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SAJBS
11,2
216
Received 11 May 2020
Revised 14 September 2020
Accepted 3 December 2020
South Asian Journal of Business
Studies
Vol. 11 No. 2, 2022
pp. 216-234
© Emerald Publishing Limited
2398-628X
DOI 10.1108/SAJBS-05-2020-0141
The impact of macroeconomic
variables on the budget
deficit in Bangladesh:
an econometric analysis
Md. Mahbub Alam and Md. Nazmus Sadekin
Department of Economics, Mawlana Bhashani Science and Technology University,
Tangail, Bangladesh, and
Sanjoy Kumar Saha
Department of Economics, Mawlana Bhashani Science and Technology University,
Tangail, Bangladesh and
Department of Economics, Chungnam National University, Daejeon, Korea
Abstract
Purpose – This paper aims to investigate the impact of selected macro-economic variables like real effective
exchange rate (REER), GDP, inflation (INF), the volume of trade (TR) and money supply (M2) on-budget deficit
(BD) in Bangladesh over the period of 1980–2018.
Design/methodology/approach – By using secondary data, the paper uses the Vector Error Correction
Model (VECM) and Granger Causality test. Johansen’s cointegration test is used to examine the long-run
relationship among the variables under study.
Findings – Johansen’s cointegration test result shows that there exists a positive long-run relationship of
selected macroeconomic variables (real effective exchange rate, inflation, the volume of trade and money
supply) with the budget deficit, whereas GDP has a negative one. The short-run results from the VECM show
that GDP, inflation and money supply have a negative relationship with the budget deficit. The Granger
Causality test results reveal unidirectional causal relationships running from BD to REER; TR to BD; M2 to BD;
GDP to REER; M2 to REER; INF to GDP; GDP to TR; M2 to GDP and bidirectional causal relationship between
GDP and BD; TR and REER; M2 and TR.
Originality/value – Bangladesh has been experiencing a budget deficit since 1972 due to a decline in sources
of revenue. This study contributes to the empirical debate on the causal nexus between macroeconomic
variables and budget deficits by employing VECM and Granger Causality approaches.
Keywords Budget deficit, GDP, Inflation, Money supply, REER, Volume of trade, VECM
Paper type Research paper
1. Introduction
The budget deficit or fiscal gap is a common scenario of almost all the underdeveloped
countries across the world, but the magnitude of the deficit is comparatively higher in
developing countries that are within the transitional phase of being developed in the future
(Chihi and Normandin, 2008; Jimmy, 2014; Amina and Murshed, 2017). However, in developing
countries, budget deficits are likely to happen due to structural and economic factors such as
high rates of inflation, a deficit in the balance of payments, extreme level of expenditures
against the insufficient level of national income, as well as other political reasons (Sen et al.,
2007). The macroeconomic impacts of experiencing a budget deficit have motivated many
researchers and policymakers in conducting several investigations to conclude the nexus
between budget deficit and other important macroeconomic variables such as GDP, interest
rates, inflation, trade deficit, money supply, the exchange rate (Georgantopoulos and Tsamis,
2011; Lwanga and Mawejje, 2014; Nguyen, 2015). This relationship with macroeconomic
This research received no financial support from any funding agency in the public, commercial, or not-
for-profit sectors.
variables can either be negative or positive. The differences in the character of the relationship Macroeconomic
between budget deficits and these macroeconomic variables are explained by the different variables on the
methodologies of the countries utilize and the nature of the data that is used by the different
researchers. Most of the studies regress a macroeconomic variable on the deficit or the deficit on
budget deficit
the macroeconomic variables. According to this view, the connection between budget deficit
and macroeconomic variables depends on how the deficit is financed.
The budget deficit can be financed through several ways, which include government
borrowing domestically, government borrowing from international sources, minting money 217
by the central bank and foreign aid from donor governments and agencies (Lwanga and
Mawejje, 2014). If the budget deficit is financed by borrowing from the domestic banking
system, there will be an increase in the domestic interest rates and the crowding out of the
private investment. Moreover, monetization of the deficit results in to raise in the money
supply and the rate of inflation (Georgantopoulos and Tsamis, 2011; Hussain and Saaed,
2014; Lwanga and Mawejje, 2014; Epaphra, 2017). Also, the exchange rate may appreciate
because of the budget deficit. The appreciation of the real exchange rate due to the inflow of
foreign exchange, which makes the country’s exports less competitive. This will further
deteriorate the balance of trade (Vuyyuri and Seshaiah, 2004; Georgantopoulos and Tsamis,
2011; Hussain and Saaed, 2014). Again, less competitive exports may lead to resources
moving away from the production of tradable to the production of nontradable. However, an
excessive budget deficit may result in a debt crisis as it leads to the growth of the country’s
external debt stock (Epaphra, 2017). Thus, the budget deficit has a large impact on the
financial, economic and political stability of the country.
Since independence, Bangladesh has been experiencing a gentle increase within the rate of
growth of GDP, accelerating from an average of less than 4% per year during 1972–1990 to
7.1% in 2015–18 (Alam et al., 2019). Although Bangladesh has gained immeasurable attention
from all over the world due to its rising economy, it has been experiencing continuous budget
deficits and rising levels of debt over the years related to the decline in sources of revenue. The
tax to GDP ratio is one of the lowest in Bangladesh as compared to other South Asian countries.
In the last 10 years, Bangladesh’s average tax to GDP ratio is 10.3%, which is 19.6% in India and
Nepal 19.6%. In developed countries, the average tax to GDP ratio is 35.8% (Dhaka Tribune,
2018). Therefore, more borrowing and foreign loans are required to finance the budget deficit
due to the slower rate of collection of revenue as compared to the total expenditure. According to
the Bangladesh Economic Review (2018), the total budget deficit (excluding grants) for FY 2017–
18 is projected at BDT 1.120.41 billion, which is around five percent of GDP. In funding the
deficit, the Government depends on both domestic and international sources. Domestic sources
are growing steadily, financing this deficit. In recent times the collection of funds from the selling
NSCs by the government has been increasing rapidly. Whereas in recent times, borrowing
money from the banking system has been in a downward trend.
Bangladesh’s macroeconomic stability vigorously relies on government budget strategies.
In any case, reducing budget deficits is a dynamic mechanism that relies on a wide scope of
economic activities, including external factors. Although Bangladesh consistently relies on a
deficit budget, there are a few numbers of studies (Hassan and Akhter, 2014; Rana and
Wahid, 2016; Ahmad and Rahman, 2017; Hussain and Haque, 2017; Abdullah et al., 2018) that
are done in Bangladesh. However, these works mostly focused on growth variables, inflation
while does not appropriately evaluate the influence of macroeconomic variables on the
budget deficit. Therefore, this study tries to find out this gap. This study aims to investigate
the impact of selected macro-economic variables like real effective exchange rate, GDP,
inflation, the volume of trade and money supply on-budget deficit in Bangladesh using an
econometric approach. For this purpose, the Johansen cointegration test, Vector Error
Correction Models (VECM) and Granger-causality test are employed for the period 1980–
2018. Specifically, this study seeks to ascertain the relationship between macroeconomic
SAJBS variables such as real effective exchange rate, gross domestic product, inflation, the volume
11,2 of trade, money supply and the budget deficit to create appropriate recommendations to curb
its negative effect on the economy.
The remaining sections of this study are arranged as follows. Section 2 and 3 describe the
literature and methodology of the study, respectively. In Section 4 the empirical results and
discussions of this study are explained, and Section 5 describes the conclusion and policy
implication of the results of this study.
218
2. Literature review
2.1 Theoretical literature
Several theories explain the nexus between budget deficits and macroeconomic variables like
GDP growth, inflation, money supply, interest rate, exchange rate, among others, which
include: Neoclassical, Keynesian and the Ricardian Equivalence theory.
The neoclassical theory is of the view that there is an inverse nexus between
macroeconomic variables and budget deficits. According to this theory, a budget deficit
leads to rise in the rate of interest, does not stimulate the issue of private bonds, private
spending and private investment. It also raises the level of inflation and leads to a similar
increase in current account deficits that may finally result in slower the economy’s growth
through resources crowding out (Van and Sudhipongpracha, 2015). When the government
sector expands, the private sector will contrast as a result of the increase in prices on these
resources owing to excess demand by the government, and thus, this leads to a fall in
consumption and investment by the private sector. Therefore the expansion of the
government sector crowds out the private sector. According to this theory, a budget deficit
has adverse effects on an economy, and hence, it advocates for a balanced budget at all time.
On the other hand, the Keynesian view (Keynes, 1936) argues that there is a positive
relationship between budget deficit and macroeconomic variables. They argue that an
expansion in government spending (raising budget deficit) leads to raises in aggregate
demand, and improves investors’ confidence on the economic potential, thereby rising
investments and aggregate savings at any given level of interest rate, which results in long-
term economic growth through crowding in private investors. The Keynesian absorption
approach suggests that a rise in the budget deficits will stimulate domestic absorption, and
thus, import expansion, causing the current account deficit (Eigbiremolen et al., 2015). These
will, in turn, bring an increase in the budget deficit, causing upward pressure on the interest
rate, capital inflows and an appreciation of the real exchange rate. In turn, the real
appreciation of the domestic currency deteriorates the current account deficits, and
consequently, budget deficit causes current account deficits. This is frequently the impact of
government sector deficit on the external sector deficit causing twin deficits. Budget deficits
can be utilized to fuel aggregate demand during times of economic recessions in this manner
shortening the periods of recovery.
Last, the Ricardian theory (Barro, 1989) is of the view that budget deficits have no positive
or negative nexus with macroeconomic variables. According to this theory, a rise in
government budget deficit is viably proportionate to a future rise in tax liabilities. Taking
into consideration that lower taxation in the present is offset by higher taxation in the future,
it implies that budget deficits do not influence the macroeconomic variables. Governments
may either finance its expenditure by taxing current taxpayers or may borrow money.
However, they eventually repay their borrowing by increasing taxes above what they have
otherwise in the future.

2.2 Empirical literature

Empirically, there are successive explores endeavoring to clarify the genuine connection
between budget deficit and several macroeconomic variables, utilizing different
methodologies applied for empirical data in both developed and developing nations. Macroeconomic
The consequences of those explores are mixed, which gives empirical evidence for all three variables on the
previously mentioned paradigms. If a relationship is found important, no matter long-run or
short-run, between budget deficits and other significant macroeconomic variables like
budget deficit
inflation, interest rates, trade, exchange rates, money supply and economic growth of the
entire nation, then how the government decides to finance its expenditure decisions will be of
instrumental significance.
The empirical review of the (developing countries) literature concerning the nexus 219
between budget deficit and macroeconomic variables is summarized in Table 1.
Overall, although the utilization of econometric models and quantitative methods on
identifying and estimating the nexus between budget deficit and other macroeconomic
variables is extensive in the developing countries, it keeps limited for the case of Bangladesh.
Therefore, to accomplish a measurable proof upheld induction on this relationship, a
quantitative-based examination with global standard procedures is of high need. This study
aims to fill in this gap and contribute both methodological and proper empirical implications
to the present literature on the issue of cointegration between budget deficit and other
macroeconomic variables in Bangladesh.

3. Data and research methodology

3.1 Description of the data and sources
The study has used annual time series data spanning from 1981 to 2018. It is based on
secondary data that are collected from World Development Indicators (WDI) expressed by
the World Bank, and the Bangladesh Economic Review produced (BER) by the Ministry of
Finance, World Economic Outlook expressed by the IMF and Bruegel annual datasets.
Meanwhile, data of budget deficit 1981 to 1993 are taken from Benson and Clay (2002)
expressed by the World Bank.
The study attempts to examine the impact of macroeconomic variables on-budget deficit.
Therefore budget deficit is considered as a dependent variable, whereas real effective
exchange rate, GDP, inflation, the volume of trade and money supply are considered as the
explanatory variables. The budget deficit measures the extent to which government
expenditure exceeds government revenue (excluding grants) that need to be financed. The
real effective exchange rate (REER) is calculated from the nominal effective rate of exchange
and a measure of the relative price or cost between the country under study and its trading
partners, and thus, an increase in the index reflects an appreciation. It is expected that there is
a negative relationship between real exchange rates and budget deficit. Gross domestic
product (GDP) is expected to negatively affect the budget deficit in this study.
Inflation (INF) is measured based on the consumer price index, which reflects the annual
percentage change in the cost of goods and services. It is expected to positively or negatively
affect the budget deficit. The volume of trade (TR) as a share of GDP is measured by taking
the ratio of the value of trade to the GDP following Hassan and Kalim (2010), Kalim and
Hassan (2013). It usually has a negative impact on the budget deficit in the countries where
the exports of a country are greater than the imports. Broad money (M2) is taken as a proxy of
money supply in an economy (Chaitip et al., 2015; Nguyen, 2015; Qamruzzaman and Wei,
2018). The study expects a negative impact of money supply on the budget deficit. Table 2
shows the summary of all variables that are used in the study and their sources.

3.2 Empirical methodology

The main aim of this study is to investigate the impact of selected macroeconomic variables
(real effective exchange rate, GDP, inflation, the volume of trade, money supply) on-budget
deficit in Bangladesh. For examining the relationship between selected macroeconomic
 11,2

220

variables
Table 1.
SAJBS

macroeconomic
literature on the

budget deficit and

relationship between
Summary of empirical
Authors (Year) Countries Study period Methodology Main finding

Nwakobi et al. Nigeria 1981–2015 ex-post facto research design The fiscal deficit has no significant impact on GDP, money supply and
(2018) inflation
Dissanayake (2017) Sri Lanka 1980–2014 ARDL Granger–Causality Long-run nexus between budget deficits, and exchange rate, inflation, interest
test rate, debts and real GDP growth rate. A uni-direction causality between
budget deficit and debt, budget deficit and inflation
Epaphra (2017) Tanzania 1966–2015 VAR-VECM approach Real GDP and exchange rate have a significant and negative effect on the
budget deficit, whereas inflation, money supply and lending interest rate is
positively related
Brima and Pearce Sierra Leone 1980–2014 Johansen Cointegration, The exchange rate, GDP, and money supply have a negative and significant
(2015) VECM, Granger Causality nexus with the budget deficit, whereas inflation has a positive one
Nkalu (2015) Nigeria and 1970–2013 SUR and 2SLS The budget deficit has negative effects on the interest rate, inflation and
Ghana economic growth in Nigeria and Ghana
Osuka and Chioma Nigeria 1981–2012 Johansen Cointegration, Long-run nexus between budget deficits and macroeconomic variables. GDP
(2014) Granger Causality granger causing the budget deficit
Binh and Hai (2013) Vietnam 2003Q1– Cointegration approach, The long-run relationship among GDP, CPI, exchange rate, money supply (M2)
2012Q4 VECM and budget deficit. The budget deficit has a negative but insignificant effect on
economic growth
Mushtaq and Pakistan 1980–2011 Johnsen Cointegration GDP, real exchange rate and credit from banks have a positive impact on the
Zaman (2013) Approach budget deficit while CPI has a negative one
Umeora (2013) Nigeria 1970–2011 OLS GDP, exchange rate, inflation rate and money supply is positively related to
the fiscal deficit while lending interest rate is a negative one
Kalim and Hasan Pakistan 1976–2010 ARDL International trade has a positive impact on the fiscal deficit while broad
(2013) money supply, GDP and total debt servicing have negative effects
Chimobi and Igwe Nigeria 1970–2005 Cointegration Approach Long-run nexus between inflation and money supply in Nigeria. A money
(2010) supply granger causes deficit
Hassan and Kalim Pakistan 1976–2009 Cointegration Approach GDP per capita, total debt servicing and money supply have a negative impact
(2010) on fiscal deficit, whereas the volume of trade and total debt servicing have a
positive impact on fiscal deficit

(continued )
Authors (Year) Countries Study period Methodology Main finding

Empirical studies on Bangladesh

Murshed et al. Bangladesh 1980–2014 Johansen Cointegration, A unidirectional causality between budget deficit and inflation in the short-
(2018) VECM run, whereas no causality between money supply M2 and inflation in both the
short-run and the long-run
Hussain and Bangladesh 1993–94 and VECM Fiscal deficit positively affects the GDP growth rate
Haque (2017) 2015–16
Haider et al. (2016) Bangladesh 2000–2012 VAR - VECM The budget deficit shows a significant negative impact on the GDP growth
and positive relation with inflation and exchange rate
Rana and Wahid Bangladesh 1981–2011 OLS, VECM, Granger The budget deficit has a significant negative impact on economic growth in
(2016) causality Bangladesh
Hassan and Akhter Bangladesh 1976–77 and VAR-VECM Approach A long-run negative relationship between budget deficit and GDP growth in
(2014) 2011–12 Bangladesh
Note(s): SUR 5 Seemingly Unrelated Regression, 2SLS 5 Two-Stage Least Squares
Source(s): Author’s research
221
variables on the

Table 1.
budget deficit
Macroeconomic
SAJBS Units and Expected
11,2 Variable Measurement scale Epithet Sign Sources

Dependent Budget Deficit National BD Bangladesh Economic

Currency Review (BER); Benson and
Billions Clay (2002)
Independent Real Effective Index REER Negative Bruegel Annual datasets
222 Exchange Rate
Gross Domestic National GDP Negative World Development
Product Currency Indicators (WDI)
Billions
Inflation, the average Percentage INF Positive World Economic Outlook
consumer prices change /Negative (WEO)
index
Trade as Share of Percentage TR Negative World Development
GDP change Indicators (WDI)
Broad Money National M2 Negative World Development
Table 2. Currency Indicators (WDI)
Summary and sources Billions
of the variables Source(s): BER, WDI, WEO

variables and budget deficit, this study uses the log-linear empirical model.
lnBDt ¼ β0 þ β1 lnREERt þ β2 lnRGDPt þ β3 lnlNFt þ β4 lnTRt þ β5 lnM2t þ εt (1)

where, BD is the budget deficit, REER is real effective exchange rates, GDP is a gross
domestic product, INF is inflation, TR is the volume of trade and M2 is money supply (broad
money) and β0 is constant, β1 ; β2 ; β3 ; β4 ; β5 are parameters or coefficients to be estimated
and ln is the natural log; ε is the error term and t is that the time.
The estimation of methodologies that are applied in the present study is the Johansen
Cointegration test, Vector Error-Correction Model (VECM) and Granger Causality test.

3.3 Econometric model estimation

3.3.1 Unit root tests. To analyze the long-run relationship among the variables, Johansen and
Julieu’s (1990) procedure suggests the use of a cointegration test that requires whether the
variables are stationary or not. The stationarity test is used to determine the order of
integration for each variable. A time series is said to have a unit root if it is nonstationary at
level but became stationary after the first differencing-integrated of order one. Therefore, the
Augmented Dickey and Fuller (ADF) test (Dickey and Fuller, 1979) and the Phillips-Perron
(PP) test (Phillips-Perron, 1988) are used to determine the order of integration.
3.3.2 Cointegration tests. The cointegration procedure requires a time series to be non-
stationary in their levels. Two or more non-stationary time series are said to be cointegrated if
they possess the same integration order of I (1) and a linear combination of these time series is
stationary I(0). If these variables are being cointegrated, then there is a long-run relationship
among these variables. The study uses the Johansen–Juselius procedure to find out multiple
cointegrating vectors. For this process, it takes the Vector of Autoregression (Var) in the
following form:
Xp−1
ΔYt ¼ α þ Πi ΔYt−1 þ ΠYt−p þ vt (2)
i¼1

where Δ is the difference operator, Yt is a column vector of n endogenous factors, α is a

constant, Π and Πi are n by matrices of unknown parameters, and vt is an error term. The
impact matrix Π capture all long-run connection between the variables. Johansen (1988) and Macroeconomic
Johansen and Julieu (1990) suggest the use of two statistical tests for cointegration, which are variables on the
known as the Trace test and the Maximum Eigenvalue test. These are estimated as follows:
Xn budget deficit
λtrace ðrÞ ¼ −T lnð1  bλi Þ (3)
j¼iþ1

λmax ðr; r þ 1Þ ¼ −T lnð1  bλrþ1 Þ (4) 223

where
λtrace test the null hypothesis r 5 0 against the alternative hypothesis of r > 0
T 5 number of sample size
bλ 5 eigenvalues or estimated characteristics root
λmax test the null hypothesis r 5 0 against the alternative hypothesis of r 5 1
If the null hypothesis of no cointegrating vector is not accepted, it indicates that there is a
long-run relationship among the variables in the model.
3.3.3 Vector error correction model (VECM). Engle and Granger (1987) enunciate that
when two series or variables are cointegrated at the same order of integration, for example,
I (1), then it is indispensable to apply the VECM to manage the combined nature of the
variables of the dynamic system. The significance of the VECM is that it considers the long-
run as well as the short-run adjustment, and it additionally provides evidence to the causal
elements that may influence variables.
Eqn (1) can be transformed into the VECM model as follows:
X
P X
P X
P
ΔlnBDt ¼ β0 þ λECMt1 þ β1 ΔlnREERt−j þ β2 ΔlnRGDPt−j þ β3 ΔlnINFt−j
i¼1 i¼1 i¼1

X
P X
P
þ β4 ΔlnTRt−j þ β5 ΔlnM2t−j þ εt
i¼1 i¼1

(5)

where β0 is a constant term, Δ is the difference operator, p denotes the lag length and λ is the
speed of adjustment, ECMt−1 is the lagged error term and εt are white noise disturbance
error term.
3.3.4 Granger causality test. For determining the direction of the causality between
macroeconomic variables and budget deficit in Bangladesh, this study used the Granger
Causality test. Engel and Granger (1987) state that if the cointegration connection exists
between two variables in the long-run model, then there must either bi-directional or
unidirectional causality between them. This test implies that given two variables X and Y, X
is caused by Y if X can be better predicted from past values of X and Y in the model rather
than using past values of X alone.
The Granger causality test for two stationary variables can be performed to test for the
following hypothesis:
H0. Xt does not cause Yt.
H1. Xt does cause Yt.
For determining the hypothesis that holds, the Granger Causality test is using the following
equations:
SAJBS X
p X
q

11,2 Xt ¼ α1 þ βiYt−i þ γ i Xt−j þ μ1t (6)

i¼1 j¼1

X
p X
q
Yt ¼ α2 þ δiXt−i þ θi Yt−j þ μ2t (7)
i¼1 j¼1

224 where α1 and α2 are constants, μ1t and μ2t are the white noise error terms, t denotes time and q
are respectively the number of lags for Y and X. These equations are based on the assumption
that μ1t and μ2t are uncorrelated white noise error terms.

4. Empirical results and discussions

4.1 Unit root tests
The presence of the unit root test is that if the time series is not stationary, then there is the
crux of spurious regression, which provides unreliable results. In order to avoid this problem,
it is necessary to examine the time series data for their stationary properties. For finding out
the order of integration, the ADF and PP unit root tests are used on levels and differences for
each variable in the model, and the results are presented in Table 3.
The unit root test results show each variable (lnBD, lnREER, lnGDP, lnINF, lnTR, lnM2)
are nonstationary at their level but became stationary after first differencing. Therefore, the
study can conclude that each of the variables is stationary and integrated order of 1 i.e. 1(1).
This result allows for the estimation of the Johansen cointegration test to determine the
existence of long-run relationships among the variables.

4.2 Johansen Cointegration test

Having confirmed that each of the variables is integrated of order 1, the Johansen
cointegration test is applied to analyze whether or not there exists a long-run relationship
among the variables. The Johansen cointegration test results are illustrated in Table 4.
The Johansen cointegration test results for the trace test shows that the number of the
cointegrating equation is two at the 5% level of significance while the maximum Eigen test
shows only one cointegrating equation. Since the power of the maximum Eigenvalue test is
greater than the trace test, this study employs the suggestion by the maximum Eigen test
statistics in estimating the Vector Error Correction Model (VECM). However, the Johansen
cointegration test results reveal that there exists a long-run relationship between budget
deficit and macroeconomic variables (real effective exchange rate, GDP, inflation, the volume
of trade and money supply). The long-run effect of the macroeconomic variables on-budget
deficit is presented in Table 5.

ADF PP
Variables Level First difference Level First difference Order of integration

lnBD 2.180 7.359 2.096 7.359 I(1)

lnREER 1.400 4.270 0.918 4.191 I(1)
lnGDP 1.243 4.550 1.637 4.595 I(1)
lnINF 3.401 8.077 3.236 9.669 I(1)
lnTR 2.949 6.686 3.027 6.675 I(1)
lnM2 2.213 4.643 2.213 4.614 I(1)
Note(s): To test ADF and PP, for the level form of the variables we take intercept and trend, and for the
Table 3. differences of the variables, we take only the intercept term. The 95% critical values for ADF and PP tests are
Results of unit 3.53 (with intercept and trend) and 2.94 (only with intercept)
root tests Source(s): Author’s estimations
 0.05 Max- 0.05
Macroeconomic
Hypothesized Trace critical Hypothesized Eigen Eigen critical variables on the
no. of CE(s) statistic value Prob.** no. of CE(s) value statistic value Prob.** budget deficit
None* 126.874 95.754 0.000 None* 0.764 53.476 40.078 0.001
At most 1* 73.398 69.819 0.025 At most 1 0.581 32.171 33.877 0.079
At most 2 41.227 47.856 0.182 At most 2 0.478 24.066 27.584 0.132
At most 3 17.161 29.797 0.628 At most 3 0.226 9.464 21.132 0.793 225
At most 4 7.697 15.495 0.498 At most 4 0.176 7.151 14.265 0.471
At most 5 0.546 3.841 0.460 At most 5 0.015 0.546 3.841 0.460
Note(s): Number of optimal lags, 1 based on SIC, and HQ information criteria’s result
*
denotes rejection of the hypothesis at the 0.05 level Table 4.
**
MacKinnon-Haug-Michelis (1999) p-values Results of Johansen
Source(s): Author’s estimations Cointegration

Independent variables Coefficient Std. error t-statistics

lnREER 4.161 ***

0.368 11.318
lnGDP 2.310*** 0.579 3.987
lnINF 0.705*** 0.072 9.819
lnTR 1.508*** 0.242 6.232
lnM2 1.917*** 0.391 4.903 Table 5.
***
Note(s): The sign of the coefficients are reversed in the long-run. indicates significance level of 1%, Results of long-run
respectively Coefficient: Long run
Source(s): Author’s estimations budget deficit model

Table 5 shows the normalized estimated long-run equilibrium nexus among real effective
exchange rate, GDP, inflation, money supply and budget deficit. Thus the estimated long-run
equilibrium nexus can be expressed as

lnBD ¼ 4:161lnREER  2:310lnGDP þ 0:705lnINF þ 1:508lnTR þ 1:917lnM2 (8)

The results from the long-run budget deficit model show that the coefficient of the real
effective exchange rate (lnREER) is a positive and statistically significant relationship with
a budget deficit, which confirms that the real effective exchange rate accelerates the rate of
the budget deficit. It means that the appreciation of the real effective exchange rate
(domestic currency) decreases the export supply of the country, and it leads to aggravating
the growth of the government budget deficit in Bangladesh. This appreciation of domestic
currency also leads to the current account deficit, and it affects the budget deficit positively.
A similar result is consistent with the Keynesian school and supported by the study that is
conducted by Chi-Chi and Ogomegbunam (2013), Ebimobowei (2013) and Mushtaq and
Zaman (2013).
Consistent with expectations, GDP has a negative and statistically significant impact on
budget deficit in the long run. The theory says that a higher level of income per capita leads to
a higher level of development that indicates the greater capacity to levy and collect taxes, and
this leads to a decline in the budget deficit, and their relationship is significant. This finding is
consistent with the Neoclassical School proposition that an increase in the GDP will reduce
the budget deficit. Similar results are also supported by the empirical study of Hassan and
Akhter (2014), Osuka and Chioma (2014), Brima and Mansaray-Pearce (2015), Dritsakis and
Stamatiou (2016), Epaphra (2017) and Nkrumah et al. (2018).
SAJBS Inflation has a positive and statistically significant effect on the budget deficit in the
11,2 long run. One possible explanation is that higher inflation leads to a decrease in
the amount of tax collection and a deterioration of real tax proceeds being gathered by the
government (Olivera, 1967; Tanzi, 1997). Hence due to the deteriorated revenue position,
the budget deficit increases. Another possibility is that the expansion in inflation lessens
the real value of government income, and along these lines requires it to borrow more to
meet the expenditure requirements (Aghevli and Khan, 1978). As a result, the budget
226 deficit increases. This result is also consistent with the Neo-classical theory and supported
by the previous studies like Olusoji and Oderinde (2011), Ezeabasili et al. (2012), Chi-Chi
and Ogomegbunam (2013), Murwirapachena et al. (2013), Brima and Mansaray-Pearce
(2015) and Epaphra (2017), which states that inflation leads to an increase in the budget
deficit.
Similarly, the volume of trade is positively contributed to the budget deficit in Bangladesh.
This is due to the reason that the volume of exports is less than the volume of imports in
Bangladesh. Therefore, low foreign exchange earnings are contributing less to the income of
the government, and payments against the imports are increasing the government
expenditures. As a result, the budget deficit increases with the increase in trade volume.
This finding agrees with the result of previous studies by Hassan and Kalim (2010) and Kalim
and Hasan (2013), which shows the share of trade volume has a positive impact on the budget
deficit in Pakistan.
Finally, the money supply has a positive and statistically significant effect on the budget
deficit in the long run. This is due to the reason that the money supply decreases revenues of
the government in real terms by increasing inflation. An increase in money supply in
developing countries like Bangladesh creates a deficit in the budget due to the immobility of
domestic resources, inflexible tax base structure and diminishing purchasing power
(Chaudhry and Shabbir, 2005). This result is in line with previous studies like Umeora (2013)
and Epaphra (2017), which show that the money supply has a positive effect on the budget
deficit in Nigeria and Tanzania, respectively.

4.3 Short-run dynamics (VECM)

Since the Johansen cointegration test results show the long-run nexus among the variables,
it is time to observe whether there any short-run deviation exists or not from the long-run
equilibrium path. Therefore, to identify the short-run dynamic relationship between
selected macroeconomic variables (real effective exchange rate, GDP, inflation, the volume of
trade and money supply) and budget deficit in Bangladesh, the vector error correction model
is employed. The results of the Vector Error Correction Model (VECM) are illustrated in
Table 6.
From Table 6 the estimated error correction term (ECTt1) shows the negative coefficient,
as expected and statistically significant, which ensures the existence of a long-run
causal relationship running from the real effective exchange rate, GDP, inflation, volume
of trade and money supply, to the budget deficit. The speed of adjustment of the error
correction term is 0.351, which implies that about 35.1% of the disequilibrium in
the previous year’s shock adjusts back to the long-run equilibrium in the current year.
Also, the short-run results of the VECM show that the real effective exchange rate has a
negative but insignificant relationship with the budget deficit in the short run. In line with the
long run estimation results, GDP has a negative and significant impact on the budget
deficit in Bangladesh. Similarly, inflation and money supply are statistically significant
and negatively related to the budget deficit in the short run. However, the volume of trade
has a positive but insignificant relationship with the budget deficit in the short run. The R2
shows 61.5% of the variation of the budget deficit is explained by the explanatory variables
Variables Coefficient Std. error t-statistic
Macroeconomic
variables on the
ECTt1 0.351*** 0.110 3.185 budget deficit
ΔlnBDt1 0.004 0.137 0.027
ΔlnREERt1 0.121 0.539 0.224
ΔlnGDPt1 1.897 *
0.975 1.947
ΔlnINFt1 0.163* 0.088 1.851
ΔlnTRt1 0.144 0.286 0.503 227
ΔlnM2t1 1.236** 0.456 2.711
C 0.486 0.146 3.318
R-squared 0.615 Durbin–Watson stat 2.389
Adjusted R-squared 0.568 Table 6.
F-statistic 2.819 The results of the
Prob.(F-statistic) 0.023 short-run dynamic
Note(s): Dependent Variable: ΔlnBD. *, **, ***indicates significance level of 10%, 5%, 1%, respectively relationship between
Source(s): Author’s estimations the variables (VECM)

and the reported F-statistic shows that the estimated VECM is statistically significant at a
5% level.

4.4 Granger causality tests

The Granger Causality test is employed to determine the direction of the causality between
macroeconomic variables and the budget deficit in Bangladesh. The granger causality test
results are given in Table 8.
The results from Table 7 show that there exists a unidirectional causal relationship
from budget deficit to the real effective exchange rate; money supply to the budget deficit
and volume of trade to the budget deficit. This finding implies that budget deficit granger
cause real effective exchange rate, and money supply and volume of trade granger affect
cause budget deficit in Bangladesh. The results also show a unidirectional causal
relationship from GDP to the real effective exchange rate, from money supply to real
effective exchange rate, from inflation to GDP and from money supply to GDP. However,
there is evidence of feedback effect or bilateral causality between GDP and budget deficit,
the volume of trade and real effective exchange rate, the volume of trade and GDP, and
money supply and volume of trade in Bangladesh. Similar results of these causal
relationships are found in Nigeria by Osuka and Chioma (2014), in Pakistan by Kalim and
Hassan (2013), in Uganda by Lwanga and Mawejje (2014) and in Sierra Leone by Brima and
Mansaray-Pearce (2015). In addition, there is no uni or bidirectional causal relationship
between inflation and budget deficit, inflation and real effective exchange rate, the volume
of trade and inflation, money supply, and inflation. Also, there is no causal relation from the
real effective exchange rate to the budget deficit, GDP and money supply, from budget
deficit to inflation and money supply, from GDP to inflation and money supply, from the
volume of trade to GDP and inflation, from inflation to real effective exchange rate and
from money supply to inflation.

4.5 Diagnostic tests

The diagnostic and stability test is essential for checking the reliability and robustness
of the VECM model. Table 8 illustrates the diagnostics test for the VECM model. The
model is free from the issues of non-normality of the errors, and serially correlated errors,
ARCH effect and heteroskedasticity from the probability values are more than a 5% level.
SAJBS Null hypothesis F-statistic Prob Decision about the direction of causality
11,2
lnREER does not Granger Cause lnBD 0.658 0.423 Accept H0
lnBD does not Granger Cause lnREER 8.161 0.007*** Reject H0
***
lnGDP does not Granger Cause lnBD 10.633 0.003 Reject H0
lnBD does not Granger Cause lnGDP 6.849 0.013** Reject H0
lnINF does not Granger Cause lnBD 0.046 0.832 Accept H0
228 lnBD does not Granger Cause lnINF 0.133 0.718 Accept H0
lnTR does not Granger Cause lnBD 3.881 0.057* Reject H0
lnBD does not Granger Cause lnTR 0.051 0.822 Accept H0
lnM2 does not Granger Cause lnBD 9.170 0.005*** Reject H0
lnBD does not Granger Cause lnM2 2.588 0.117 Accept H0
lnGDP does not Granger Cause lnREER 5.393 0.026** Reject H0
lnREER does not Granger Cause lnGDP 1.791 0.190 Accept H0
lnINF does not Granger Cause lnREER 0.647 0.427 Accept H0
lnREER does not Granger Cause lnINF 0.005 0.944 Accept H0
lnTR does not Granger Cause lnREER 7.283 0.011** Reject H0
**
lnREER does not Granger Cause lnTR 4.685 0.037 Reject H0
lnM2 does not Granger Cause lnREER 4.964 0.032** Reject H0
lnREER does not Granger Cause lnM2 0.012 0.914 Accept H0
lnINF does not Granger Cause lnGDP 15.120 0.000*** Reject H0
lnGDP does not Granger Cause lnINF 0.643 0.428 Accept H0
lnTR does not Granger Cause lnGDP 3.651 0.064* Reject H0
lnGDP does not Granger Cause lnTR 6.425 0.016** Reject H0
lnM2 does not Granger Cause lnGDP 4.826 0.035** Reject H0
lnGDP does not Granger Cause lnM2 0.279 0.601 Accept H0
lnTR does not Granger Cause lnINF 0.475 0.495 Accept H0
lnINF does not Granger Cause lnTR 0.421 0.521 Accept H0
lnM2 does not Granger Cause lnINF 0.474 0.496 Accept H0
lnINF does not Granger Cause lnM2 0.070 0.794 Accept H0
**
lnM2 does not Granger Cause lnTR 7.053 0.012 Reject H0
Table 7. lnTR does not Granger Cause lnM2 4.598 0.039** Reject H0
Pairwise granger Note(s): *, **, ***indicates significance level of 10%, 5%, 1%, respectively
causality test result Source(s): Author’s estimations

Test type Null hypothesis Statistic Probability Inference

Normality test (Jarque-Bera Errors are normally Jarque-Bera Probability 5 0.126 Fail to
statistics) distributed Statistics 5 3.872 reject H0
Serial correlation (Breusch- No serially correlated F-statistics 5 1.615 Prob. Chi- Fail to
Godfrey serial errors Square 5 0.154 reject H0
correlation LM test)
ARCH test (Autoregressive ARCH effect does not F-statistics 5 0.322 Prob. Chi- Fail to
Heteroskedasticity characterize Square 5 0.573 reject H0
Test) model’s errors
Table 8. Heteroskedasticity Homoscedasticity F-statistics 5 0.441 Prob. Chi- Fail to
Diagnostic test results Test Square 5 0.877 reject H0
based on the residuals (Breusch-Pagan-Godfrey)
of the VECM model Source(s): Author’s estimations

The result of the stability test considering both the CUSUM and CUSUMQ plot lies within
the bounds of the critical line at a 5% significant level that confirms the stability of the
coefficients, and therefore, the correct specification of the VECM model (see Figures 1
and 2).
 16 Macroeconomic
12
variables on the
budget deficit
8

0
229
–4

–8

–12

–16
90 92 94 96 98 00 02 04 06 08 10 12 14 16 18

Figure 1.
CUSUM 5% Significance
Plot of cumulative
sum (CUSUM)
Source(s): Author’s estimations

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

–0.2

–0.4
90 92 94 96 98 00 02 04 06 08 10 12 14 16 18
Figure 2.
CUSUM of Squares 5% Significance
Plot of cumulative sum
of squares (CUSUMQ)
Source(s): Author’s estimations

5. Conclusion
The study investigates the impact of the selected macroeconomic variables like real effective
exchange rate, GDP, inflation, the volume of trade and money supply on-budget deficit in
Bangladesh for the period 1980 to 2018 by applying Johansen cointegration, VECM and
Granger Causality tests. The Johansen cointegration result shows that the variables are
cointegrated, and thus, have a long-run nexus between selected macroeconomic variables and
budget deficit. The empirical results from the long-run model indicate that the real effective
exchange rate, inflation, volume of trade and money supply has a positive and significant
impact on the budget deficit in Bangladesh. These findings are in line with the Keynesian
SAJBS school proposition that there exists a positive nexus between budget deficit and
11,2 macroeconomic variables (real effective exchange rate, GDP, inflation, the volume of trade
and money supply), which states that an increase in these variables raises budget deficit. GDP
has negative and significant effects on budget deficit both in the long run and short run,
which reduces budget deficit significantly. This result is in conformity with the Neo-classical
theory, which states that GDP leads to a decrease in the budget deficit. The results of the
VECM show that there exists a long-run causal nexus running from the real effective
230 exchange rate, GDP, inflation, volume of trade and money supply to the budget deficit.
Considering in the short run, GDP, inflation and money supply have a significant negative
impact on the budget deficit in Bangladesh. The real effective exchange rate is negatively
related, and the volume of trade is positively related to the budget deficit, although these
variables are statistically insignificant.
The Granger Causality results show that there is a unidirectional causal relationship from
budget deficit to real effective exchange rate; from the volume of trade to the budget deficit;
from money supply to the budget deficit; from GDP to real effective exchange rate; from
money supply to real effective exchange rate; from inflation to GDP; from money supply to
GDP and bidirectional causal relationship between GDP and budget deficit; the volume of
trade and real effective exchange rate; GDP and volume of trade; money supply and volume of
trade in Bangladesh. The diagnostic test shows that there are no serial correlation,
misspecification, non-normality and heteroscedasticity issues in the error term of the long-
run budget deficit model. Based on the overall findings, the study concludes that
macroeconomic variables have a significant impact on the budget deficit in Bangladesh.
Similar results are also supported by the empirical study of Kalim and Hassan (2013), Osuka
and Chioma (2014), Brima and Mansaray-Pearce (2015), Epaphra (2017), which shows that
macroeconomic variables have a significant impact on the budget deficit in Pakistan, Nigeria,
Sierra Leone, Tanzania, respectively.

5.1 Policy implications

The study results have some policy implications on the impact of macroeconomic variables
on the budget deficit and way of finance. The policy implication is given below:
(1) The Government of Bangladesh should decrease the size of the budget deficits,
mainly by increasing domestic revenue mobilization through tax base expansion
while lessening foreign and borrowing deficit financing. The tax base can be
extended by bringing down the size of the informal sector, battling against corruption
and tax avoidance, decreasing unproductive tax exemption and overall efficiency
improvement in tax organization. A decrease in the overall recurrent expenditure bill
compared to GDP may also assist with relieving the budget deficit problem that leads
to the accumulation of debt in Bangladesh.
(2) Since its independence, the volume of trade in Bangladesh has remained negative.
The government should be taken some steps and revamp the trade policy to control
the negative trade balance. This is possible by increasing exports by improving the
quality of products and by capturing more international markets. For reducing
imports, the import substitute industry must be installed by providing an enabling
environment for both domestic and foreign investors.
(3) Since in the long-run, inflation and money supply can significantly increase the
budget deficit, the government should impose fiscal policies and control inflation to
restrict CPI and money supply. To prevent too much money in circulation that might
lead to inflation, the excessive budget deficit to be avoided by all costs by the
government, and recurrent expenditure should be reduced to the barest minimum.
 (4) However, as GDP can help to reduce the budget deficit, this is an interesting Macroeconomic
implication for the government that fostering GDP growth rate is an effective way to variables on the
lessen the budget deficit.
budget deficit
(5) In the long run, the exchange rate and money supply may significantly impact the
budget deficit. Therefore, the government should keep these two variables stable so
that the budget deficit is appropriately predicted and managed.
231
5.2 Limitations and suggestion for further studies
It is advantageous to specify that macroeconomic variables that are identified with budget
deficits are various, and in this way, it is hard to consolidate every one of them in one study.
For investigating further connections between budget deficits and macroeconomic variables,
the future examination could incorporate variables like interest rate, gross fixed capital
formation, foreign direct investment, labor force and unemployment. Moreover, the future
investigation may stretch out the examination to catch the causal connection between budget
and current account deficits.

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Corresponding author
Sanjoy Kumar Saha can be contacted at: skumarsaha9@gmail.com

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