DEFICIT FINANCING, INFLATION AND CAPITAL FORMATION IN NIGERIA, 1970-2017

Abstract

Deficit financing (DF) is the excess of government expenditure over its revenue. The DF occasioned by low domestic savings and low capital formation (CF), have characterised the Nigerian economy since the 1970s with attendant increase in inflation. Empirical studies on Nigeria have shown that DF directly affects inflation and CF when examined independently. But, little attention has been paid to a simultaneous investigation of the direct and indirect effects of DF on inflation and CF in Nigeria. Therefore, this study was designed to examine the direct and indirect effects of DF on inflation and CF. The DF was disaggregated into three components, and their direct and indirect effects on inflation and CF were examinedfor Nigeria from 1970 to 2017.

The Keynes-Wicksell Three Asset Money Growth Theory provided the framework. A simultaneous model that shows the linkage among DF, inflation and CF was estimated. Aggregate DF and its three components: domestic financing (DMF), external financing (EF), and other sources of financing (OSF) were used for the estimation. Inflation and CF were proxied bythe consumer price index and gross fixed capital formation, respectively. DF’s direct and indirect effects on inflation and CF were estimated by a linear and chain rule equation, respectively. The indirect effect of DFon inflation was through the broad money supply channel, while the indirect effect of DF on CF was through the broad money supply and inflation channels. The Generalised Method of Moments and the Two Stage Least Squares were used for the estimation. Data were sourced from the Central Bank of Nigeria Statistical Bulletin,International Monetary Fund Investment and Capital Stock Dataset, World Development Indicators and Open Data for Africa.All estimates were validated at ∝≤0.05.

Aggregate DFindirectly increased inflation by 0.01% (t= 3.41). The DMF and EF indirectly increased inflation by 0.01% (t= 9.21) and 0.001% (t= 5.22) respectively, while OSF indirectly decreased inflation by -0.02% (t= -3.79).Inflation deteriorated CF by -0.2%(t= -4.88) with aggregate DF and by -0.2% (t= -6.07), -0.18% (t= -4.55) and -0.22% (t= -6.29) with DMF, EF and OSF, respectively. Aggregate DF, DMF and EF indirectly reduced CF by -0.002% (t= -2.12), -0.001% (t= -7.26) and -0.0002% (t= -5.84) respectively, OSF directly increased CF by 0.03% (t= 2.12) and indirectly by 0.004% (t= 5.89). The aggregate DF affected inflation indirectly through the money supply channel. Inflation impacted on capital formation through reduced real returns on savings and investments. The DF indirectly influenced CF through money supply and inflation channels to reducecapital formation.

Deficit financing in the aggregate and its components indirectly impacted on inflation and capital formation in Nigeria from 1970 to 2017. Therefore, there is a need for better synergy of fiscal and monetary policies for effective control of inflationand growth of capital formation.