The Relationship Between Fiscal Deficit and Inflation in India: A Cointegration Analysis
Keywords:Exchange Rate, Fiscal Deficit, Granger Causality, Inflation, Johansen Cointegration, Money Supply
AbstractMaintaining price stability is an important macroeconomic goal for sustainability of economic growth. Fiscal deficit has come to be widely regarded as the key player in determining inflation dynamics. Theoretical insights on inflation, however, give a contrasting view on the inflationary tendencies of fiscal deficit. The fiscal theory of price level suggests that persistent budget deficits can result in inflation, while the monetarists consider inflation to be a monetary phenomenon. The structural economists attribute rising prices to the changes in demand and supply constraints while Ricardian Equivalence Hypothesis views fiscal deficit and inflation to be independent of each other. In light of these competing theoretical views on the factors affecting inflation, this study empirically examines the equilibrium relationship between fiscal deficit, money supply, exchange rate and inflation using Indian annual data for the period 1970-71 to 2014-15. The econometric framework used for the analysis is the Johansen cointegration technique, which tests both the existence and the number of cointegrating vectors. Furthermore, for testing the short-run causality, Granger Causality tests have been employed. The results show that there exists a long-run relationship between fiscal deficit, money supply, exchange rate volatility and inflation. Granger Causality tests do not confirm the causality running from fiscal deficit to inflation. This implies that the fiscal theory of the price level does not find empirical support in the Indian case. Given these findings, the efficacy of fiscal deficit as an instrument of price stabilisation in the short-run is questioned.
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