The Influence of Budget Deficits on Interest Rates: An Empirical Analysis in the Sri Lankan Context

Abstract

Since Sri Lanka liberalized its economy in 1977, it has persistently faced challenges with budget deficits, leading to a substantial increase in public debt. These consistent deficits have raised concerns about the economic impact, especially regarding higher interest rates and reduced investment. This study aims to examine the effects of budget deficits on interest rates in Sri Lanka using the Autoregressive Distributed Lag (ARDL) bound testing approach, impulse response function, variance decomposition analysis, and VAR causality analysis. The data considered for this analysis covers the period from 1990 to 2019. The findings from the impulse response, variance decomposition, and VAR causality analysis illustrate that the effect of interest rates, increasing government fiscal deficits are initially gradual. This explains that higher government deficits reduce the available funds for loans, and discourage private-sector investment. Further, the findings revealed the neutrality of the budget deficit on the interest rate. Also, the economic growth rate and consumer price index have a significant and negative influence in the short-run and long-run. In addition, the positive fluence of the budget deficit, a negative impact of economic growth, and trade balance ensure the crowding–out effect, suggest that increasing government borrowing may reduce private-sector investment and output expansion during the study period. It is recommended that the government of Sri Lanka implement an efficient tax system and that target specific sectors like education, research, and infrastructure which enhance the productive capacity and stimulate private sector investments in these areas.