Dynamic Relationship Between Gross Domestic Product and Domestic Investments in Rwanda

Abstract

This study uses a VAR model to analyse the dynamic relationship between gross domestic product (GDP) and domestic investment (DI) in Rwanda for the period 1970 to 2011. Several selection lag criteria chose a maximum lag of one and a bivariate VAR(1) model specification in levels was adopted. Unit root tests show that both GDP and DI series are nonstationary in levels but stationary in first differences, implying that both are integrated of order one I(1). Tests of cointegration established that GDP and DI are CI(1,1), suggesting there is a long-run equilibrium relationship between the two series. The error correction model indicates that DI adjusts to GDP with a lag whereby 0.2 percent of the discrepancy between long-term and short-term DI is corrected within the year. Granger causality tests show that there is unidirectional causality where GDP causes DI. The bivariate VAR (1) was unstable when estimated at levels, but was stable in first differences. Finally it was found out that GDP almost perfectly predicts DI in the estimated VAR (1) model. The forecasted value of DI in 2011 was 22.6%of GDP while the actual value was 22.7% of GDP. The small discrepancy may be attributed to the appropriate policy measures the Rwandan government and the private sector federation have thus far taken to facilitate investors in their businesses.

Keywords: Gross Domestic Product (GDP); Domestic Investment (DI); Granger Causality; Cointegration; Vector Autoregression (VAR) and Vector Error Correction Model (VECM)