LITERATURE REVIEW

Impact of Inflation on Government Spending

Taruna Bajaj

There appear to be two schools of thoughts regarding this relationship. Some believe that
government spending has a bidirectional relationship with inflation while other authors think
that there is just a unidirectional causality that flows from government expenditure to
inflation. Ezirim & Ofurum (2003), were among the first ones to have attempted to
investigate the relationship between public expenditure and inflation. The study attempts to
examine empirically the structure and growth of federal government expenditure in Nigeria.
The ordinary least squares (OLS) method was the main method applied to estimate data. The
results revealed that there was a positive coefficient of inflation i.e. there exists a positive
relationship between inflation and growth of public expenditure. This is inline with the
relevant economic theory that a unit increase in inflation rate will lead to an increase in
government expenditure.

Mostafavi (2007) in a paper examines the causal relationship between inflation and money in
Iran. For this purpose, a method of Granger causality in inflation and Johansen’s weak
exogeneity test is used. The study reveals that real government spending has a positive and
significant effect on inflation.

Ezirim, Muoghalu, & Elike (2008) in their paper indicate that public expenditure and
inflation are cointegrated and thus there exists a long-run equilibrium relation between the
two variables. Inflation significantly influences public expenditure decisions in the United
States of America. They also show that there exists a bicausational relationship between
public expenditure growth and inflation in the United States of America. This implies that
inflation causes public expenditure growth and vice versa; both in the short run and in the
long run. They applied Cointegration analysis and Granger Causality Model to Time Series
Annual Data from 1970 – 2002.

Magazzino (2011) tries to assess the empirical evidence of the nexus between public
expenditure and inflation for the Mediterranean countries during the period 1970-2009, using
a time series approach. Granger causality tests results at 1% significance level show a long
run relationship between the growth of public expenditure and inflation only for Portugal.
Furthermore at 10% significance level the Granger causality test shows a short-run evidence
of a directional flow from expenditure to inflation for Cyprus, (5% significance level) Malta
and Spain. There appears a bidirectional flow for Italy and a flow from inflation to public
expenditure for France. We thus see an inflation Granger-cause public expenditure growth in
few cases.

Olaiya, Ifeachukwu, & Ditimi (2012), investigated the extent of causality among economic
growth, public expenditure and inflation rate in Nigeria for the period 1970-2010. The Vector
Error Correction (VECM) estimate revealed a unidirectional causality in the short run from
economic growth and government expenditure to inflation rate. The implication of this result
is that increase in government spending can enhance economic growth but at the same time
can cause inflation rate in the economy. The study utilized both the Augmented Dickey-
Fuller (ADF) and the Philip Perron tests to examine the properties of the variables.

Olayungbo (2013), examines asymmetry causal relationship between government spending

and inflation in Nigeria from the period of 1970 to 2010. The asymmetry causality test shows
that a unidirectional causality exists from negative government expenditure changes to
positive inflation changes (high inflation) in the Vector Autoregression (VAR) model. The
finding implies that is high inflation is caused by low or contractionary government spending.

Pandey & Shettigar (2018), took total central government expenditure in India as a proxy for
fiscal policy initiatives and used VECM and ARDL-bound testing for estimating the long run
relationship between fiscal policy initiatives and inflation in India. According to them, if
fiscal expenditure is given a positive shock of 100% then its cumulative impact on WPI based
inflation in the country in 5 years would be 14%.

Oyerinde (2019), through his study showed that apart from the bi-directional relationship that
exists between the variables, there also exists a strong relationship between government
expenditure and inflation rate and that a significant impact is sustained from the short run
through the long run. His region of study was Nigeria and the secondary data was analysed
using Johansen Cointegration Analysis and VECM.

Thus, we see that though there exists a significant relationship between government
expenditure and inflation it is not so easy to judge whether the causality is unidirectional or
bidirectional. This problem seems to be present even after most of the authors in this subject
use the same methodology to analyse data, they use but conclusions vary within them. One
reason that can be ascertained to such variations in data is that not much research has been
done only on the topic regarding the impact of inflation on government spending. There can
always be found ample examples of how inflation and government expenditure impact
economic growth together and individually. Thus, there seems to be a need to dedicate
research more focused on estimating the nature of the relationship between government
expenditure and inflation to arrive at better results which can stand all grounds.

Works Cited

Ezirim, B., & Ofurum, C. (2003). Public Expenditure Growth and Inflation in Developed and Less
Developed Countries. Nigerian Business and Social Review Vol 2 No. 1. January, 75-94.

Ezirim, C., Muoghalu, M., & Elike, U. (2008). Inflation versus Public Expenditure Growth in US: An
empirical investigation. North American Journal of Finance and Banking Research Vol 2 No. 2.

Magazzino, C. (2011). The Nexus Between Public Expenditure and Inflation in the Mediterranean
Countries. Theoretical and Practical Research in Economic Fields, Assosciation for
Sustainable Education, Research and Science, Vol (0)1, June, 94-107.

Mostafavi, M. (2007). Casual Relationship Between Money and Inflation in Iran. Journal of
Quantitative Economics, Journal of Economic Studies; 3(14), 3-17.

Olaiya, A., Ifeachukwu, N., & Ditimi, A. (n.d.). A Trivariate Causality Test among Economic Growth,
Government Expenditure and Inflation Rate: Evidence From Nigeria. Research Journal of
Finance and Accounting, Vol 3 No. 1 .

Olayungbo, D. O. (2013). Government Spending and Inflation in Nigeria: An Asymmetry Causality

Test. International Journal of Humanities and Management Sciences (IJHMS) Volume 1, Issue
4, 238-242.

Oyerinde, A. A. (2019). An Assessment of the Nexus between Government Expenditure and Inflation
in Nigeria. Folia Oeconomia Stetinensia Volume 19 Issue 2.

Pandey, A., & Shettigar, J. (2018). Impact of Fiscal Policy Initiatives on Inflation in India. Advances in
Finance and Applied Economics, (10.1007/978-981-13-1696-8_7), 105-118.