The budget deficit and financial crowding out: evidence from Sri Lanka

Fiscal policy is an important factor that influences the effectiveness of private investment. An expansionary fiscal policy might lead to growth in total income of a country, while such may also raise interest rates and thereby reduce private investment. The present study examined whether there is such a financial crowding out with reference to Sri Lanka, amidst a dearth of studies examining the impact of the budget deficit on private investment. Time series data from 1960 to 2007 were used for empirical tests based on Neoclassical Flexible Accelerator and Mundell-Fleming models. The bounds testing co-integration procedure was adopted to test the long-run relationships and dynamic interactions among variables. The results show that there is a long run co-integration relationship between real interest rate and budget deficit, money supply, exchange rate, and the expected inflation. The study found evidence for the absence of a financial crowding out effect as a result of fiscal expansions in Sri Lanka, where private investment appears to have increased as a result of fiscal expansions. The Central Bank of Sri Lanka appears to have mitigated any crowding out effect of fiscal expansions by an accommodative monetary policy which has been financed through capital inflows, foreign aid, foreign debt, and worker remittances.