Analyzing the relationship between Fiscal Deficit and Inflation: The Case of Egypt

Abstract

For decades, Egypt has had a chronic fiscal deficit and high inflation problem. Recently, both variables have been trending downward due to COVID-19 and the implementation of the economic reform programme in 2016. This study reinvestigates the relationship between the fiscal deficit and inflation from 1981 to 2020 using the Vector Error Correction Model (VECM) and the Granger causality test. The results indicate that fiscal deficit has a significant effect on inflation in the long run, as the increase in fiscal deficit increases the inflation rate. The results of the Granger causality test reveal a two-way causality relationship between fiscal deficit and inflation in the short run. This relationship is captured through the causal effect of money supply on the inflation rate and the interest rate. The interest rate also affects the fiscal deficit which eventually affects the inflation rate. On the other hand, the interest rate does not seem to affect the inflation rate in the short run. These results indicate that the problem of inflation in Egypt seems to be a fiscal rather than a monetary phenomenon. Breaking the vicious circle of the fiscal deficit, money supply growth, and the interest rate represents a critical factor in dealing with Egypt's inflation and fiscal deficit.