There has been a plethora of studies concerning the relationship between budget deficit and interest rate. An expansionary fiscal policy followed by the Government to finance the deficit leads to a shift of the IS curve to the right, resulting in an increase in interest rate. On the other hand, Ricardian Equivalence Theorem negates any such relation. This study involves IPS data, where the real interest rate is used. This study is based on a battery of tests like ADF, PP unit root test, Correlogram followed by the estimation of Co- integration, Vector ECM, Granger Causality. This study rejects the Ricardian Equivalence Theorem and finds that there exists a long run as well as short run dynamics in the relationship where unidirectional Granger Causality runs from Budget Deficit to Interest Rate over the period 1972–2003 in the economy of Nepal in the short -run while in the long-run just the opposite has happened, that is, Interest rate Granger causes the budget deficit. This result implies that the high interest rate fuelled the accumulation of more debt through an increase in interest payments and the consequent debt-deficit spiral.
