Does public debt granger-cause inflation? A multivariate analysis

Abstract

The optimal balance between fiscal and monetary policy in achieving price stability has been contested in literature. In the main, however, it is widely recognised that whether public debts are financed in a monetary way or otherwise, the choice of policy action affects the effectiveness of monetary policy in ensuring price stability. This study contributes to the debate by testing the dynamic causal relationship between public debt and inflation in Tanzania covering the period 1970-2020. The study applies the autoregressive distributed lag (ARDL) bounds testing technique to cointegration and the ECM-based Granger-causality test to explore this relationship. In order to address the omission-of-variable bias, which has been the major methodological deficiency detected in some previous studies, two monetary variables, namely money supply and interest rate, were added as intermittent variables alongside public debt and inflation. The findings from this study show that there is a consistent long-run cointegrating relationship between public debt, inflation, money supply and interest rate in Tanzania. However, the results fail to find evidence of causality between public debt and inflation in Tanzania, irrespective of whether the causality is estimated in the short run or in the long run. The findings of this study, therefore, show that Tanzania’s current debt is not inflationary; hence, policymakers may continue to pursue the desirable fiscal policies necessary for the country’s long-term optimal growth path.