KOTEBE METROPOLITAIN UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

TITLE: DETERMINENT OF BUDGET DEFICIT IN ETHIOPIA

DEPARTMENT OF ECONOMIC RESEARCH PROPOSAL SUBMITTED TO
DEPARTMENT OF ECONOMICS IN THE PARTIAL FULFILLMENT OF
REQUIRMENT FOR BACHELOR OF ART (BA) DEGREE IN ECONOMICS

PREPARED BY:
NAME ID NO
BELYIHUN GETACHEW weco-011/11

ADVISOR; ABENEZER W.

KOTEBE, ETHIOPIA, 2013 E. C

Declaration
The researcher undersigned, declare that this study entitled “the determinant of
budget deficit in Ethiopia”. That all sources of materials are used for the research
have been duly acknowledged.

Acknowledgement
First of all I would like to thanks Jesus Christ with his Mother ST-Merry because they are the
base a base for whom I am today for doing all these and make my dream start a journey of
success.
Also I would like to express my deepest appreciation and gratitude to my Advisor Mr. Haile-
Michael who gave me good advice, suggestion, and constructive comment.
Let me say in my words Mom all these are by and for you. Thank you very much for everything
you did in my life. I also owe to my Dad and all my relatives for their potential help during my
life in university.
Finally, thanks to all whom wish my success
Table Content
Declaration..................................................................................................................................................1
Acknowledgement.......................................................................................................................................2
ACRONYMS..................................................................................................................................................7
Abstract.......................................................................................................................................................8
CHAPTER ONE............................................................................................................................................10
1.INTRODUCTION......................................................................................................................................10
1.1 BACKGROUND OF THE STUDY..........................................................................................................10
1.2 STATEMENT OF THE PROBLEM........................................................................................................12
1.3 RESEARCH QUESTION......................................................................................................................13
1.4 Objective of the study......................................................................................................................14
1.4.1 General objective......................................................................................................................14
1.4.2 Specific objective......................................................................................................................14
1.5 Hypothesis.......................................................................................................................................14
1.6 Scope of the study...........................................................................................................................15
1.7 Significance of the study..................................................................................................................15
1.8 Limitation of the study.....................................................................................................................15
1.9 Organization of the study................................................................................................................15
CHAPTER TWO...........................................................................................................................................16
2. LETRATURE REVIEW...............................................................................................................................16
2.1. Theoretical literature reviews.........................................................................................................16
2.1.1 Concept of budget deficit.........................................................................................................17
2.1.2 Current account........................................................................................................................17
2.1.3 Causes of budget deficit...........................................................................................................17
2.1.4 Method of deficit financing......................................................................................................18
2.1.4.1 Drawing from reserves..........................................................................................18
2.1.4.2 Domestic borrowing.............................................................................................19
2.1.4.3 External borrowing................................................................................................19
2.1.4.4 Money printing......................................................................................................19
2.1.5 Determinant of budget deficit..................................................................................................19
2.2 EMPIRICAL LETRATURE....................................................................................................................20
CHAPTER THREE........................................................................................................................................23
3. METHODOLOGY OF THE STUDY.............................................................................................................23
 3.1 Introduction.....................................................................................................................................23
3.2 Data Description and Source...........................................................................................................23
3.3 Methods of data analysis.................................................................................................................23
3.3.1 The Unit Root test of stationary................................................................................................23
3.4 Model specification.........................................................................................................................24
3.5 Description of the variable..............................................................................................................24
3.5.1 Dependent variable..................................................................................................................24
3.5.2 Explanatory variables................................................................................................................25
3.6 Model diagnosis...............................................................................................................................26
3.6.1 Testing stationary.....................................................................................................................26
3.6.2 Heteroscedasticity test.............................................................................................................27
3.6.3 Auto correlation test.................................................................................................................27
3.6.4 Multicollinearty test.................................................................................................................27
CHAPTER FOUR..........................................................................................................................................28
4. DESCRIPTIVE AND ECONOMETRIC ANALYSIS.........................................................................................28
4.1. DESCRIPTIVE ANALYSIS...................................................................................................................28
4.1.1. Government Budget deficits....................................................................................................28
4.1.2. Total government revenue.....................................................................................................29
4.1.2.1. Foreign trade tax...................................................................................................30
4.1.2.2. Indirect tax...........................................................................................................30
4.1.2.3. DIRECT TAX......................................................................................................31
4.1.2.4. Non tax revenue...................................................................................................31
4.1.3. Government Expenditure.......................................................................................................31
4.1.3.1. Current expenditure...........................................................................................32
4.1.3.2. Capital expenditure..............................................................................................32
4.1.4. Real GDP Annual Growth rate..................................................................................................33
4.1.5. Real GDP per capital................................................................................................................34
4.1.6. Inflation rate............................................................................................................................35
4.1.7. External Debt...........................................................................................................................37
Source: own compilation from WB (2019)................................................................................................37
4.2. Econometric Analysis.....................................................................................................................38
4.2.1. Results of ordinary least square (OLS) estimation...................................................................38
4.2.1.1 Stationary test........................................................................................................38
4.2.1.2 Testing the significance of the model.................................................................40
 4.2.1.3 Heteroscedasticity test...........................................................................................40
4.2.1.4 Auto-correlation test..............................................................................................41
4.2.1.5 Multicollinearity test..............................................................................................42
CHAPTER FIVE............................................................................................................................................43
5. Conclusion and Recommendation.........................................................................................................43
5.1. Conclusion......................................................................................................................................43
5.2. Recommendation...........................................................................................................................44
REFERENCE................................................................................................................................................45
Appendix One............................................................................................................................................46
Appendix Two............................................................................................................................................47
ACRONYMS
OLS ___________________________________ Ordinary least square
LDC s __________________________________ Least developed countries
GDP ___________________________________ Growth domestic product
NBE ___________________________________ National bank of Ethiopia
MoFED ________________________________Minister of Finance and Economic development
ECA ___________________________________ Economic commission for Africa
SAP ___________________________________ Structural adjustment policies
MLFIs _________________________________ Multilateral financial institution
Abstract
The purpose of this study was to investigate determinants of budget deficit in Ethiopia by using
time series data from 1985 to 2018. The study used quantitative research approach and
secondary data are analyzed by using multiple linear regression models. The OLS method was
applied to investigate the impact of real GDP annual growth rate, real GDP per capital,
external debt and inflation rate on budget deficit. The explanatory variables that of real GDP
annual rate and inflation rate within this study have positive effect on the budget deficit and the
others have negative effect. The empirical results show that three explanatory variables (real
GDP annual rate, real GDP per capital, external debt) were statistically significant whereas
inflation rate were statistically insignificant. Finally, the researcher have made conclusion and
recommendation based on the analyzed results.
Keywords; Budget Deficit; Real GDP annual rate; Real GDP per capital;
External debt; Inflation rate; Ethiopia.
 CHAPTER ONE
1. INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Fiscal Imbalance is among one of the prime macroeconomic problems for all the policy advisors
of the world. If a country experiences fiscal deficit in its budget then to finance it, a country has
to rely on the both domestic and foreign borrowings which ultimately declines the self-respect of
the country as whole and citizens of the country as well. Therefore, a country has to keep balance
between its expenditure as compared to public revenue entails many implications on the
functioning of the economy. There has been persistent rise in fiscal deficits in most of the
developed and developing countries.
This issues surrounding budget deficit are not certainly new, but the economic development of
the past decades has led to renewed interest in the fiscal themes. Government budget deficit is a
perennial topic of debate among policy makers. Traditional view of government deficit taken by
most economist said that when government runs a budget deficit and issues deficit. It reduces
national saving which in turn lead to lower investment and a larger foreign debt. This view
concludes that government debt places burden on future generation. While Ricardian view of
government deficits stress that budget deficits merely represent a substitution of future taxes for
current taxes. Budget deficit of government may affect a nation’s role in the world economy
(Mankiw 7th Edition 2007).
In recent years’ government spending LDC s has increased significantly. This is mainly
attributed to the fact that the governments of LDC s are involved in social, political and
economic affairs. Meanwhile revenues do not grow rapidly in the same proportion as expenditure
due to narrow taxes basis and inefficient tax collection of systems resulting in a budget deficit. In
industrial countries, too, the failure of market mechanism in 1930s (during great depression)
calls for government intervention in the economy paving the way for increased government
expenditure in those countries.
Despite the consensus on the need to reduce budget deficit, LDCs offer a wide range of
expenditure with budget deficit. From country to country budget led to high and variable
inflation with crowding out of investment and growth. While in some countries moderately high
budget deficit seem not to generate macroeconomic imbalance at all. The explanation for this
different outcome is that different governments adopt different techniques of financing their
deficits.
In an effort to escape sever poverty in developing countries like Ethiopia the role of government
in the economy is indispensable because government engages on building roads, different power,
generating plant, communication facilities, schools and health facilities. However; government is
constrained by under developed financial sector, high informal sectors, erratic nature of the tax
collection (Adunya, 1997) and (Yemane, 2008). This in turn enlarge the gap between
government expenditure and revenue receipt then leads to large and persistent budget deficit
which is possibly linked to monetary expansion, inflation, reduced competitiveness of domestic
producers (appreciation of real exchange rate) and eventually runs to trade and current account
deficit.
Ethiopia faces big budget deficit. The combined effect of a very rapid increase in expenditure
and a relatively slower increase in revenue is obviously increase governments budget deficit. The
budget deficit including grants increased from a little less than one billion birr in 1996/97 to over
6 billion in 1999/00. The fast increase in the budget deficit has started in 1997/98 when it more
than doubled from its previous year level to 2.1 billion birr again doubling to 4.5 billion birr in
1999/00. Budget deficit excluding grants increased from about 2.5 billion birr in 1996/97 to over
7.7 billion birr in 1999/00. The deficit excluding grants rose to as high as 15% of GDP in
1999/00 from its level of 6% in 1996/97 increasing to 7.5% and 13% in the following two years.
This is a significant and certainly unsustainable increase in the country’s budget deficit and
compares unfavorably with the average level of deficit of both the early years of a new
government (4% including grants) and the last years of the Dergue (8% including grants. In
general budget deficit is increase from time to time (Befekadu Degefe, Berhanu Nega,
Getahun Tafesse, 200/01).
The annual increase in the federal budget is a key manifesto of this approach. As a result, the
deficit is increasing, debt is a heavy burden, and inflationary money printing has become the
norm. This adds up to a considerable economic risk. The deficit for fiscal year that began in July
2016 doubled to 60 billion birr as revenue and grants growth was outpaced by expenditure.
While income increased by 10% to 269 billion birr, expenditures expanded by 21% to 329 billion
birr. The spending budget for the financial year that just ended was 321 billion birr. With an
ambitious tax-collection target, the budget deficit was 54 billion birr. Additional spending of 14
billion birr was requested during the fiscal year without identifying plausible revenue sources.
The government apparently has not learned any lessons from the preceding years under
performance in collection and the consequent gaping deficits. For this budget year, which began
on July 8, the spending budget increased by 3.6 percent to 347 billion birr. Although that
represent a slower rate of spending growth, despite last year huge underachievement in tax
collection, revenue from local sources is budgeted to increase by 6.6 % to 236 billion birr-this is
not credible. Regardless, the budget was approved by parliament without serious debate.
1.2 STATEMENT OF THE PROBLEM
Government budget deficits happen when government spending is higher than tax revenue. It
represents negative value in national saving, which would reduce the whole value of national
saving. Total savings of the economy will shrink, shifting the supply curve in the loanable funds
market left. This will raise the real interest rate and encourage foreigners to invest in the
domestic economy, leading to exchange rate appreciation. This makes domestic goods and
services more expensive relative to foreign goods. Therefore, the countries import more and
export less, increasing the trade deficit.
Attaining a sound macroeconomic balance has become a priority of industrial and developing
country economies in the measurement of government success. Ethiopia has a long economic
history characterized by macroeconomic imbalance, one of which the gap between government
spending and revenue. It is perceived that a larger deficit always signifies a more expansionary
fiscal policy. But that is not always true, because during recession as GDP falls, the
government’s most important source of tax revenue; income taxes, corporate taxes, and payroll
taxes all shrink because firms and people pay lower taxes when they earn less (Carlos. R 2003).

According to Sill (2012) the expenditure of an entity, which exceeds the earning or income it has
termed as budget deficit. In the absence of financing from external source the deficit carry
forward to next financial year. The deficit can be a result of delays in collection of the revenues
i.e. Sales, taxes other macroeconomic variables represents one of the most widely debated topics
among economists. Ethiopians budget deficit has been increasing over time. For instance, the
overall fiscal balance in Ethiopia has moved from surplus in the early 1950 to a balance budget
up to the mid- 1960 and rather small deficit in 1964 to 1974. Following the 1974 revolution the
government of Ethiopia increased its participation in economic activities through nationalization
of private enterprises this leads to the country to large budget deficit (National Bank of Ethiopia
annual reports).
Hence, the study attempts to observe the determinants of budget deficit in Ethiopia. Our
research contributes to fill the research gap on the determinant of budget deficit in Ethiopia. This
type of paper has been ever conducted in the case of our country used some variable like; real
GDP annual growth rate, inflation rate, real exchange rate, real GDP per capital and real interest
rate. Even if the various factors (determinants) of budget deficit of Ethiopia is addressed in
different period, our paper is different by the time period that it covered from 1985-2018 and the
other is variable gap by including External debt. The Study also analyzes the significance of each
determinant of budget deficit and their implication on the Ethiopia economy by using both
econometric method and descriptive methods of analysis using the data from the period 1985 to
2018. Finally, the study attempts to find out the significant determinants of budget deficit in
Ethiopia and arrived at the concluding remarks. .

1.3 RESEARCH QUESTION

 The main research question is to establish how the External debt and other factors relate
to the budget deficit in Ethiopia?
 Sub-question

i. Which factor significantly affect budget deficit?

ii. What are the policy implications for the study findings/ research find?

1.4 Objective of the study

1.4.1 General objective
The main objective of this study is to investigate the determining/factors of budget deficit in
Ethiopia.
1.4.2 Specific objective
 To assess the effect of the real GDP annual growth rate on budget deficit.
  To assess the effect of the real per capital GDP on budget deficit.
 To assess the effect of the inflation rate on budget deficit.
 To assess the effect of the external debt on budget deficit.

1.5 Hypothesis
The following relationships are hypothesized based on the earlier studies and tested with
reference to the time series data as follow;
 There is positive relationship between real GDP annual growth rate and budget deficit.
 There is positive relationship between real per capital GDP and budget deficit
 There is negative relationship between external debt and budget deficit.
 There is negative relationship between the inflation rate and budget deficit.

1.6 Scope of the study

This study is limited both in time and geographical coverage or place. This study is also covered
from the period of 1985 up to 2018. Because it was time series study and its geographical
restrictions are in Ethiopia. The focus of this study is the determinant of determinant of budget
deficit in Ethiopia.

1.7 Significance of the study

Our study conducted on the determinants of budget deficit at national level.
The study is significant in the context of the following:
 Provides information about the determinants of budget deficit.

 Shows the proper measures taken to reduce budget deficit.

 Finally, this study may also give a clue for further study about determinants of budget deficit
in the future.

1.8 Limitation of the study

To conduct this paper the researcher faced many constraints like time, financial, internet access
and availability of consistent time series data. Despite the above constraint by changing the
constraint in to opportunity, the researcher will be able to accomplish this research in good
manner.

1.9 Organization of the study

Organization of the study the study is organized in to five chapters. The first chapter of study
deals with background of the study, statement of the problem, objective of study, hypothesis,
significance of the study, scope of the study, limitation of the study and organization of the
study. The second chapter discusses the theoretical literature on budget deficit, means of
financing budget deficit. In addition review of the empirical literature is dealt. The third chapter
deals with the methodoly of the study. Chapter four deals with the discussion and review of
descriptive and econometrics issue. Under the econometrics issue: specification of the model,
tests and interpretation of the results. Finally concluding remarks and policy implication of the
study are discussed in chapter five.

CHAPTER TWO

2. LETRATURE REVIEW
This chapter covers theoretical and empirical literature review related to the study. In order to
provide suitable theories and empirical evidence on the topic investigation, the researcher has
reviewed a number of existing literature; these are helps to explain some key terms, which will
be relevant to the study and the researcher has also reviewed other researchers discussion related
to the study area.

2.1. Theoretical literature reviews

Theories of budget deficits run in two general ways. Some theories look on the effect of budget
deficits on economic variables, while others look on the reverse direction, that is, what
macroeconomic and budget variables (including budget rules and institutions) affect and
determine budget deficits. Therefore our paper was depending on the determinant of budget
deficit.
The Neoclassical school proposes an adverse relationship between budget deficits and
macroeconomic variables. They argue that budget deficits lead to higher interest rates,
discourages the issue of private bonds, private investments, and private spending, increases
inflation level, and cause a similar increase in the current account deficits and finally slows the
growth of the economy through resources crowding out. The standard neoclassical model has
three central features. First, the consumption of each individual is determined as the solution to
an inter-temporal optimization problem, where both borrowing and lending are permitted at the
market rate of interest. Second, individuals have finite lifespans. Each consumer belongs to a
specific cohort or generation, and the lifespans of successive generations overlap. Third, market
clearing is generally assumed in all periods. Rising interest rates stimulate additional saving and
reduce investment until market equilibrium is reestablished. Thus, persistent government deficits
crowd out private capital accumulation.
The Keynesian economists propose a positive relationship between budget deficits and
macroeconomic variables. They argue that usually budget deficits result in an increase in
domestic production, increases aggregate demand, increases savings and private investment at
any given level of interest rate. In the Mendel ̶Fleming framework, an increase in the budget
deficit would induce an upward pressure on interest rate, causing capital inflows and an
appreciation of the exchange rate that will increase the current account balance.

2.1.1 Concept of budget deficit

Any attempt to assess budgetary impact on macroeconomic variables such as money supply,
balance of payment, public debt and aggregate economic activity requires a specific measure of
the budget deficit. Several concept of budget deficit, however, seem to be in circulation.
Notwithstanding this, a deficit has tended to be viewed as summary of government receipt and
payment in a single budget year.

2.1.2 Current account

The current account deficit of the government is the excess of non-capital expenditures over non-
capital revenue. It depicts government dis saving and could be used as a measure of the extent to
which government exercises prudence in its financial management. However, useful the current
deficit may be the problems surrounding its calculation are intractable. A case in point is the
treatment of depreciation in enterprise account on accrual basis, which contradict public sector
accounts that tend to be first available on the basis.
2.1.3 Causes of budget deficit
In recent years government spending in LDC’s has increased significantly. This is mainly
attributed to the fact that governments of LDC’s are involved in social, political and economic
affairs. Meanwhile, revenues do not grow rapidly in the same proportion as expenditures due to
narrow tax bases and inefficient tax collecting systems resulting in a budget deficit. In dcs too,
the failure of market mechanism in the 1930s (during great depression) calls for government
intervention in the economy paving therefore increasing government expenditure in those
countries.
Changes in the general price level, income and population size determine growth of government
spending while tax administration and income determine the growth of government revenue and
the imbalances growth of the two(spending over revenues) causes budget
deficit(http://swbplus.bsz-bw.de/bsz118062182kap.pdf). While Shibeshi (1992) has identified
fiscal indiscipline aligned with structural variables as a major factor underlying the expansion of
fiscal deficit.
Taylors (1988) on the other hand tried to explain the reasons why government is open to high
fiscal deficits by forwarding three arguments. First, a government deliberately favors high
spending and lower taxes for political reasons to make there governance legitimate and this view
are known as the view of political deficit. Second, it is argued that structural factors like fall in
term of trade (TOT), export supply and their price fluctuations etc. Aggravate the growth of
public sector deficit; this view is called the structural view. The third view, on the other hand,
argues that inflation reduces real tax revenue and thus causes high fiscal deficit. This is called the
inflationary approach to fiscal deficit.
2.1.4 Method of deficit financing
In general, the problem of deficit financing is one of the controversial issues in economics which
does not have conclusive theoretical analysis. The method of financing is also an important
factor determining its effects. There are four sources of deficit financing namely; drawing from
reserves, domestic borrowing, external borrowing and money printing (Clayton, 1995). These are
discussed below.
2.1.4.1 Drawing from reserves
One of the methods of financing government budget deficit is to run down the foreign exchange
reserves. This method of financing can be used to pay for import bills. It has two merit of
reducing inflationary pressures in the domestic economy and reduces the risk of external debt
crises. However, it tends to appreciate the domestic currency by increasing the supply of foreign
currency. In turn, this will deteriorate the current account by making import attractive and
discouraging export. Moreover, there are limits imposed by international organizations like the
IMF to its use in financing budget deficits.
2.1.4.2 Domestic borrowing
Government can obtain domestic borrowing from the banking system or the private sector. Funds
can be obtained by selling securities (government bonds and treasury bills). It is non-inflationary
and reduces the risk of external debt crisis. Nevertheless, domestic borrowing from the banking
system (excluding the central bank) requires a relative well developed financial inter-mediation
system. Furthermore, if the exchange rate and the interest rates are subject to government
control, resorting to domestic financing has a more crowd out effect on private sector and
translates in to credit rationing.
2.1.4.3 External borrowing
External borrowing often appears to be attractive because of the crowd out effect on private
investment and its being non-inflationary. It allows government to carry out expansionary
domestic policies without drawing upon domestic saving and thereby putting pressure on
domestic interest rate to rise. Although, government external borrowing does not directly affect
domestic interest rates and the supply of loan able fund, it may also crowd out private investment
through its impact on prices or the nominal exchange rate in flexible or managed exchange rate
regimes. When the budget deficit stems from expenditure on locally produced goods, external
borrowing brings about an appreciation of the real exchange rate under a fixed or managed
exchange rate regime. This has crowd out effect on certain local producers (Mankiw, 2007).
2.1.4.4 Money printing
The budget deficit can be covered directly through money creation by the central bank or more
generally by increasing credit of the banking system. However, excessive use of monetary
financing results in excess overall demand, which in turn translate in to inflation or under fixed
exchange rate on the balance of payment.
2.1.5 Determinant of budget deficit
There can be socio-economic development differences, political and structural factors beyond the
belief of policy practitioners about the role of government in economic activities that can explain
the reason why government run deficits. Budget deficits may occur as a result of increasing
government activities in the economy, development theorizing problems related to the structure
of the economy and political pressures to spend more than what government collect as revenue.
Budget deficit may also accrue due to inflation. But, the direct link of the case can be
problematic. Reversed causation can be established for instance monetization of deficit may
prove to be inflationary. On the other hand, in economies where there is inflation there is
pressure for running budget deficits. This is because, taxes collection exhibits collection lags that
when there is inflation the real balance of tax revenue would decrease at the collection.
2.2 EMPIRICAL LETRATURE
It is known that fiscal deficit adversely affects the economic structure and this impact depends on
the way of financing. Generally, to analyze budget deficit and related issues in the studies were
taken from LDC s and DCs countries and econometric estimation was applied to each case. The
reason for choosing them is because of their representatives of developing worlds and their
diverse fiscal and macro experience. This section thus summarizes the major empirical finding of
the studies related our topic.
Karras (1994) studies the relationship between budget deficits and macroeconomic variables in a
cross-sectional study involving 32 countries for the period 1950-1980, by using OLS and GLS.
He found out that deficits do not lead to inflation, they are negatively correlated with rate of
growth of real output and increased deficits appear to retard investment. Nelson and Sing (1994)
used data on cross section of 70 developing countries during two time period, 1970-1979 and
1980-1989, to investigate the effects of budget deficits on GDP growth rates. They estimated the
relationship between growth (GDP growth rate) and the public policy variables using ordinary
least squares (OLS) method. Their study concluded that the budget deficits have no significant
effect on the economic growth of those nations in the 1970 and 1980s.
(Carlos A. Rodger: 2002). Econometric analysis is the relationship between budget deficit and
economic growth in Colombia. The study concludes that the simple correlation between fiscal
deficit and individual indicators of macroeconomic imbalances (interest, inflation etc) are weak
to non-existent. This is clearly due to different mechanism that each country relies to finance its
deficit. However, the study found strong negative correlations between deficit and growth. The
study also examined the degree to which deficit are affected by external shocks (foreign
exchange, commodity price fluctuation and foreign interest rates or by domestic macroeconomic
variables (inflation, domestic interest rates, real exchange rates) and found that only in
Colombia, more than 50% of the variation in deficit was explained by foreign shocks.
Ahmad (2013), investigates the relation between Budget Deficit and Gross Domestic Product of
Pakistan using a time series data for the period of 1971-2007.Ordinary least square methodology
is employed. ADF test has been used to check the stationary of the data. All variables get
stationary at 5% level of significance at level. The results of Granger causality test show that
there is bi-directional causality running from budget deficit to GDP and GDP to budget deficit.
Njenga (2013) investigates the effects of budget deficits on selected macroeconomic variables in
Kenya for the period 1980-2010. Cointegration and Error Correction Models were used as the
econometric techniques. Causality relationship was also established and Wald test utilized.
Results suggest that Current GDP, balance of payment and private investments rates are
significant determinants of budget deficit. Result also indicates a long run equilibrium
relationship between budget deficit and these macroeconomic variables. The Granger causality
test revealed that the twin deficit hypothesis in Kenya is not supported by this study.

In the past the Thailand government usually ran a budget deficit. But in recent years the deficit
has become a surplus because tax capacity relative to GDP has increased significantly and
expenditure over revenues were also reduced. The evidence from the country show that the
government adopted non-inflationary, means of deficit financing more relaying on domestic
borrowing through bonds. Evidence also shows that there is no clear relationship between
inflation and seignorage in the country (Virabongase, Ramangkura: 1991).
Genius murwera pachena (2013); He examine the impact of selected macroeconomic variables
on budget deficits in South Africa. According to him, vector auto-regression model was used to
estimate the respective impact of unemployment, economic growth, foreign reserves, foreign
debt, and government investment consumption on the budget deficit. The analyses covered the
period 1980 to 2010 using time series annual data.
Teshome Ketema (2006) the impact of government spending on economic growth: in the case of
Ethiopia. He used both descriptive and econometrics analysis and also used various components
of government spending (investment, consumption and human capital expenditure) on the
growth of real GDP for the period (1960/61-2003/04) by using Johansen Maximum likelihood
Estimation procedure.

Tewolde Girma H.M (2013), has been examined the effect of budget deficit on monetary
aggregates and the foreign sector of Ethiopia using the Vector Error Correction Model over the
period 1970/71 to 2010/11. Estimation result shows the existence of fairly significant
relationship between fiscal deficit, monetary aggregates and the foreign sector in Ethiopia.
Budget deficit is at the root of monetary expansion. Monetary expansion intern contributes
positively to rising inflation and overvalued exchange rate. The Inflation and overvalued
exchange rate intern contributes to the low performances of the foreign sector through adversely
affecting export incentive. Fiscal deficit for small open economy like Ethiopia is also sign of
stimulated domestic import demand, because government not only spends on goods and services
produced in domestic economy. Thus, the result is in favor of the twin deficit hypothesis
therefore fiscal restraint bucked by export diversification will improve the performance of the
foreign sector and status of inflation.

CHAPTER THREE
3. METHODOLOGY OF THE STUDY
3.1 Introduction
This chapter has been specified the model and the methodology used to examine the relationship
between explanatory variable and dependent variable. It is followed by an explanation of
variables used, source of data and the diagnostic tests employed in the study.
3.2 Data Description and Source
This study aims at establishing the determinant of budget deficit in Ethiopia. Our study intends to
use secondary time series data collected from different sources for the period from 1985-2018.
Hence, the data for determinant of budget deficit variables; real gross domestic p

? . ..roduct per capital, Real Growth Domestic Product Annual Growth rate, Inflation rate and
External Debt has been obtained from Ministry of Finance and Development (MOFED), Central
Statistics Authority (CSA), National Bank of Ethiopia (NBE) and other sources.
3.3 Methods of data analysis
The data obtained from secondary sources are analyzed by using description and econometrics
model for a better clarification and discussion. Our paper used time series data estimation by
following; test of stationary in order to eliminate the possibility of spurious regression results,
test for co-integration. The essence of co-integration is to ascertain whether the residual of the
regression estimated using the non- stationary variables is stationary.
3.3.1 The Unit Root test of stationary
The first step in time series Regression analysis was to test stationary of each variable. The need
to test stationary of the variables arises because estimating regression using non-stationary based
on OLS leads to spurious and inconsistent result (Gujarat1995). In addition, if variables are
non–stationary it is difficult to conduct hypothesis testing as the classical assumption on the
property of the error term namely that it has zero mean, constant variance, and is non-auto
correlated is violated (Rao1994). So, stationary test is important. There are different ways of
testing stationary. In this paper, the two widely applicable (most available in statistical software)
test of unit root, namely The Dickey-fuller (DF) and Augmented Dickey-Fuller (ADF) are used.
It is known that most time series variables are non-stationary at level. Differencing the respective
variables and running regression on the same can handle the non-stationary problem.
3.4 Model specification
Model specification refers to mathematical demonstration of the relationship between the
dependent and independent variables. The budget deficit model of this study can be specified by
using four most important determinant variables that determine budget deficit. Such variables
are inflation rate, the real GDP annual growth rate, External Debt and real per capital GDP as
explanatory variables and budget deficit as dependent variable. The linear functional relationship
between explanatory variable and dependent variables as follows;
Bdt= f (rgdpt, grgdpt, exdt, irt)
Where t=denotes time
 Bdt= denotes the government budget deficit at time t
 rgdpt= the real GDP per capital at time t
 Grgdpt= the real GDP annual growth rate at time t
 Exdt= external debt at time t
 Irt=inflation rate at time t

The estimated equation is therefore as follows:

 Bdt = β 0 + β 1 grgdpt+ β 2 rgdpt + β 3 βexdt+ β 4 irt+ut ut
 = error term
 β 1 , β 2 β, β 3 ¿ β 4 4 are unknown estimator.

3.5 Description of the variable

3.5.1 Dependent variable
Dependent variable is a variable which its entire values depends on other explanatory variables.
Thus, in our model dependent variable is the budget deficit.
3.5.2 Explanatory variables
Explanatory variable is one that explains changes dependent variables. It can be anything that
might affect the response variable. From this study the explanatory variables include in the
model due to the reason that discussed below;
 LRGDP; (Real GDP per capital) is introduced in the function to indicate the level of
economic development. So, higher level of income per capital reflecting a higher level of
development is held to indicate greater capacity to levy and collect taxes (Mankiw, 7 th,
 2007). This is true concerning the management and efficiency of public expenditures.
Moreover, according to Roubini (1991), the GDP per capital may capture some
sociopolitical effects if social conflicts are more important in poor countries. The GDP
per capital is positive.

 GRGDP; (Real GDP annual growth rate) is included in the model as a proxy for
economic activity because government budget balance is sensitive to economic
fluctuation. Indeed , when the level of economic activities low or moderate the amount of
tax revenues collected by the government decreases while social expenditure increase,
that lead to a deterioration of budget balance. Conversely, a higher economic growth
generates an improvement of budget balance (automatic stabilizers). However, some
authors (Talvi and Vegh, 2000) have suggested that fiscal policy can be pro-cyclical in
developing countries with weak governments, because political pressures to increase
public spending go hand in hand with the growing tax revenue due to higher economic
growth. The strong increase in the fiscal demands during economic boom is called
“voracity effect” (lane and tornell, 1999).

 EXD :( External Debt) External debt is quit important financial resource for many
national economies around the world. In this context, external debt have been taken
recently in order to reduce saving and external exchange gaps, close the budget deficits,
and maintain the economic growth and development. When external debt taken due to in
adequate domestic resources are used effectively, they will increase savings, investments
and employment opportunities. However, the ineffective and unproductive use of external
debt results to several problems in the economy. As result external borrowing will
become a current issue again in order to repay these debts.
 IR :( Inflation rate) Keynesian believes that the great depression could have been
averted if the government had engaged in more government spending and income tax
cuts (fiscal policy). Inflation reduces real tax revenue and thus causes high fiscal deficit.
This is called the inflationary approach to fiscal deficit. Sometimes the situation may be
described as “olvera –Tanzi effect” of fiscal deficit, i.e. Deficit caused by a decline in real
 tax revenues during period of high inflation as a result levels reduce real tax revenues of
the government significantly as the government collects and accounts its tax receipts in +
 +latter and expenditures causing high budget deficit in the country (Carlos Rodriguez:
1994).

3.6 Model diagnosis

Diagnosing the model was established whether the estimation coefficients are tenable or the
extent to the regression coefficients fitted in the model makes linear and unbiased estimator of
the determination of budget deficit for the purposes of our research. The model would be tested
to verify the existence of multicolleniarity, error auto-correlation, stationary and model adequacy
those are mostly common in time series data.
3.6.1 Testing stationary
Most economic data are non-stationary (random walk). There exists a trend element in which
both the independent variable and dependent variable grow up ward or decreases down ward
continuously together (Gujarati, 2009).
There common tests used are Dickey Fuller (DF) and Augment Dickey Fuller (ADF) tests. These
tests are basically required to ascertain a number of times variables have to be differenced to
arrive at stationary. A time series data are said to be differenced of ordered 'p' if it became
stationary after differencing it 'p' times. Economic variables stationary from the outset are I (0)
series and a variable that requires to be differenced once to be stationary is I (1) series (Gujarat,
1995).
3.6.2 Heteroscedasticity test
Heteroscedasticity is a problem which is occurred when one of the classical linear regression
assumptions is violated (homoscedastic assumption of the error tem is violated). It occur when
the error term have different variance. In this study we employed Brush pagan test to detect it.
Decision rule;
H0=constant variance
H1=not constant variance

IF prob>chi2 is greater than 5%, accept null hypothesis. This means no heteroscedasticity
problem in the regression. Whereas if prob>chi2 is less than 5%, accept alternative hypothesis,
there is heteroscedasticity problem.
3.6.3 Auto correlation test
It is a correlation between members of a series observation ordering in time (as a time series
data). The classical linear regression model assumes that the disturbance (error) term relating to
any observation is not influenced by disturbance term relating to any other observation. In
running OLS estimation by disregarding to auto correlation was result in inefficiency on the
estimated result and its standard errors are estimated in the wrong way (Gujarat, 2009).

3.6.4 Multicollinearty test

Multicolleniarty is one of the violation of classical linear regression model assumption due to the
highly correlation of explanatory variables. The OLS estimation is no longer BLUE and affects
the estimation of the coefficience magnitude and sign (Gujarati; 2009).

CHAPTER FOUR
4. DESCRIPTIVE AND ECONOMETRIC ANALYSIS

4.1. DESCRIPTIVE ANALYSIS

4.1.1. Government Budget deficits
This section would reveal the descriptive analysis followed by various variables incorporated in
the model with that of the budget deficit. Government Budget is an itemized accounting of the
payments received by government (taxes and other fees) and the payments made by government
(purchases and transfer payments). A budget deficit occurs when a government spends more
money than it takes in. It occurs when expenses exceed revenue and indicates the financial health
of a country. The government generally uses the term budget deficit when referring to spending
rather than businesses. Accrued deficits form national debt. Ethiopia recorded a Government
Budget deficit equal to 3.70 percent of the country's Gross Domestic Product in 2018.
The large size of current expenditure may have impeded growth by reducing the resources
available for capital expenditure. Defense expenditure, poverty targeted expenditure (which
includes education, health and agriculture) and expenditure on interest payment constitute the
most important components of current expenditure.

From the table above largest budget deficit was occurred in 1990, which is about 2147.9 million.
The average budget deficit as a percentage of GDP was 10.0 during five year of Dergue regime.
0
-2.5e+09 -2.0e+09 -1.5e+09 -1.0e+09 -5.0e+08
BD

1980 1990 2000 2010 2020

Year

Source: World Bank indicator and own computation

The budget deficit as ratio of GDP reflects increasing from time to time. AS we seen from above
table, the budget deficit as a percentage of GDP was 82.5% in 1998. The largest budget deficit
was incurred in 2018, which is about 118975.5 million excluding grant. On average budget
deficit as a % of GDP were 17.5 during the present government regime.
4.1.2. Total government revenue
Total government revenue in Ethiopia comes from the following sources: Ordinary revenue, external
assistance and capital receipts. Ordinary revenues are further classified into Direct taxes, Indirect
taxes, and foreign trade tax and non-tax revenue.
300000
200000
total revenue
100000 0

1980 1990 2000 2010 2020

year

As we have seen the above tables various reform were introduced by the post 1990/91
government of Ethiopia that increased government revenue. As a result of this reform the trends
for government revenue show sharp rise and increased constantly after reform period. But
increase in revenue is less than the increase of expenditure which leads to budget deficit still.
4.1.2.1. Foreign trade tax
Taxes on international trade include import duties, export duties, profits of export or import
monopolies, exchange profits, and exchange taxes.
4.1.2.2. Indirect tax
Indirect taxes are basically taxes that can be passed on to another entity or individual. It is
usually imposed on manufacturer or supplier who then passes on taxes to the consumer. The
most common example of indirect tax are excise tax (cigarettes and alcohol), value added tax and
etc.

4.1.2.3. DIRECT TAX

Direct taxes are one types of taxes an individual pays that are paid straight or directly to the
government, such as, personal income tax, poll tax, land tax, and personal property tax. Such
direct taxes are computed based on the ability of the tax payer to pay, which means that the
higher their capability of paying is, the higher their taxes rate

4.1.2.4. Non tax revenue

It is money that a government takes in by means other than taxation. Examples of non- tax
revenue include bonds issues and profit from state owned companies. Some government
agencies earn non-tax revenue through use fees. For example a bank regulator may charge the
banks that it regulates so me percentage of their assets for the privilege of being regulated. Some
of these revenues are mandated, while others are offered as an incentive.

4.1.3. Government Expenditure.

Government spending or expenditure includes all government consumption, investment, and
transfer payments. In national income accounting the acquisition by the governments of goods
and service for current use, to directly satisfy the individual or collective needs of the
community, is classed as government final consumption expenditure. Government acquisition of
goods and service intended to create future benefits, such as, infrastructure investment or
research spending, is classed as government investment (government growth capital formation).
These two types government spending, on final consumption and on gross capital formation,
together constitute one of the major components of growth domestic product.
 15000
10000
TGE
5000
0

1980 1990 2000 2010 2020

Year

As we seen the above table, current expenditure is greater than capital expenditure
during five year dergue regime.
4.1.3.1. Current expenditure
Current expenditure is expenditure on goods and services consumed within the current year,
which needs to be made recurrently to sustain the production of educational services.
Minor expenditure on items of equipment, below a certain cost threshold, is also reported
as current spending
4.1.3.2. Capital expenditure

Capital expenditure is an expense that a company makes towards the purchase of

new equipment or the improvement of its long term assets, namely property, plant,
and equipment
4.1.4. Real GDP Annual Growth rate
In 2018, real GDP growth for Ethiopia was 7.7 %. Though Ethiopia real GDP growth fluctuated
substantially in recent years, it tended to increase through 1999 - 2018 period ending at 7.7 % in
2018.
Figure 4.5 Trend of growth rates of real GDP of Ethiopia 1980-2018

Source
: own compilation from Knoema.Com (2019)
As we observe from figure 4.5 there is a very high fluctuation in real GDP growth rate owing to
different factors. In 1980 the growth rate of GDP was 4% and in 1983 7.8%. However in 1984
and 1985 the growth rate was -2.3% and -11.4% respectively due to severe drought during that
period .In 1986 and 1987 the growth rate reach 9.7% and 13.9% due to favorable rainfall. In
1990 and 1991 the trend also decline due internal conflict between the military and EPRDF.
Starting from 1993 Ethiopia began to experiencing accelerated economic growth and it shifted to
an even higher in 2004. Real GDP growth averaged 11.7% in 2005 and 12.6% in 2006 per
annum. This is because of the EPRDF has been adopted typical structural adjustment policies of
market liberalization which issued a new economic policy in November 1991 by openly a market
oriented economic policy and other development initiative program (Befikadu, 2005). However
the current government experience up and down trend of real GDP because the majority of
Ethiopian economy depends on agriculture which is highly affected by natural hazards. For
example decline in real GDP growth rate in 2016 was due to El-Nino and severe drought.
 15
10 5
GRGDP
0 -5
-10

1980 1990 2000 2010 2020

Year

4.1.5. Real GDP per capital

GDP per capital is growth domestic product divided by midyear population. GDP
is the sum of gross value added by all resident producers in the economy plus any
product taxes and minus any subsidies not included in the value of the products. It
is calculated without making deduction for depreciation of fabricated assets or for
depletion and degradation of natural resources.
Data are in the current u.s dollars.
-Ethiopia gdp per capita for 2019 was $858, 11.14% increase from 2018
-Ethiopia gdp per capita for 2018 was $772, 0.39% increase from 2017
-Ethiopia gdp per capita for 2017 was $769, 7.17% increase from 2016
-Ethiopia gdp per capita for 2016 was $717, 11.96% increase from 2015
….This data shows that there is continuous increase of per capita gdp in
Ethiopia…source world bank
20000
15000
RGDP
10000
5000

1980 1990 2000 2010 2020

year

4.1.6. Inflation rate

Historically Ethiopia has been one of the low inflation economies with average inflation rate of
less than 5 per cent. Since 2006 however Ethiopia has no longer been considered a low inflation
country and in July 2008 an all-time high inflation rate of 44.4 per cent was recorded. The major
causes were the then high fuel and food prices shocks, weaker foreign exchange earnings, and
rising demand for imports that depleted international reserves of the country. The highest price
increase was observed in food, housing, fuel and transport services, making the urban poor the
most vulnerable to the effects of inflation. Owing to strong policy measures and abated world
price shocks inflation rates declined during the years 2010 and 2011.Inflation re-emerged in
2011 and 2012 reached a peak of about 33.2 per cent in 2011 24 per cent in 2012. Looking at the
components, the food and non-alcoholic beverages category has been the main drivers of overall
price movement. Both internal and external factors contributed again to the hike in inflation.
Well-coordinated monetary and fiscal policy stance coupled with slowdown in the world
commodity prices have resulted in significant decline in inflation. Inflation rate for the month of
December 2016 declined to a single digit of 6.7 per cent (CSA, 2016).
40
30
20
IR
10
0
-10

1980 1990 2000 2010 2020

Year

4.1.7. External Debt

Ethiopia, as being a developing country, has relied on external debt for financing of growth
enhancing and pro-poor projects that are given priority in the overall development policy and
strategy of the country. The available statistics reveal the significant changes of the country’s
external debt in terms of level of stock. The total external debt to GDP ratio is around 30 percent
(UNDP, 2018).
Source: own compilation from WB (2019)
AS we can see from the above figure, total debt stock increases at decreasing rate from 1989 up
to 2004. However, 2009 onwards it increases at increasing rate.

4.2. Econometric Analysis

A multiple linear regression analysis was employed to address the major objective of the study.
To check the adequacy or significance of the regression model F-test was examined and the
statistical reliability or significance of the regression coefficients (parameter estimates) was
checked by using t-test. To measure the goodness of fit of the regression model coefficient of
determination (R2) was used.

4.2.1. Results of ordinary least square (OLS) estimation

BD = 5.64e+08 +1.88e+07GRGDP-141192RGDP +2073164IR-0.037556EXD
The value of the constant term 5.64e+08, which is statistically significant, show that BD will
have a value of 5.64e+08 units if all the explanatory variables (included in the model) zero. Real
GDP annual growth rate have positive relationship with budget deficit and it was statistically
significant at 5% level and also confirmed with the hypothesis of the study. When the level of
economic activities is low the amount of tax revenues collected by government decreases while
social expenditure increases. The relationship between budget deficit and real GDP per capital
were negative, which is not confirmed with hypothesis of the study. The relationship was
statistically significant at 5% level. As holding other variables constant, as real GDP per capital
increase by 1 million birr budget deficit will decrease by 141192 units. The relationship between
budget deficit and external debt were negative, which is confirmed with the hypothesis of the
study. The relationship was statistically significant at 5% level. As holding other variables
constant, as total external debt increase by one million dollar budget deficit decrease by
0.0375519 units. The relationship between budget deficit and inflation rate were positive, which
is not confirmed with the hypothesis study. The relationship was statistically insignificant at 5%
level of individual. When there is high inflation there is high budget deficit because taxes
collection exhibits lags and tax revenue would decrease at the time of collection (further
information refer appendix)
4.2.1.1 Stationary test.
The data employed in this study was time series, which the variables involved in the multiple
linear regression model need to fulfill some sort of stability over time. This because of the
variable is non-stationary; we can study its behavior only for the time period under
consideration. As a result, it is not possible to generalize it to other time periods. Therefore, for
the purpose of forecasting, such non-stationary series may be of little practical value (Gujarati,
2004). So, in order to show the relationship between the dependent and independent variable and
know the extent to which a change in one variable affects the other, we should not allow the
variables of interest involved in the regression analysis to change arbitrarily over each time
period (Wooldridge, 2004). The unit root test shows the stationary of the data. Stationary implies
that the mean, variance, and co-variance of a variable do not vary over time i.e. the variable is
time invariant. The Augmented Dicky-Fuller (ADF) test for unit root was employed in this study.

Variables ADF-test 1% 5% 10%

Critical Critical Critical Stationary test results
value value value
BD 0.527 -3.696 -2.978 -2.620
GRGDP -5.439 -4.306 -3.568 -3.221

RGDP 0.949 -4.306 -3.568 -3.221

EXD -1.376 -4.306 -3.568 -3.221

IR -5.152 -4.306 -3.568 -3.221

For the sake of convenience, the stationary properties of variables have been examined by
employing ADF tests. The decision whether accept or reject the null hypothesis was based on by
comparing the critical value at 5% level of significance and the t-statistics. If the t-statistics less
than the critical at 5% level of significance there is a unit root or non-stationary or by using the
Mackinnon P-value which indicates if P-value greater than 0.05 there is unit root or non-
stationary. So once the series were identified to contain unit root at level, the next option would
be to difference once and then apply the test procedures again.

Hence, the variables like real GDP annual growth rates, and inflation rate were stationary
without differencing the values or (0) lags. But budget deficit, real per capital GDP and external
debt becomes stationary after differencing the values of the variables.
4.2.1.2 Testing the significance of the model
The statistical values that measure the goodness of fit and significance of the model fit
reasonably well. To be specific the R2 value shows that about 76.72% of the variations in budget
deficit are explained by the explanatory variables. The overall significance of the model is also
significant. (Refer more information from appendix)
F-test
Test the significance of the whole explanatory variables simultaneously using F-test.
H0-all slope coefficients are zero
H1-all slope coefficients are different from zero
F = ESS/Df = ESS/K-1
RSS/Df = RSS/n-K+1
The probability that critical F-value at 5% level of significance greater than F calculated is at
1%, then we will reject the null hypothesis means that all parameters are different from zero
(refer the appendix part)

4.2.1.3 Heteroscedasticity test

Heteroscedasticity poses potentially severe problems for inferences based on ordinary least
squares. One can rarely be certain that the disturbances are heteroscedasticity however, and
unfortunately, what form the heteroscedasticity takes if they are. As such, it is useful to be able
to test for heteroscedasticity and if necessary, modify our estimation procedure accordingly
(Green, 2002). Several types of tests have been suggested to test heteroscedasticity but, in this
study, Breusch-Pagan test and white test were used.
 Breusch pagan test for heteroscedasticity
The breusch-pagan test result show that the probability value of the chi-square statistic is less
than 0.05. Therefore the null hypothesis of constant variance can be rejected at 5% level of
significance, which implies the presence of heteroscedasticity in the residual (refer more
information from appendix).

White test for heteroscedasticity

Similar to the results of the breusch-pagan test, the probability value of the chi-square was less
than 0.05. The null hypothesis of constant variance can be rejected at 5% level of the
significance. Therefore there was heteroscedasticity in the residuals.
White's test for Ho: homoscedasticity
Against Ha: unrestricted heteroscedasticity
Chi2 (14) = 15.96
Prob > chi2 = 0.3155

Correction for heteroscedasticity

Thus we must correct this problem by using a robust command in the regression. The robust
standard errors were different from the standard errors in the first regression. For example, the
robust standard error for the variable rgdp was 18488.23, which different from 16218.53 given
from first regression.

4.2.1.4 Auto-correlation test

The classical linear regression model assumes that the disturbance term relating to any
observation is not influenced by the disturbance term relating to any other observation. In this
particular study, in order to check auto-correlation in the multiple regression model Breusch-
Godfrey LM test and Durbin's Alternative test for auto-correlation are employed. According to
the test result, we reject the null hypothesis at 5% (0.05) level of significance since the p-values
for both Breusch-Godfrey LM test and Durbin's Alternative test for auto-correlation were less
than 5% (0.05) level significance. Therefore, there is presence of auto-correlation in the multiple
linear regression models.
4.2.1.5 Multicollinearity test

One of the most important considerations in multiple linear regression analysis is that the
explanatory variables should not significantly linearly related with each other because if any two
explanatory variables are highly or perfectly linearly correlated, the real magnitude of the
relationship they have with the dependent variable is either deemed best or it can be depressed

Gujarati (2014) explained multi-collinearity problem can be detected either by computing

correlation coefficients of independent variables or checking related statistics such as tolerance
value or variance inflation factor (VIF). Therefore, using the VIF as an indicator of
multicollinearity, the larger the value of VIF, the more “troublesome” or collinear the
explanatory variables. As a rule of thumb, if the VIF of a variable exceeds 10 is said be highly
collinear. As indicated in table below, the VIF values for all variables were less than 5, which
indicates that there is no a problem of multicolleniarity.

Variable VIF 1/VIF

Rgdp 1.30 0.767102
Exd 1.03 0.972116
Grgdp 1.26 0.795107
Ir 1.13 0.881098
Mean VIF 1.18
 CHAPTER FIVE
5. Conclusion and Recommendation
5.1. Conclusion
The paper sought to examine the impact of selected macroeconomic variables on budget deficit
in Ethiopia.
It was attempted to achieve objectives of the study with the data obtained from NBE using two
techniques of analysis. This chapter aims to link the objectives of the study with the result
obtained and draw some policy implications. The result of works on deficit has been mixed that
some empirical work have resulted positive relationship while other have found clear cut
negative relationship between budget deficit and its financing.
The empirical analysis was based on time series econometrics. It was found out that the two
variables like real GDP annual growth rate and inflation rate were stationary without differrncing
the values or (0) lags. But budget deficit, real per capital GDP and external debt becomes
stationary after differencing the values of the variables.
As to the causes of rising budget deficits, it has been argued that it was mainly caused by the
growth of expenditure over revenue. Apart from this, there were four reasons discussed in the
literature as to why government may open to high fiscal deficit level; political reasons, that
governments may deliberately favor high spending levels and low tax rates to make their
government legitimate; structural reasons; which makes the economy inflexible in the short term;
inflation, that reduces the real balance of tax revenue as a result of the existence of collection
lags and finally development theorizing.

The descriptive analysis has revealed that expenditure has been persistently growing due to the
growth of the public sector economy. In turn, this has created budget deficit since it was not
followed by equally proportionate growth revenue. Since 1974, large and rapid expansion of
state activity in the economy has led to the growth of both government revenue and spending
with the dominance of the latter. As a result, budget deficit have been growing over time.
Looking further in to the structure of current expenditure and capital expenditure the relative
share of the current expenditure was high.
For much reliable conclusion econometric analysis was employed to examine the empirical
relationship between budget deficit and it’s financing. To this effect, the model specified in
chapter four is estimated using the available data and the ordinary least square method. In the
econometric analysis, the attempt has been made to test the hypothesis that financing budget
deficit through money creation leads to high inflation, domestic borrowing to finance budget
deficit leads to crowding out effect and excessive resort to foreign borrowing for financing
budget deficit leads to high external debt a service burdening. To reduce budget deficit the
government should restructure its budgeting system and mode of financing.
5.2. Recommendation
 To increase tax revenue and decreases the deficit problems, fundamental
reform of tax structures should be made and the reform should focus on
broadening the tax bases (as opposed to mounting high tax rates),
minimize tax exemption and improve the tax administration system which
would affect the tax collecting systems.
 The government should also exercise control over its expenditures and its
financing techniques especially through limiting its domestic borrowings
from banks.
 Finally the fact that GDP growth in the country follows agricultural growth
trend implies that agriculture is the key to economic growth in the country.
Since the sector is subjected to several of the nature which are beyond
policy measures and control, due emphasis should be given to other
sector of the economy. Apart from policies directed towards improving
productivity in agriculture. In addition, the government should, not only
formulate, but also implement appropriate policies to further encouraging
private sector investment and saving which should gear the country to the
pace of rapid economic growth.

REFERENCE
 Befekadu Degefe, Berhanu Nega, Getahun Tafesse, 200/01 second annual
report on the Ethiopia economy volume two.
  Carlos Rodriguez, westerly, k. Schmidt Hebbel, 1994 fiscal performance with
fixed exchange rates, in carols Rodriguez, World Bank, Washington DC.
 Clayton, 1995 economics principles and practices video disc edition.
 Easterly W and Fishers (1990) the economics of the government budget deficit
constraint” the World Bank research observer, VOL-5.
 Gujarati, N, Damodar (1995), basic econometrics, 4 th edition, MC Graw Hill,
network
 Mankiw, G. (2007) macroeconomics, 7th edit. Worthy publisher.
 National bank of Ethiopia (NBE), various annual bulletins.
 Rodger Durnbusch, Stanley Fischer and Richard Startz, 2001 macroeconomics
8th edition.

APPENDIX

Appendix One: Data Table

year GRGDP LRGDP IR BD EXD
1985 -11.4 5618.77 19.06 -4.5E+08 8.24E+08
4
1986 9.7 5968.77 -9.81 -3.9E+08 8.24E+08
5
1987 13.4 6582.14 -2.43 -3.8E+08 8.24E+08
2
1988 0.6 6404.23 7.08 -3.8E+08 8.24E+08
4
1989 -0.5 6172.17 7.82 -5E+08 8.24E+08
5
1990 2.6 6126.55 5.15 -8.4E+08 5.21E+09
2
1991 -7.2 5491.78 35.72 -8.1E+08 6.14E+09
1992 -8.9 4838.61 10.53 -7E+08 7.38E+09
9
1993 13.4 5282.25 3.54 -3.7E+08 7.72E+09
9
1994 3.5 5264.51 7.59 -4.3E+08 7.86E+09
9
1995 6.2 5404.26 10.02 -2.3E+08 8.65E+09
3
1996 13.5 5886.40 -8.48 -3.4E+08 9.13E+09
1
1997 2.8 5889.45 2.4 -1.5E+08 9.36E+09
1998 -4.8 5521.11 0.89 -2.8E+08 9.72E+09
9
1999 6.3 5640.51 7.94 -6.5E+08 1.01E+10
6
2000 9.8 5813.06 0.66 -7.3E+08 1.03E+10
6
2001 7.4 6116 8.24 -3.1E+08 1.01E+10
2002 1.6 6034.66 0.68 -4.5E+08 1.01E+10
 5
2003 -2.1 5737.71 13.67 -4.8E+08 1.04E+10
4
2004 11.7 6334.86 3.33 -2.7E+08 5.57E+09
9
2005 12.6 6888.09 9.97 -5.1E+08 5.52E+09
8
2006 11.5 7425.97 12.3 -5.8E+08 5.75E+09
2
2007 11.8 8052.52 17.24 -7E+08 6.55E+09
2
2008 11.2 8680.05 44.36 -7.7E+08 7.28E+09
7
2009 10 9187.31 8.48 -3E+08 6.57E+09
9
2010 10.6 10056.4 8.15 -4E+08 6.18E+09
9
2011 11.4 10870.5 33.25 -5.1E+08 2.22E+09
5
2012 8.7 11481.1 24.12 -4.9E+08 2.59E+09
1
2013 9.9 12342.1 8.08 -9E+08 2.85E+09
7
2014 10.3 13232.4 7.4 -1.4E+09 5.36E+09
4
2015 10.4 14210.5 10.11 -1.2E+09 7.29E+09
1
2016 8 15135.5 7.26 -1.7E+09 8.61E+09
6
2017 10.1 16138.4 9.85 -2.5E+09 1.05E+10
1
2018 7.7 16791.7 13.8 -2.4E+09 1.26E+10
Appendix Two: The Results of OLS Estimation
. regress bd grgdp lrgdp ir exd

Source | SS df MS Number of obs = 34

-------------+------------------------------ F( 4, 29) = 23.89
Model | 7.8368e+18 4 1.9592e+18 Prob > F = 0.0000
Residual | 2.3785e+18 29 8.2016e+16 R-squared = 0.7672
-------------+------------------------------ Adj R-squared = 0.7351
Total | 1.0215e+19 33 3.0955e+17 Root MSE = 2.9e+08

------------------------------------------------------------------------------
bd | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
grgdp | 1.88e+07 8260618 2.27 0.031 1878957 3.57e+07
lrgdp | -141192 16218.53 -8.71 0.000 -174362.6 -108021.4
ir | 2073164 4757188 0.44 0.666 -7656377 1.18e+07
exd | -.0375519 .0150137 -2.50 0.018 -.0682583 -.0068455
_cons | 5.64e+08 1.55e+08 3.64 0.001 2.47e+08 8.81e+08
------------------------------------------------------------------------------

Stationary Test
1 . dfuller bd, lags(0)

Dickey-Fuller test for unit root Number of obs = 33

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value
------------------------------------------------------------------------------
Z(t) 0.527 -3.696 -2.978 -2.620
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 0.9857

2 . dfuller grgdp, trend lags(0)

Dickey-Fuller test for unit root Number of obs = 33

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
------------------------------------------------------------------------------
Z(t) -5.439 -4.306 -3.568 -3.221
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 0.0000

3 . dfuller lrgdp, trend lags(0)

Dickey-Fuller test for unit root Number of obs = 33

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
------------------------------------------------------------------------------
Z(t) 0.949 -4.306 -3.568 -3.221
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 1.0000

4 . dfuller ir, trend lags(0)

Dickey-Fuller test for unit root Number of obs = 33

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
------------------------------------------------------------------------------
Z(t) -5.152 -4.306 -3.568 -3.221
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 0.0001

5 . dfuller exd, trend lags(0)

Dickey-Fuller test for unit root Number of obs = 33

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
------------------------------------------------------------------------------
Z(t) -1.376 -4.306 -3.568 -3.221
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 0.8678

. generate bd_d1 = d1.bd

(1 missing value generated)
. dfuller bd_d1, trend lags(0)

Dickey-Fuller test for unit root Number of obs = 32

---------- Interpolated Dickey-Fuller ---------

Test 1% Critical 5% Critical 10% Critical
Statistic Value Value Value
------------------------------------------------------------------------------
Z(t) -5.715 -4.316 -3.572 -3.223
------------------------------------------------------------------------------
MacKinnon approximate p-value for Z(t) = 0.0000

Multicollinearity Test

. vif

Variable | VIF 1/VIF

-------------+----------------------
lrgdp | 1.30 0.767102
grgdp | 1.26 0.795107
ir | 1.13 0.881098
exd | 1.03 0.972116
-------------+----------------------
Mean VIF | 1.18

Heteroscedasticity Test

. estat hettest

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity

 Ho: Constant variance
Variables: fitted values of bd

chi2(1) = 3.86
Prob > chi2 = 0.0495

. estat imtest, white

White's test for Ho: homoskedasticity

against Ha: unrestricted heteroscedasticity

chi2(14) = 15.96
Prob > chi2 = 0.3155

Cameron & Trivedi's decomposition of IM-test

---------------------------------------------------
Source | chi2 df p
---------------------+-----------------------------
Heteroskedasticity | 15.96 14 0.3155
Skewness | . 4 .
Kurtosis | . 1 .
---------------------+-----------------------------
Total | . 19 .
---------------------------------------------------

. regress bd lrgdp grgdp exd ir, vce(robust)

Linear regression Number of obs = 34

F( 4, 29) = 15.41
Prob > F = 0.0000
 R-squared = 0.7672
Root MSE = 2.9e+08

------------------------------------------------------------------------------
| Robust
bd | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
lrgdp | -141192 18488.23 -7.64 0.000 -179004.7 -103379.3
grgdp | 1.88e+07 6346925 2.96 0.006 5792898 3.18e+07
exd | -.0375519 .0137034 -2.74 0.010 -.0655786 -.0095252
ir | 2073164 4173550 0.50 0.623 -6462705 1.06e+07
_cons | 5.64e+08 1.64e+08 3.44 0.002 2.29e+08 9.00e+08
------------------------------------------------------------------------------

. clear

. *(6 variables, 34 observations pasted into data editor)

. tsset year
time variable: year, 1985 to 2018
delta: 1 unit

. regress bd grgdp lrgdp ir exd

Source | SS df MS Number of obs = 34

-------------+------------------------------ F( 4, 29) = 23.89
Model | 7.8368e+18 4 1.9592e+18 Prob > F = 0.0000
Residual | 2.3785e+18 29 8.2016e+16 R-squared = 0.7672
-------------+------------------------------ Adj R-squared = 0.7351
Total | 1.0215e+19 33 3.0955e+17 Root MSE = 2.9e+08
------------------------------------------------------------------------------
bd | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
grgdp | 1.88e+07 8260618 2.27 0.031 1878957 3.57e+07
lrgdp | -141192 16218.53 -8.71 0.000 -174362.6 -108021.4
ir | 2073164 4757188 0.44 0.666 -7656377 1.18e+07
exd | -.0375519 .0150137 -2.50 0.018 -.0682583 -.0068455
_cons | 5.64e+08 1.55e+08 3.64 0.001 2.47e+08 8.81e+08
------------------------------------------------------------------------------

Auto-correlation Test
. estat bgodfrey

Breusch-Godfrey LM test for autocorrelation

---------------------------------------------------------------------------
lags(p) | chi2 df Prob > chi2
-------------+-------------------------------------------------------------
1 | 8.987 1 0.0027
---------------------------------------------------------------------------
H0: no serial correlation

. dwstat

Durbin-Watson d-statistic( 5, 34) = .976096

. prais bd grgdp lrgdp ir exd, corc

Iteration 0: rho = 0.0000

Iteration 1: rho = 0.5125
Iteration 2: rho = 0.6626
Iteration 3: rho = 0.6836
Iteration 4: rho = 0.6863
Iteration 5: rho = 0.6867
Iteration 6: rho = 0.6867
Iteration 7: rho = 0.6867
Iteration 8: rho = 0.6867

Cochrane-Orcutt AR(1) regression -- iterated estimates

Source | SS df MS Number of obs = 33

-------------+------------------------------ F( 4, 28) = 8.41
Model | 1.7596e+18 4 4.3989e+17 Prob > F = 0.0001
Residual | 1.4647e+18 28 5.2312e+16 R-squared = 0.5457
-------------+------------------------------ Adj R-squared = 0.4808
Total | 3.2243e+18 32 1.0076e+17 Root MSE = 2.3e+08

------------------------------------------------------------------------------
bd | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
grgdp | 801008 6957569 0.12 0.909 -1.35e+07 1.51e+07
lrgdp | -140597.8 30852.92 -4.56 0.000 -203797.1 -77398.47
ir | -2614829 3541338 -0.74 0.466 -9868932 4639273
exd | -.0631142 .0253293 -2.49 0.019 -.1149988 -.0112295
_cons | 9.18e+08 3.34e+08 2.75 0.010 2.33e+08 1.60e+09
-------------+----------------------------------------------------------------
rho | .6867334
------------------------------------------------------------------------------
Durbin-Watson statistic (original) 0.976096
Durbin-Watson statistic (transformed) 2.004527