SELALE UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

DETERMINANT OF BUDGET DEFICIT IN ETHIOPIA

SENIOR ESSAY SUBMITTED TO THE DEPARTIMENT OF ECONOMICS IN

PARITAL FULLFILMENT OF THE REQUIRMENT FOR DEGREE OF BACHILOR
ART IN ECONOMICS.

PREPARED BY : …………………………………………………………ID NO.

MELAKU ABEBE : ……………………………………………………RU/0893/13/

ADEVISOR : SAMUEL SAHILE (Msc)

DECEMBER, 2023

FITCHE, ETHIOPIA
Table of Contents page

ACRONYMS.................................................................................................................................III

CHAPTER ONE..............................................................................................................................1

1. INTRODUCTION.......................................................................................................................1

1.1 Background of the study........................................................................................................1

1.2 Statement problem..................................................................................................................4

1.3 RESEARCH QUESTION......................................................................................................5

1.4.1 General Objective of the Study......................................................................................6

1.4.2 Specific objective............................................................................................................6

1.5 Scope of the study..................................................................................................................6

1.6 Significance of the study........................................................................................................6

1.7 Organization of the study.......................................................................................................6

CHAPTER TWO.............................................................................................................................7

2. LETRATURE REVIEW..............................................................................................................7

2.1. Theoretical literature reviews................................................................................................7

2.1.1 Concept of budget deficit................................................................................................8

2.1.2 Current account................................................................................................................8

2.1.3 Causes of budget deficit..................................................................................................8

2.1.4 Method of deficit financing.............................................................................................9

2.1.4.1 Drawing from reserves.............................................................................................9

2.1.4.2 Domestic borrowing................................................................................................9

2.1.4.3 External borrowing................................................................................................10

2.1.4.4 Money printing.......................................................................................................10

2.1.5 Determinant of budget deficit........................................................................................10

1
 2.2 EMPIRICAL LETRATURE................................................................................................11

CHAPTER THREE.......................................................................................................................14

3. METHODOLOGY OF THE STUDY.......................................................................................14

3.1. Nature and Source of data.......................................................................................................14

3.2 Method of data analysis........................................................................................................14

3.3 Model specification..............................................................................................................14

3.4 Description and expected sign of the variables used in the analysis....................................15

3.4.1 Dependent variable........................................................................................................15

3.4.2 Explanatory variables....................................................................................................16

3.5. Estimation Procedure..........................................................................................................17

3.5.1.Stationary and Unit Root Tastes....................................................................................17

3.5.2 Co-integration test.........................................................................................................18

3.5.3. Diagnostic Tests...........................................................................................................18

Model specification test..................................................................................................19

Heteroskedasticity Test...................................................................................................19

CHAPTER FOUR..........................................................................................................................20

4. WORK PLAN AND BUDGET SUMMARY..........................................................................20

4.2 Budget Summaries...............................................................................................................21

REFERENCE.................................................................................................................................22

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 ACRONYMS

ECA ___________________________________ Economic commission for Africa

GDP ___________________________________ Growth domestic product

LDC __________________________________ Least developed countries

MLFI _________________________________ Multilateral financial institution

MoFED _______________________________ Minister of Finance and Economic development

NBE ___________________________________ National bank of Ethiopia

OLS ___________________________________ Ordinary least square

SAP ___________________________________ Structural adjustment policies

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 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 both domestic and foreign borrowing which ultimately declines the self-respect of the
country as a 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 (MS Hassan,2013).

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 ,2007).

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In recent years government spending in least developed countries (LDCs) has increased
significantly. This is mainly attributed to the fact that the governments of LDCs 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 efficient tax collection of systems
resulting in a budget deficit. In industrial countries, too, the failure of market mechanism in
1930’s (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 wide range of expenditure with budget deficit. For 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 seems not to generate macroeconomic
imbalance at all. The explanation for these different outcomes is that different governments
adopt different techniques of financing their deficits. Thus, the consequences of fiscal deficit
depend on the way they are financed (William easterly, 2010/08 and Mankiw, 2007).

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
Ethiopian government fiscal position has showed a significant change over the last four decades.
The government budget, which was in surplus in the 1950s and 1960s, has adapted to continuous
and growing deficit (MEDaC, 1999; Berhanu and Befekadu 1999/2000). Compared to other
African countries like Kenya, Zimbabwe and Burundi, the overall deficit including grant as
percentage of GDP is among the highest. Although domestic financing is equally important
source of financing, the switch to foreign ones in fear of negative consequences like inflation,
however, has resulted in growing debt burden, which was averaged to 96.9 percent of GDP over
the period 2001/01 to 2002/03. In Ethiopia it is quite clear that the government budget balance

5
has never been in surplus since the 1970s. Moreover, the extent of the deficit has undergone
significant changes over the different periods. During the period 1955-65 balanced budgets were
maintained more or less while between 1965-74 deficits were kept small as the result of fiscal
conservatism. Afterwards a large and persistently rising fiscal deficit was sustained. The budget
deficit has also remained significant even after the introduction of various reform programs in
1992/93. In 1999/00 government expenditure was around 32 percent of GDP while total
government revenue was 19.4 percent of GDP. Abinet Gebrekidan 234 This clearly indicates that
there is an excess of government expenditure over revenue, which leads to a huge budget deficit.
In 1998/99 and 1999/00 this fiscal deficit increased to 9.6 percent and 13.6 percent of GDP,
respectively. This is due to the breakout of war with Eritrea in 1998 and the natural disaster in
the same year. In 2000/01 this figure decreased to 8.2 percent of GDP. Based on updated
estimates, in 2003/04 the fiscal deficit (including grants) is likely to be about 4.8 percent of
GDP. In nominal terms, revenue surpassed the program target because of strong indirect tax
receipts stemming from buoyant import growth and improved customs administration, which
more than offset lower-than-projected direct taxes that reflected weak corporate profits following
the drought of 2001/02. Moreover, donors provided more external grants and less project loans,
given the vulnerable debt situation. The external current account deficit (including grants) is
estimated to narrow to 4 percent in 2003/04. However, deficits had been financed from both
external and domestic sources. External sources include external borrowing and grants while
domestic sources include borrowing from banking system and non-banking sources. 2.3.
External Debt The poor performance of the Ethiopian economy has made external assistance a
prominent feature of the country’s economic structure. Since 1974, at which Ethiopia applied for
loan from the IMF, the country has frown more and more dependent on external assistance and
has reached a stage where it cannot function without it (Berhanu and Befekadu, 1999/2000).
Ethiopia’s external debt has changed significantly in its magnitude, structure and composition
over the last quarter of the 20th century. To put it in a historical context, the size of the debt and
its composition has changed since the mid 1970s. During the Imperial regime the size of the debt
was modest. The magnitude of the debt in 1975 when the Imperial regime fell was only USD 371
million. But by the end of 1991, it reached USD 8790 million. More than half (USD 4744
million or 54 percent) of the total debt was contracted for defence purposes. Consequently, the
major share (74.6 percent) of the debt was owed for bilateral creditors in which the Former

6
Soviet Union alone accounted for about 78 percent of the total bilateral debt. In contrast to the
composition of the present debt, the share of Multilateral Institutions in the total debt was only
16.8 percent during the previous regime (Teklu, 2000). 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 and it 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 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 loan able 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 (https//sc.sogang.kr>jeonsh>prin-2).

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

7
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,1980).

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 from other 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 2021. Finally, the study attempts to find out the significant determinants of
budget deficit in Ethiopia and will be arrive at the concluding remarks.

1.3 RESEARCH QUESTION

1. What is the effect of the real per capital GDP on budget deficit?
2. What is the effect of the inflation rate on budget deficit?
3. What is the effect of the external debt on budget deficit.

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1.4 Objective of the Study

1.4.1 General Objective of the Study

The main objective of this study is to investigate the determinant/factors of budget deficit in
Ethiopia.

1.4.2 Specific objective

 The researcher will be assess the effect of real per capital GDP on budget deficit.
 The researcher will be assess the effect of inflation rate on budget deficit.
 The researcher will be assess the effect of external debt on budget deficit.

1.5 Scope of the study

This study will be limited both in time and geographical coverage. It will also cover from the
period 1985 to 2021, because it will be time series study and its geographical restriction in
Ethiopia. The focus of the study will be the determinant of budget deficit in Ethiopia.

1.6 Significance of the study

My study will be conduct on the determinants of budget deficit at national level. It will
significant in the context of the following: Provides information about the determinants of
budget deficit and Shows the proper measure to take reduce budget deficit. Finally, It may also
give a clue for further study about determinants of budget deficit in the future.

1.8 Organization of the study

The organization of the study will organize in to five chapters. The first chapter of the study will
deals with background of the study, statement of the problem, objective of study, hypothesis,
significance of the study, scope of the study and organization of the study. The second chapter
will discuses the theoretical literature on budget deficit and means of financing budget deficit. In
addition review of the empirical literature will deal. The third chapter deals with the
methodology of the study.

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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

10
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. Not
withstanding 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 LCD'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

11
fiscal indiscipline aligned with structural variables as a major factor underlying the expansion of
fiscal deficit.

Taylor's (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

12
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 socioeconomic 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.

13
2.2 EMPIRICAL LETRATURE
This section summarizes the major empirical findings of different previous studies. It is known
that fiscal deficit adversely affect the economic structure and this impact depends on the way of
financing. Generally, to analyze budget deficit and related issues ten case studies will be taken
out of fifty nine countries (LDCs and DCs) and econometric estimation will be applied to each
cases. The ten countries are Argentina, Chile, Colombia, Coetdivore, Ghana, Mexico, Morocco,
Pakistan, Thailand and Zimbabwe. The reason for choosing them is because of their
representative of the developing worlds and their diverse fiscal and macro experiences (Rodger,
1994).

The study concludes that the simple correlation between fiscal deficit and individual indicator of
macroeconomic imbalances (interest, inflation etc.) are weak to nonexistent. This is clearly due
to the application of different mechanisms 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 rate, real exchange rates)) and found that only in Colombia,
more than 50% of the variation in deficit was explained by foreign shocks, but in Chile, Ghana
and Zimbabwe foreign shocks do not seems to explains the direct variation the Oliver Tansy
effect by inflation lower tax revenue are seen only in Ghana, Colombia, Thailand and Zimbabwe.
Revenue from money creation associated with inflation was found in Thailand and Argentina.
An additional percentage in GDP from money creation induces by 5% additional: inflation in
Thailand and 97% inflation in Argentina (ibid).

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.

( 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

14
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. Co-integration 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(Ramangkuria,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

15
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.

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 CHAPTER THREE

3. METHODOLOGY OF THE STUDY

3.1. Nature and Source of data

This study will aims at establishing the determinant of budget deficit in Ethiopia.My study will
intends to use secondary time series data collecte from different sources for the period from
1985-2018. Hence, the data for determinant of budget deficit variables are; real gross domestic
product per capital, Real Growth Domestic Product Annual Growth rate, Inflation rate and
External Debt will be obtaine from Ministry of Finance and Development (MOFED), Central
Statistics Authority (CSA), National Bank of Ethiopia (NBE) and other sources.

3.2 Method of data analysis

The data will obtain from secondary sources and analyze by using description and econometrics
model for a better clarification and discussion. My paper will be use time series data estimation
following; test of stationary in order to eliminate the possibility of spurious regression results,
test for co-integration. The essence of co-integration will to ascertain whether the residual of the
regression estimate using the non- stationary variables is stationary.

3.3 Model specification

Model specification refers to mathematical demonstration of the relationship between the
dependent and independent variables.
To find the determinants budget deficit during the period of 1995 up to 2006. Cambes and Saadi-
Sedik specify the following models.
BDi=f (CBIi, lnRGDPi, GRGDPi, URBi, AGRIi, ILLYi, OPENi,Ei)
Where i=denotes the time
Ei=error term and variables are defined as follows
BDi = denotes the government budget deficit

17
 CBIi= central bank independence
LRGDPi= the log of real per capita GDP
URBi=the degree of urbanization
AGRIi=the share of agriculture in the GDP
ILLYi= the ratio of liquid liabilities of the financial system to GDP
OPENi=the trade openness
Following the model specified by Cambes and Saadi-Sedik the budget deficit model of this study
can be specifie 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 ,Ut )
The linear equation is therefore,
BDi = BO+ B1RGDPt + B2GRGDPt+ B3EXDt+B4IRt+ Ui
Where t=denotes time, Ui random term
BDt = denotes the government budget deficit
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
B0 = the value of budget deficit when explanatory variables are zero

3.4 Description and expected sign of the variables used in the analysis

3.4.1 Dependent variable

The dependent variable will the budget deficit in the percent of GDP and it will take from
National Bank of Ethiopia (NBE). This measure of budget surplus which excludes net interest
payments of the treasury is probably the most appropriate measure of the fiscal discipline
because it assesses the orientation of the fiscal policy over a year. Furthermore, from an
econometric point of view, this measure allows us to avoid a potential simultaneity bias between
the dependent variable and the principal explanatory variables

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3.4.2 Explanatory variables
Explanatory variable is the one that explains change in dependent variables. It can be anything
that might affect the response variable. From this study the explanatory variable will include in
the model due to the reason that discusse 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 socio political effects if social conflicts
are more important in poor countries. The GDP per capital is positive.
GRGDP; (Real GDP annual growth rate); is include 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 are low or moderate the amount of tax revenue collecte by the
government decreases while social expenditure increase, this leads 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 suggeste that fiscal
policy can be pro-cyclical in developing countries with weak governments, because political
pressure 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 will be take in recently in order to
reduce saving and external exchange gaps, close the budget deficits, and maintain the economic
growth and development. When external debt is take due to in adequate domestic resources is
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

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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).

3.5. Estimation Procedure

In macroeconomic variables of time series data, it is mandatory to pass different stages of
estimation techniques before entering into analysis or regression of the variable. These stages are
Stationary unit root test and co integration tests are called pre-estimation and diagnostic tests are
called post-estimation tests of estimation techniques will be employing.

3.5.1. Stationary and Unit Root Tastes

To estimate a more specific relationship between budget deficit and its determinants we have to
sure that the time series data is stationary. Most economic data are non-stationary (random walk).
There exists a trend element in which both the independent variables and dependent variables
grow up ward or decreases down ward continuously together.
Running ordinary least squares (OLS) on this data give higher R2 which seems as the
explanatory variables well explain the regressed. However, the higher magnitude of the multiple
coefficient of determination (R2) arises from spurious (false) relationship between the dependent
and independent variables (Thomas, 1993).
If the time series data are found to be non-stationary, most of classical assumption for
econometric estimation will be violated clearly and available data mean and variances will
change over time. In such cases econometric results may not be ideal for policy making because
the OLS estimation gives inconsistent estimates (Gujarati, 1995).
In the past the popular method to overcome the problem was to estimate the rates of changes
between variables instead of using their absolute levels. However, this doesn’t capture the long
run information of the model. Besides, the disturbance term, this is obtained after first
differencing auto correlates.
The common tests used are Dickey Fuller (DF) and Augment Dickey Fuller (ADF) tests. These
tests are basically required to ascertain a number of time variables have to be differenced to
arrive at stationary. A time series data are said to be differenced of ordered ‘p’ if it became

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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).
The Phillips–Perron (PP) unit root tests are similar to ADF tests except that Phillips and Perron
use nonparametric statistical methods to take care of the serial correlation in the error terms
without adding lagged difference terms (Gujarati, 2004). The PP tests have the same asymptotic
distribution as the corresponding ADF z and t tests, but they are computed quite differently. The
Phillips-Perron (PP) unit-root tests differ from Augmented Dickey Fuller (ADF) tests mainly in
how they deal with serial correlation and heteroskedasticity in the residual and also the Phillips-
Perron (PP) tests ignore any serial correlation in the regression of test.

3.5.2 Co-integration test

After checking Stationary and Unit Root Tastes, i will be test co-integration taste. Co-integration
test tells us about whether there is long run (term) relationship or not. If variables will have
different trained process, they will not stay in fixed long run relation to each other, implies that
you can not model the long run and there is usually no valid base for inference based on standard
distribution (Sjo, 2008). According to Wooldridge (2000) the issue of co-integration will applies
when two series are I (1) spurious, but a linear combination of them is I(0); in this case the
regression on other is not spurious, but instead tells us something the long run relationship
between them. If a linear combination of I (1) variables will stationary, then the variable are said
to be co-integrated.

3.5.3. Diagnostic Tests

In this study a number of Diagnostics tests will be undertake to detect model misspecification
and as a guide for model improvement. And it must to test the data for different diseases which
will mislead the output and end up with wrong interpretations and conclusions.

Tests for normality

The Jarque-Bera normality test will be use to determine whether the regression errors are
normally distributed. Since normal distribution of variable and residual are very important
assumptions in regression. It is a joint asymptotic test whose statistic is calculated from the
skewness and kurtosis of the residuals.

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Model specification test

Test for omitte variable bias will important for our model since it is related to the assumption
that the error term and the independent variables in the model are not correlated (E (e|X) = 0). If
there is missing variable in our model and “is correlated with the included regression and the
omitted variable is a determinant of the dependent variable” (Stock and Watson, 2003,) Then our
regression coefficients are inconsistent. In Stata by using the ovtest command: omitted-variable
bias can be found. The null hypothesis is that the model does not have omitted-variables bias, if
the p-value is higher than the usual 95% significance.

Heteroskedasticity Test
The test for Heteroskedasticity investigates whether the variance of the errors in the model are
constant or not. Breusch-Pagan-Godfrey test is used to check whether the residuals are
Homoscedasticity. It tests the null hypothesis that the residuals are both Homoscedasticity and
that there is no problem of misspecification. The test regression is run by regressing each cross
product of the residuals on the cross products of the regressors and testing the joint significance
of the regression. If the test statistic is significant, that is, P value is less than 0.05; the null
hypothesis of Homoscedasticity and no misspecification will be rejected (Brooks, 2002: 445).
Tests for autocorrelation
In running ordinary least squares estimation the most important assumption is that the
consecutive error terms are not correlated or there is no autocorrelation. Running OLS estimation
by disregarding autocorrelation will result in inefficiency on the estimate result and its standard
errors are estimate in the wrong way. Therefore detecting autocorrelation is a vital issue for my
study .Since i use OLS estimation.
Detecting autocorrelation
The Durbin Watson (DW) test
H0- no autocorrelation
H1-autocorrelation exist
Autocorrelation prevails in time series data analysis in which correlation exist between residuals
exist (et depends on et-1). The problems of autocorrelation can be tested using DW (Durbin
Watson statistics).
Tests for multicollinearity

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It occurs when the explanatory variables are highly interrelated. Variance inflation factor (VIF)
can be employe to detect this problem. If VIF is greater than 10, then there is a problem of
multicollinearity. In the case serious multicollinearity, although BLUE, the OLS estimators have
large variance and covariance’s, making precise estimation difficult and because of this the
confidence interval tends to be much wider leading to acceptance of the zero null hypothesis
more readily (Guajarati, 20)

CHAPTER FOUR

4. WORK PLAN AND BUDGET SUMMARY

4.1 WORK PLAN

Table 1: Time schedule

No Activity November December January

1 Title selection ✔

2 Title approval ✔

3 Literature finding ✔

4 Proposal writing ✔

5 First draft proposal ✔

submission

6 Final proposal ✔
submission

Presentation of ✔
proposal

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4.2 Budget Summaries
Table 2 Logistics and budget summaries

No. Items Unit Quantity Unit cost Total

(ETB)

1 Duplicating paper In number 20 2 40

2 Flash disk 16 GB 1 400 400

3 Pen In number 2 25 50

4 Pencil Number 1 10 10

5 Pencil sharpener Number 1 5 5

6 Cost for internet package Hour 5 15 75

7 Typist 40 pages 5 200

Eraser Number 1 5 5

7 Other expences 300

Total 885

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 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, 4th 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.

(William easterly,2008/2010 and Mankiw,2007)

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