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Archives of Business Research – Vol. 10, No. 2

Publication Date: February 25, 2022

DOI:10.14738/abr.102.11709. Tenny, L. Z., & Ekperiware, M. (2022). The Macroeconomics of Fiscal Policy Behavior in Liberia: An Error Correction Methodology.

Archives of Business Research, 10(02). 17-25.

Services for Science and Education – United Kingdom

The Macroeconomics of Fiscal Policy Behavior in Liberia: An

Error Correction Methodology

Lester Zomatic Tenny, PhD

University of Liberia, Monrovia, Liberia

Moses Ekperiware, PhD

Caleb University, Lagos, Nigeria

ABSTRACT

The debate of the size of government and economic growth has been popular

especially in Africa. This study examined the relationship between fiscal variables,

inflation and economic growth in Liberia. The Vector Error Correction Model

(VECM) is employed. Results from the Impulse Response Function (IRF) analysis

reveal that the response of inflation to growth in the Liberian economy over the

study period, was weak, though significant and negative in the short run. However,

it became positive and normalized in the medium and long runs. This means that

inflation retarded growth only in the short run which is consistent with Barro

(1996) empirical findings that inflation impact growth negatively and significantly.

Also observed is the relationship between government expenditure and economic

growth. For the Liberian economy and despite the interruption of the war,

government expenditure impact on growth is a short run positive event, In medium

to long run, it has a negative effect. This means that government expenditure only

spur growth in the short run slightly but did not bring about growth in the medium

to long run. This makes Keynesian theory relative to the intervention of

government through spending given rise to growth invalid for the Liberian

economy in the long run. However, the impact of growth on expenditure in the

medium and long run is significant and strong. This suggests that indeed Wagner’s

Law of increasing State spending is valid for the Liberian economy. Hence, fiscal

policy is still a mix in stirring economic growth in Liberia. This study recommends

well stirred fiscal policies that would positively impact on long run development in

the Liberian economy.

Keywords: impulse response function, vector error correction, Keynesian model

INTRODUCTION

Fiscal policy has been prominent of the four basic issues arising from economic management

like; self-regulating or laissez faire, allowing for non-government interventions; the use of fiscal

policy or a mixture of both fiscal policy and monetary policy. How fiscal policy behavior reflects

in inflation rate in determining productivity is germane to any government involved economic

management system like the Liberian economy. The intricacies of the interrelationships among

the components of these three macroeconomic variable (inflation, economic growth and

government expenditure) which have generated a healthy debate of how fiscal policy reflects

on inflation and economic growth is the core of this study.

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Archives of Business Research (ABR) Vol. 10, Issue 2, February-2022

Services for Science and Education – United Kingdom

There is a wide range of issues on the applicability of Wagner’s Law and the theories of

increasing state spending. There are mixed results from various research done to test the

validity of the Law and varied methodologies have produced different results. It is a research

motivation as mixed results abound when the law is being tested in various regions. Also to

note is that the law seems to be valid for developed countries where the availability of

infrastructure and systems are visible, unlike the developing counterparts.

LITERATURE REVIEW

Studies like Perotti (2005) has examined the subject matter government spending. Blanchard

and Perotti (2012), in their empirical characterization of the dynamic effects of changes in

government spending and taxes on output using the USA mixed structural VAR/EVENT

Approach. The study concluded that positive government shocks have a positive effect on

consumption, while positive tax shock has a negative effect. Private consumption investment

was constantly crowded out by taxation, and crowded in by government spending. Fatas (2003)

looked at the effect of fiscal policy on consumption and employment through theory and

evidence in USA with structural VAR. the duo concluded that positive shocks in government

expenditure are accompanied by strong and relentless increases in consumption and

employment. Doessel and Valadkhani (2003) further examine the effect of government on

economic growth in Fiji, using OLS using Annual time series. The results were mixed: that

government expenditure exerts a strong beneficial impact on economic growth. However,

marginal factor productivity in the government sector is found to be lower than that of the

private sector.

Alexander (1980) studied the relationship between economic growth and government

expenditure in OECD countries (13 OECD countries), using the OLS from panel data. The result

indicates that growth of government expenditure has a negative impact on economic growth

from the study. Gregorious and Ghosh (2008) examine the impact of government expenditure

on economic growth in 9 OECD countries, using the heterogenous panel data employing OLS.

The results show that countries with large expenditure tends to experience higher growth. In

another study, Abizadeh and Yousif (1998) demonstrate the dynamics of public spending and

growth through an empirical analysis in South Korea using annual data employing Granger

causality test. The findings indicate that government expenditure did not contribute to

economic growth in Korea. More so, Singh and Sahni (1984) contributed to the discuss by

looking at the causality between public expenditure and national income with India total

aggregate and disaggregate data using granger causality. The results show a positive direction

between national income and public expenditure between 1950-1981.

Tang, Tuck and Cheong (2001) illustrate the Wagner Law validity in Malaysia in an empirical

analytical approach in Malaysia with annual data from 1960-1998 employing Johnasen

multivariate cointegration approach. No longrun relationship among the non-stantionary

variables existed; however, a unidirectional causality was observed from national income to

government expenditure growth, which supports Wagner’s Law for the short run. Cheng and

Lai (1997)on Wagner’s law did an econometric test for South Korea 1950–1981. Applying Sims

(1980) Johanesen 8-cointegration and Hsiao version of granger causality method. The Wagner

Law was valid for public expenditure and economic growth in the study. Also, Folster and

Henrekson (2001) looked at government spending and economic growth in sample of 22

developed countries between 1970-1995 with various econometric approaches. The findings

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Tenny, L. Z., & Ekperiware, M. (2022). The Macroeconomics of Fiscal Policy Behavior in Liberia: An Error Correction Methodology. Archives of Business

Research, 10(02). 17-25.

URL: http://dx.doi.org/10.14738/abr.102.11709

came up with a more meaningful and robust result to validate Wagner Law for public

expenditure and economic growth. Further testing the Validity of Wagner’s Law in Bolivia,

Bojanic (2010) used a cointegration and causality analysis with disaggregated annual time

series data from the periods 1940 to 2010. The results, after testing nine versions of Wagner’s

Law on the Bolivian economy, was consistent with Wagner’s proposition. Also, a bidirectional

granger causality was found between income and government expenditures in six of the nine

versions of the law. The findings also suggest that government expenditures do not exert a

positive influence on growth, hence the need to rethink how public funds are spent on a variety

of public services was recommended.

Overall, few studies exist for both developed and developing countries according to Schclarek

(2007). They have been restricted by relatively short time series and highly aggregated fiscal

data in economy like Liberia. This study contributed to the very scanty literature on fiscal

behavior in the Liberia economy by providing a more detailed analysis of the effects of fiscal

policy actions in Liberia, using Error- Correction Mechanism Model (VECM). The study covered

a forty-four-year period, from 1970 to 2014. The periods were chosen because it was a period

that Liberia experience increased growth from exports of iron ore and other natural resources

in the 70s. It also covers the periods of war and post war economic situation in Liberian

economy. Hence, it will be informing and contributive to the understanding of fiscal policy and

inflation dynamics affecting economic growth. The basic research question is to what extent

fiscal Policy and inflation influenced economic growth in Liberia? Based on the puzzle this

research exercise is concerned, the study is set to examine the trend of fiscal policy and

economic growth and analyze the effect of fiscal policy on the relationship between inflation

and economic growth.

Keynes (1936) and his supporters emphasize the role of fiscal policy as a tools that should be

used during times of recession to boost economic activities, that is expansionary fiscal policy,

expanding public expenditure to raise national output (Aruwa, 2010). Higher government

spending may hinder overall economic performance if the spending comes at a cost of increased

taxes and/or borrowing to finance the government expenditures.

A fiscal framework that asks for the implementation of sound fiscal policies, notably within the

Public Financial Management Act of Liberia is an indispensable tool for the well-functioning of

the country’s economy. However, Liberia track records of complying with the fiscal rules laid

down in the public financial management (PFM) documents are mixed. Therefore, it is relevant

to analyze fiscal behavior or government spending, and revenue as well as inflation and the role

they played in contributing to the improvement of the nation’s economy.

METHODOLOGY

This section discusses the econometric frameworks behind this study. The empirical approach

for this study relied on restricted Vector Auto Regression (VECM) in providing for the effect of

fiscal policy in the Liberian economy. The VECM presents the needed impulse response to

shocks in examining fiscal policy. It is an extension of VAR and it incorporates the possibly

cointegrating error term ( ) into the VAR model.

VAR (j) (3.1)

ECTit-1

Yt Yt j

Yt j ECTt t =a +f + +f +p +e 1 -1 - -1 ...