
We use the techniques discussed earlier to empirically estimate and analyze the
relationship between inflation and its main determinants. Table 4.1 reports the bi-variate
Granger (1969) causality results. Table 4.2 and Table 4.3 report the unit root test results.
Table 4.4 reports the estimation results. Appendix A reports the cointegration relations
 28

and Appendix B reports the Error Correction test results. We also make some
explanations of the obtained coefficients.

4.2 GRANGER CAUSALITY ANALYSIS

Under this section, we report the test results for the causation. We adopted
Granger’s representation. This follows from the fact that theory suggests that inflation
(CPI) is explained by money growth, budget deficit, wage rate, import prices, foreign rate
of interest as well as the growth rate of GDP. It is therefore necessary to determine
whether money growth and budget deficit play any role if any in the inflationary process
in South Africa.
There seems to be no causality between inflation and the growth of money supply
between 1975 and 2003. This is justified by the F-value that is insignificant as depicted
by its probability value. What this means is that money growth does not cause inflation.
This is in contradiction with what the theory postulates that money growth causes
increases in prices. Inflation also does not cause money growth. There is no causation
between money growth and inflation between 1975 and 2003.
The causality between budget deficit and inflation was tested. The hypothesis that
budget deficit does not granger cause inflation is rejected and thus we accepted an
alternative (budget deficit granger causes inflation). The probability value for the F-
statistic is 0.0825, which implies that the F-value is highly significant, therefore we
conclude that budget deficit causes inflation. The opposite, is the case with the null
hypothesis that inflation does not granger cause budget deficit. We tend to accept and
conclude that there is unidirectional causality with causality running from budget deficit
to inflation. Table 4.1 reports the results of the Granger bi-variate causality.

Table 4.2 Granger causality test results.

 29

SAMPLE- 1975-2003
Null Hypothesis Lags F-Statistic (Probability)
MS does not Granger cause BD 4 2.6569 (0.0371)
BD does not Granger cause MS 4 0.1420 (0.9659)
BD does not Granger cause Inf 7 1.6335 (0.0825)
Inf does not Granger cause BD 7 0.7354 (0.7550)
Inf does not Granger cause MS 3 1.1751 (0.3229)
MS does not Granger Inf 3 0.7999 (0.4966)

From the table above we see that the hypothesis that budget deficit does not
Granger cause money growth is accepted, whereas for the hypothesis that money growth
does not cause budget deficit we reject and conclude that money growth causes budget
deficit in South Africa. . Therefore there is unidirectional causation. In conclusion,
between money growth and budget deficit, only budget deficit causes inflation and that
money growth is not caused by huge budget deficits in South Africa for the period 1975-
2003.

4.3 STATIONARITY TEST RESULTS

This section presents the unit root test results and the results are reported in table
4.3 and Table 4.3.1. We have adopted the methods by Dickey and Fuller (1979) and the
ADF. Our equation used the constant (drift) with no trend as the trend variable is found to
be insignificant. The results are verified by the PP test, which also gives the same output
as the ADF. The McKinnon critical values for the analysis of unit root are -3.4895,
-2.8872 and -2.5803 for 1, 5 and 10 percent respectively. The optimal lag is chosen using
only the AIC because AIC is more preferred over SIC as it gives smaller value than the
SIC. The results are given on Table 4.2 below.
 30

TABLE 4.3 UNIT ROOT RESULTS

ADF PP
Inflation rate t-value (Lag) AIC t-value (Lag) AIC
-4.6660 (4) 1.7257 -6.4273 (4) 1.7412
-5.9458 (3) 1.7052 -6.6143 (3) 1.7413
-4.5415 (2) 1.7963 -6.5378 (2) 1.7413
-5.3662 (1) 1.7674 -6.5472 (1) 1.7412
BD -2.0900 (4) 4.9139 -6.4273 (4) 1.7412
-2.2955 (3) 4.9148 -6.6143 (3) 1.7412
-5.5423 (2) 5.4786 -6.5378 (2) 1.7412
-6.3136 (1) 5.4526 -6.5472 (1) 1.7412
MS -3.6845 (4) 4.9221 -8.7709 (4) 4.9077
-3.6626 (3) 4.9099 -8.6871 (3) 4.9077
-5.5449 (2) 4.9591 -8.7096 (2) 4.9077
-6.7700 (1) 4.9332 -8.7209 (1) 4.9077
DGP -4.1748 (4) 4.1808 -10.1754 (4) 4.2204
-4.5725 (3) 4.1539 -10.1579 (3) 4.2204
-6.2131 (2) 4.1910 -10.1705 (2) 4.2204
-6.5147 (1) 4.1901 -10.1465 (1) 4.2204
r* -4.7255 (4) 9.4705 -10.6595 (4) 9.3605
-5.2932 (3) 9.4424 -10.6578 (3) 9.3605
-6.1317 (2) 9.4146 -10.6569 (2) 9.3605
 31

-7.5249 (1) 9.3874 -10.6566 (1) 9.3605

IMP -4.6799 (4) 5.3073 -8.5684 (4) 5.2559
-4.9017 (3) 5.2913 -8.6059 (3) 5.2559
-5.6035 (2) 5.2719 -8.6300 (2) 5.2559
-8.5598 (0) 5.2559 -8.5396 (1) 5.2559
Wag 0.5839 (4) 1.7080 -1.0140 (4) 2.1370
1.0505 (3) 1.7385 -0.8155 (3) 2.1370
-0.2372 (2) 1.9410 -1.1404 (2) 2.1370
-0.5098 (1) 1.9236 -1.1680 (1) 2.1370

Note: The values in parentheses are the lags. The McKinnon critical values for the analysis of unit root are
-3.4911, -2.8879 and -2.5807 for 1,5 and 10 percent respectively.

The decision criterion is that the hypothesis of the presence of unit root is
rejected if the t-statistic is less than the critical values. For our case it can clearly be seen
that the variables, inflation rate, budget deficit, money growth, import prices, GDP
growth and average interest rate of the trading partners are stationary at 5 percent level of
significance. However, the wage rate appeared to contain unit root and had to be
differenced once to become stationary. This implies that the wage rate is integrated of
order one (I(1)) whereas other variables are integrated of order zero (I(0)). The unit root
test results for first difference for the variable wage rate is given on Table 4.3 below.

TABLE 4.3.1 UNIT ROOT TEST FOR WAGES: FIRST DIFFERENCE

ADF PP

t-statistic (Lag) AIC t-statistic (Lag) AIC

-4.4875 (4) 1.7202 -20.5523 (4) 1.9082
-6.4037 (3) 1.7252 -21.0862 (3) 1.9082
-11.3338 (2) 1.7256 -19.1436 (2) 1.9082
-9.8747 (1) 1.9235 -17.9015 (1) 1.9082

The test results show that the wage rate variable is integrated of one denoted by
x~I(1). The results from the PP test also suggest that wage rate is stationary at first
difference. Only Akaike Information Criterion was used to choose the lag length. The
reason being that AIC is in most cases preferred over the SIC because AIC gives smaller
 32

value as compared to the SIC. Therefore, only the value of the AIC is recorded on the
table above.

4.4 MODEL ESTIMATION

The main aim of this paper is to find the macroeconomic impact of budget deficit
and money growth on inflation in South Africa. This is determined by the estimation
coefficients. The results of the estimation are reported in Table 4.4. From the ADF and
PP test results, we have seen that the variables are integrated of zero and that only wage
rate is integrated of order one, therefore the series might exhibit long-run relationship.
Therefore the estimation is called cointegration2 analysis and the coefficients give long-
run estimates. Economic theory leads to believe that the long-run relationships could be
found between prices, budget deficits, money growth, GDP growth, wages, foreign
interest rates and import prices. As such, long-run relationships could be found among
the variables in the model.
Budget deficit seems to have a positive effect on inflation in South Africa. The
passed values of the deficit have mixed signs, for example, the coefficient at lag one turns
out to bear a negative sign which now does not support economic theory and is
statistically insignificant. This tells us that inflation in South Africa is determined by
current budget deficit and its passed values. The sign changes with lags.
Money growth also has a positive effect on inflation and is statistically
significant as judged by the t-statistic. The passed values seem not to contribute towards
the inflationary process in South Africa. Other variables also contribute positively to
inflation in South Africa. We also inspected the contributing effect of the apartheid using
the Chow- Break point approach. The hypothesis that the apartheid era contributed to
huge deficits, money growth and as such inflation, is rejected. This therefore tells us that
the apartheid era did not have some contributory effect on growth on budget deficits,
money supply and inflation. The estimation results are reported in Table 4.4. The Jaque-
Bera (JB) test accepts the null hypothesis that the error terms are normally distributed.
The Breusch-Godfrey LM test also accepts the null hypothesis of no serial correlation in

2
The results for the Johansen cointegration test are give in Appendix A
 33

residuals. This is shown by the probability of the F-statistic for the LM test which is
0.755008. Under the Ramsey’s (1969) RESET test the F-statistic is 1.5625 and its
probability is 0.000, which then leads us into rejecting the null hypothesis that the model
is misspecified. The test for the overall significance of the explanatory variables (F test)
signifies that the coefficients are not equal to zero. The null hypothesis that all
coefficients are simultaneously equal to zero is rejected, implying that not all slope
coefficients are simultaneously equal zero.

TABLE 4.4 ESTIMATION RESULTS

Dependent Variable: Inflation (Inf)
Variable Coefficient t-Statistic Prob. Diagonistic tests
C 0.763121 0.170140 0.0864 R2=0.870438
INFLAION_RATE(-1) 0.327840 2.727825 0.0080 AdjR2=0.865771
INFLAION_RATE(-2) 0.100821 0.764340 0.4472 F-Stats=3.558018
INFLAION_RATE(-3) 0.145771 1.125729 0.2640 Prob(F-Stats)=0.000002
BUDGET_DEFICIT 0.013143 2.456547 0.0064
BUDGET_DEFICIT(-1) -0.103835 -0.669032 0.5056 RESET
BUDGET_DEFICIT(-2) -0.008808 -0.457732 0.6485 H0:Model misspecified
BUDGET_DEFICIT(-3) 0.006525 3.324011 0.0749 F-Stats=1.5625
BUDGET_DEFICIT(-4) 0.024688 0.959506 0.3405 Prob= 0.0000
BUDGET_DEFICIT(5) -0.004620 -0.209160 0.8349
GDP_GROWTH -0.005896 -2.163802 0.0873 Breusch-Godfrey LM
GDP_GROWTH(-1) -0.000536 -0.014929 0.9881 H0:No serial correlation
GDP_GROWTH(-2) 0.018527 2.503675 0.0660 F-Stats=0.282143
GDP_GROWTH(-3) -0.012626 -2.330592 0.0741 Prob=0.755008
GDP_GROWTH(-4) -0.027838 -0.672732 0.5033
MONEY_GROWTH 0.012514 3.449225 0.0656 White Heteroskedasticity
MONEY_GROWTH(-1) 0.015535 2.565240 0.0573 H0:No Heteroskedasticity
in residuals
MONEY_GROWTH(-2) -0.003314 -0.133256 0.8944 F-Stats=1.570978
MONEY_GROWTH(-3) 0.028130 1.119114 0.2668 Prob=0.656013
MONEY_GROWTH(-4) 0.013126 0.488236 0.6269
MONEY_GROWTH(-5) 0.022592 0.833162 0.4075 Jaque-Bera (JB)
IMPORT_PRICES 0.014713 2.575301 0.0669 H0:Errors normally
distributed
IMPORT_PRICES(-1) 0.014518 0.601784 0.5492 JB=1.07696
IMPORT_PRICES(-2) -0.035992 -1.474923 0.1446 Prob=0.15076
IMPORT_PRICES(-3) 0.069056 2.441401 0.0171
IMPORT_PRICES(-4) 0.059998 1.970336 0.0526 Chow-Break Point-1994:1
IMPORT_PRICES(-5) 0.006813 0.225933 0.8219 H0:Structural break
present
AVER_RATE 0.001315 1.747129 0.0140 F-Stats=2.378057
AVER_RATE(-1) 0.001757 1.766236 0.0180 Prob=0.005138
AVER_RATE(-2) 0.000995 0.416328 0.6784
AVER_RATE(-3) 0.001956 0.822086 0.4137
WAGERATE 0.056308 2.615100 0.0539
WAGERATE(-1) -0.038756 -0.381738 0.7034
WAGERATE(-2) 0.060435 2.600522 0.0495
WAGERATE(-3) 0.112607 1.193634 0.2353
AVER_RATE(-4) -0.001108 -0.456006 0.6498
 34

Note: the values in parenthesis are the lags

The theoretical determinants of inflation in South Africa are consistent with

economic theory. The model explains 87 percent of the variation in inflation in South
Africa.

4.4 COINTEGRATION
Appendix A presents the cointegration analysis of the relationship between the
variables under consideration. The test procedure is to move through from the most
restrictive model at each stage to compare the trace or maximal eigen value statistic to its
critical value and only stop the first time the null hypothesis is not rejected. The results
show that there are seven cointegrating vectors. We therefore carried out the long–run
regression analysis based on those seven cointegrating vectors. We first normalize
inflation and run a regression. A typical co integrating relationship for inflation, budget
defict and money growth gives a normalized equation
Inf = 0.25809 BD + 0.236012 MS

This implies that budget deficit and money exert positively towards inflation.

4.5 ERROR CORRECTION MODELLING

Since the variables guaranteed existence of cointegration with each other as

depicted in appendix A, there is a need to perform the error correction mechanism. The
intuition behind this, is to capture the long-run responses in series. This is achieved by
running equation 3.3.3.1. The results of the short-run dynamics are presented in Table 4.6
below.
 35

Table 4.6 ERROR CORRECTION TEST RESULTS

DEPENDENT VARIABLE: Inf

VARIABLE COEFFICIENT T-STAT PROB.

C 0.040622 0.221433 0.8253

ECt-1 0.912824 -2.586651 0.0115

∆IMP -0.026546 -1.262068 0.2105

∆WAG -0.000227 -0.006791 0.9946

∆r* 0.003035 1.620093 0.1091

∆Inft-1 1.706403 3.496279 0.0008

∆Inft-2 -0.546574 -2.314554 0.0232

∆Inft-3 0.106483 0.850264 0.3977

∆Inft-4 -0.282244 -2.555652 0.0125

∆BD 0.023280 3.974169 0.0332

∆BDt-1 -0.005438 -0.150094 0.8811

∆BDt-2 0.012147 0.290280 0.7723

∆BDt-4 0.030909 2.705370 0.04826

∆BDt-5 0.031231 2.892222 0.03749

 36

∆MS 0.030662 2.363169 0.1036

∆MSt-1 0.008040 1.980909 0.0795

∆MSt-2 -0.014524 -0.483592 0.630

∆GDP -0.005896 -2.163802 0.0873

∆GDP(-1) -0.000536 -0.014929 0.9881

SUMMARY STATISTICS

R2 =0.86789 ADJ R2 = 0.86615

RAMSEY

H0: Model misspecified

F= 0.7789 Prob = 0.38800

B-G Serial correlation LM Test

F = 1.8203 Prob = 0.133459

WHITE HETEROSCEDASTICITY TEST

F= 1.7277 Prob = 0.023617

J-B = 20.567 (0.1301)

Prob = 0.243012

CHOW BREAK POINT: 1994:1

H0: Structural break in 1994:1

F = 2.6756 Prob = 0.0000

 37

Inflations expectation proxied by lag one one of inflation is positively correlated

with current inflation. The coefficient of ECt-1 has to be a number that lies between zero
and negative one (-1≤ β8 ≤0). It shows the amount by which inflation adjusts. For our
study the value is -0.9128, which implies that about 91 percent of inflation is adjusted
each quarter. This suggests the validity of the equilibrium relationship indicating the
existence of market forces that operate to restore long-run equilibrium after a short-run
shock. It shows the speed of adjustment of inflation disequilibrium to long-run.
The model explains 87 percent of the variation in inflation and the F-statistic is
statistically significant, meaning that the respective explanatory variables indeed explain
inflation. It rejects the hypothesis that all coefficients are equal to zero. Using the Ramsey
(1969) RESET test, the hypothesis that the model is misspecified is rejected. This is
shown by the F-statistic for the RESET test. From that we can infer that the model is
correctly specified. The errors are also found to bear no autocorrelation, that is they are
homoskedastic.

4.6. INTERPRETATION OF RESULTS.

The results of Table 4.6 provide reliable evidence explaining the relationship
between inflation and our independent variables. The results reveal positive and highly
significant coefficients of budget deficit and money growth as is shown in Table 4.6. The
primary focus of this study is to examine the inflationary effects (or absence thereof) of
deficits and money growth. The deficit variable carries a positive sign and negative at lag
one. This means that current deficit contributes positively to inflationary process in South
Africa. At lag one, the negative sign suggests that each percent point of deficit as a ratio
of GDP subtracts 0.1 percent point from the rate of inflation the next year. The evidence
here suggests that government deficits have a significant effect on the price level in South
African economy. This indirectly supports Darrat’s (1985) conclusion which casts doubt
on the presence of a significant crowding-out effect of budget deficits in the United
States.
The coefficient of money growth variable is positively correlated with inflation
and statistically significant but negative at lag one. This implies that money growth
 38

lagged by two appears to be more significant than when it lagged by one quarter. These
results are consistent with economic theory and are in contrary with Darra’ts (1985)
findings which revealed a negative relationship between the rate of inflation and the
growth rate on money supply. The negative relationship by Darrat (1985) may be due to
what Rasche (1987) calls a “drift in drift”. This phenomenon attributes changes in M1
velocity to the decline of inflationary expectations and instability of the economy. GDP
growth has a negative impact on inflation rate in South Africa. It suggests that GDP
growth reduces inflation rate by 0.5 percent. This also is in line with economic theory.
This implies that at less than full employment a rise in GDP growth does not necessarily
lead to inflation but rather leads to a reduction in inflation.
Apart from the contribution by these two variables, other variables are also
investigated and are found to be inflationary in the economy. The import price variable
has a negative sign, which does not support economic theory. It suggests that import
prices reduce 0.2 percent from inflation in South Africa. Wages are non-inflation
contributing and reduce inflation by 0.02 percent to inflation and the foreign rate if
interest (average of the interest rates of South Africa’s major trading partners, U.S, U.K
and Germany) contributes to inflation process. The passed value of inflation has a higher
contributory effect on current inflation since it adds about 0.03 percent to inflation. Based
on the Chow (1960) break point test previously reported, the coefficient of D (dummy)
carries a positive sign and is significant. This supports our earlier claim that the post-
apartheid era has not contributed to increases in deficits and money supply, hence
inflation. In sum, our model of this study explains the underlying variations in the rate of
inflation during 1975-2003.
 39

CHAPTER 5

5.0 SUMMARY, CONCLUSION AND POLICY RECOMMENDATIONS

5.1 INTRODUCTION

This section discusses the summary, conclusions and the policy recommendations
based on the results obtained. In the policy recommendations, policy implications of the
findings are discussed and some suggestions are made to get rid of the problem
associated with budget deficit, money growth and inflation in the economy of South
Africa.

5.2 SUMMARY AND CONCLUSIONS

Using quarterly data covering the period 1975-2003 the existence of a stable long-
run relationship between budget deficit, money growth and inflation is tested in this study
and the results have been affirmative. Causality and cointegration tests have been done.
Using the cointegration vectors found in the study, a significant impact of budget deficit
on inflation cannot be refuted. The inertia in the inflation could be due to the
accumulation of the inflationary expectations. It can also be explained by the general
equilibrium nature of price system where the increase in one price will drive up the other
 40

ones and the continuity of the process will be guaranteed whenever overshooting of some
prices occur.

5.3 POLICY IMPLICATION AND RECOMMENDATIONS

The policy implication of this study is that inflation in South Africa is mainly due
to increases in budget deficit and the growth of money supply. The study has shown that
inflation in South Africa is largely structural in nature and that the monetary authorities
have limited control over the main determinants thereof as the fiscal side of the economy
contributes towards inflation process. This suggests that it be difficult to achieve the
objective of reducing inflation to the levels prevailing in the countries main trading
partners. Inflation reduction is likely to be particularly slow and costly in terms of output
and employment if pursued exclusively by interest rate manipulation and wage increases
in excess of productivity growth.
The study shows that fiscal budget deficit and growth of money supply have
equally contributory impact on South Africa’s inflationary process. Therefore, in order
for South Africa to control its inflation rates, it needs to cut the size of government deficit
perhaps by cutting the size of its bureaucracy drastically. The policy of cutting
government expenditures to control domestic inflation was also advocated by Corsepius
(1989) when addressing the Peruvian experience. The government each year increases the
amount of social grants and these have to be held constant for sometime. This will help in
the reduction of government expenditure. Perhaps equally important, this direct and
potent impact of budget deficit on inflation is not contingent upon debt monetization
since the monetary authorities are trying to maintain the significant impact of money
growth on inflation. It should be noted that, compared to other determinants of inflation,
budget deficit and money growth seem to have a quicker and stronger effect on inflation.
It seems useful to note that our study’s evidence for the significance impact of
budget deficit on aggregate demand (inflation) is inconsistent with the Ricardian
Equivalence hypothesis (Barro, 1974). Both the fiscal and monetary authorities must act
such that budget deficit is reduced and that money supply is not excessive, as that leads to
inflation. Like we pointed out that high budget deficits are not desirable at all, they lead
 41

to inflation if monetized, reduce national savings and thus crowd out private investment.
Since economic theory suggests that there is a positive relationship between investment
and economic growth, crowding out private investment leads to a decline in economic
growth. Therefore the government should try to reduce its expenditures so that there
would not be high deficits, which in fact will transform to inflation on a later date,
otherwise the economy will suffer the costs of inflation. The control of inflation requires
deliberate action by the budgetary authorities if the monetary is not to be excessive.

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APPENDICES
APPENDIX A
Johansen Cointegration Test results.
SAMPLE :1975:1 2003:3
Test assumption: Linear deterministic trend in data.
Likelihood 5 Percent 1 Percent Hypothesized
Eigenvalue Ratio Critical Value Critical Value No. of CE(s)
0.288901 147.5941 124.24 133.57 None **
0.248429 110.4312 94.15 103.18 At most 1 **
0.239994 79.30191 68.52 76.07 At most 2 **
0.160315 49.38913 47.21 54.46 At most 3 *
0.117251 30.34373 29.68 35.65 At most 4 *
0.103785 16.74984 15.41 20.04 At most 5 *
0.043136 4.806219 3.76 6.65 At most 6 *
Unnormalized Cointegrating Coefficients:
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
0.103633 -0.001399 0.026747 0.004915 -0.064139 -0.055548 -0.007823
0.076911 0.001118 0.033971 -0.134553 0.017257 0.011232 -0.029392
0.012532 0.006020 0.018447 0.009801 0.031238 -0.053962 -0.008053
0.056605 -0.006154 -0.007113 0.000387 0.032999 -0.012669 0.004770
-0.004093 0.002063 0.027864 0.041662 -0.042401 0.004565 0.031563
0.249191 -0.000464 0.002963 0.013329 0.036819 0.010434 -0.039614
-0.075891 -0.001499 0.047745 -0.009242 0.029877 -0.014731 -0.019602
1 cointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 -0.013496 0.258098 0.047432 -0.618905 -0.536012 -0.075484
(0.01382) (0.14527) (0.21001) (0.32152) (0.24740) (0.07590)

Log likelihood -1615.896

2 ointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 0.000000 0.346478 -0.817550 -0.212967 -0.207690 -0.223106
(0.15513) (0.79024) (0.40646) (0.33735) (0.14033)
0.000000 1.000000 6.548729 -64.09304 30.07901 24.32788 -10.93842
(11.2193) (57.1510) (29.3952) (24.3977) (10.1488)
Log likelihood -1600.331
3 cointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 0.000000 0.000000 4.737226 -2.227003 -2.914914 0.606124
 46

(12.8986) (5.83339) (7.49800) (1.94188)

0.000000 1.000000 0.000000 40.89704 -7.988013 -26.84099 4.734743
(115.739) (52.3429) (67.2795) (17.4244)
0.000000 0.000000 1.000000 -16.03213 5.812887 7.813558 -2.393314
(38.9920) (17.6342) (22.6663) (5.87025)
Log likelihood -1585.375
4 cointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 0.000000 0.000000 0.000000 3.278967 -1.359159 -0.028282
(12.2140) (4.33509) (0.49582)
0.000000 1.000000 0.000000 0.000000 39.54568 -13.40998 -0.742167
(129.347) (45.9087) (5.25070)
0.000000 0.000000 1.000000 0.000000 -12.82089 2.548438 -0.246300
(42.2338) (14.9899) (1.71444)
0.000000 0.000000 0.000000 1.000000 -1.162277 -0.328410 0.133919
(3.25070) (1.15376) (0.13196)
Log likelihood -1575.852

5 cointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 0.000000 0.000000 0.000000 0.000000 -1.018442 -0.408963
(1.10359) (0.45232)
0.000000 1.000000 0.000000 0.000000 0.000000 -9.300786 -5.333327
(15.4834) (6.34612)
0.000000 0.000000 1.000000 0.000000 0.000000 1.216220 1.242175
(3.93159) (1.61142)
0.000000 0.000000 0.000000 1.000000 0.000000 -0.449183 0.268857
(0.63209) (0.25907)
0.000000 0.000000 0.000000 0.000000 1.000000 -0.103910 0.116098
(0.98830) (0.40507)
Log likelihood -1569.055
6 cointegrating
Equation(s)
AINFLAION_RATE AVER_RATE BUDGET_DEFICIT GDP_GROWTH IMPORT_PRICES MONEY_GROWTH WAGERATE
1.000000 0.000000 0.000000 0.000000 0.000000 0.000000 -0.224176
(0.11782)
0.000000 1.000000 0.000000 0.000000 0.000000 0.000000 -3.645782
(3.23148)
0.000000 0.000000 1.000000 0.000000 0.000000 0.000000 1.021503
(0.89457)
0.000000 0.000000 0.000000 1.000000 0.000000 0.000000 0.350357
(0.22322)
0.000000 0.000000 0.000000 0.000000 1.000000 0.000000 0.134951
(0.28406)
0.000000 0.000000 0.000000 0.000000 0.000000 1.000000 0.181441
(0.28625)
Log likelihood -1563.084

Note: *(**) denotes rejection of the hypothesis at 5% (1%) significance level..

 47

APPENDIX B.

ERROR CORRECTION TEST RESULTS

DEPENDENT VARIABLE: Inf

VARIABLE COEFFICIENT T-STAT PROB.

C 0.040622 0.221433 0.8253

ECt-1 0.912824 -2.586651 0.0115

∆IMP -0.026546 -1.262068 0.2105

∆WAG -0.000227 -0.006791 0.9946

∆r* 0.003035 1.620093 0.1091

∆Inft-1 1.706403 3.496279 0.0008

∆Inft-2 -0.546574 -2.314554 0.0232

∆Inft-3 0.106483 0.850264 0.3977

∆Inft-4 -0.282244 -2.555652 0.0125

∆BD 0.023280 3.974169 0.0332

∆BDt-1 -0.005438 -0.150094 0.8811

∆BDt-2 0.012147 0.290280 0.7723

∆BDt-4 0.030909 2.705370 0.04826

∆BDt-5 0.031231 2.892222 0.03749

 48

∆MS 0.030662 2.363169 0.1036

∆MSt-1 0.008040 1.980909 0.0795

∆MSt-2 -0.014524 -0.483592 0.630

SUMMARY STATISTICS

R2 =0.86789 ADJ R2 = 0.86615

RAMSEY

H0: Model misspecified

F= 0.7789 Prob = 0.38800

B-G Serial correlation LM Test

F = 1.8203 Prob = 0.133459

WHITE HETEROSCEDASTICITY TEST

F= 1.7277 Prob = 0.023617

J-B = 20.567 (0.1301)

Prob = 0.243012

CHOW BREAK POINT: 1994:1

H0: Structural break in 1994:1

F = 2.6756 Prob = 0.0000

49