The Dynamics of Public Debt, Inflation and Exchange Rate in Ghana: A Vector Autoregressive Analysis

ABSTRACT

The rising trend in Ghana’s public debt has sparked some controversies about the relationship and the direction of causality between the public debt and two of its determinants ― inflation and the exchange rate. While some argue that public debt affects the exchange rate and inflation, others are of the view that inflation and exchange rate rather affect the public debt. This study therefore investigates the relationship and the direction of causality between the public debt, inflation and the exchange rate in Ghana. We employ the vector auto-regressive technique to empirically investigate these relationships for the period 1990-2013, both in the short run and the long run. The dynamic interactions are studied with Granger causality tests, impulse response functions, and forecast error variance decompositions. Using the Johansen approach, the empirical results found a long-run relationship running from inflation and exchange rate to the public debt ratio with no feedback from the public debt to inflation and the exchange rate in the long run. In the short-run, while the study found a negative significant relationship between inflation and the public debt, no strong relationship was found to exist between the public debt and exchange rate in the short run.

One channel of unidirectional causality was found in the short run, actively running from inflation to public debt. All the impulse response functions of shocks to the variables were found to be permanent over time which was reinforced by the level effects (estimated using cumulative impulse response functions). The diagnostic test confirmed the validity of the model and CUSUM and CUSUMSQ test revealed the stability of the model. The results from the study imply that policy makers should choose inflation over exchange rate as a policy variable to reduce the public debt in the short-run. Moreover, a higher and rising public debt has no exchange rate risk or inflation risk in the case of Ghana, and hence the government can still borrow in the short run with no negative impact on inflation and exchange.