Identifying fiscal inflation in India: some recent evidence from an asymmetric approach.
| Autor | Bhat, Javed Ahmad |
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Introduction
Higher inflation (INF) has been considered a growth retarding factor and a means of reducing the welfare standard of common masses. Therefore, maintaining a stable price level featured by low INF rate has remained a priority objective of macroeconomic management of various economies including India. Among the many factors fueling the inflationary tendencies in an economy such as monetary shocks, structural shocks, demand shocks, external shocks and demographic changes, the issue of INF has also been found related to fiscal policy decisions of the government. The fiscal theory of price level (FTPL) (Leeper, 1991; Sims, 1994 and Woodford, 2001) and the seminal work of Sargent and Wallace (1981) developed the theoretical contours for the establishment of an interaction between inflationary pressures in an economy and the government budgetary imbalances. The former talks about the complementarity between monetary and fiscal policies for the price level determination; and on policy plane, the theory suggests the sustainability of government finances to ensure the stable price level. The latter highlights the role of relative dominance of monetary/fiscal authorities in the determination of the price level. In a monetary dominance regime, fiscal authorities abide with the decisions of independently determined monetary policy and are constrained to follow a fiscal discipline strategy to avoid the inflationary pressures in the economy. On the contrary, in a fiscal dominance regime, the fiscal authorities determine the level of current and future fiscal imbalances and thereby constrain the monetary authority for the demand of government bonds. This leads to excess money creation through debt monetization, and hence, inflationary tendencies emerge [1]. The deficit could be financed either through the imposition of higher taxes or domestic or external borrowings. However, developing countries quite often finance their deficit through debt monetization because of the high costs associated with higher tax rates, political instability and market borrowings. As a result, fiscal view of INF is more often reported in the developing countries than in the developed countries, which are seen to have efficient tax collection system and considerable access to external borrowings (Catao and Terrones, 2005).
The present paper aims at examining the impact of fiscal deficit on the inflation in case of Indian economy. Though several studies have been conducted in the Indian context, the deficit-INF nexus has not been evaluated exhaustively and the evidence reported by earlier studies remained inconclusive. India is chosen as a candidate for analysis because of its vibrant INF dynamics and its observed downward inflexibility of deficit financing (Figures 1 and 2). The deficit financing has always been considered a viable instrument to avoid any recessionary tendencies in the economy. Recognizing the adverse impacts of excess deficit, the government followed the fiscal consolidation program through the FRBM Act[2] (2003-04) and finalized the pro-growth targets for fiscal imbalances. However, the recent fiscal response to the 2008 global crisis, following the suspension of fiscal targets, not only enabled India to avoid the crisis at home but also to continue along its growth trajectory as well. The move, however, represented a deviation from the fiscal discipline path. Even though the efforts have been made to curtail the deficit figures appreciably, the economy is still plagued with persistent deficit of 3.52% of gross domestic product (GDP) in 2016-17[3]. In light of swelling deficit figures and vibrant inflationary phenomenon, as observed from the Figures 1 and 2 in the economy, it would, therefore, be important to examine the possible interaction between these two variables.
Though the inflationary pressures in India have been theoretically ascribed to both domestic and foreign factors and to both supply and demand shocks, however, the empirical evidence reported remains inadequate (Mohanty and John, 2015). The possible reason for such an inadequacy could be the changes in determinants of INF over the period of time (Mohanty and John, 2015). Given the backdrop, we attempted to analyze the inflationary phenomenon from the viewpoint of fiscal deficit to sort out the likely role of the latter in explaining the overall INF. Work reported is motivated by lack of adequate literature so far as India is concerned and mixed evidence reported in the general literature on the deficit-INF nexus. The study adopts a broader analytical framework to include all the potential determinants of INF in addition to fiscal deficit. Data for the period 1970-2016 has been examined to provide an evaluation of Indian inflationary problem with some recent evidence. The paper hopes to contribute to the existing literature in the following ways. First, taking note of dynamic nature of the relationship between these two variables, we examined the deficit INF nexus in a dynamic and asymmetric framework. The novelty of the study is ensured by the very nature of it is the first study in case of India to identify the fiscal INF in an asymmetric configuration. We applied a non-linear autoregressive distributed lag model (NARDL), given by Shin et al. (2014) to examine the existence, if any, of cointegrating relationship in an asymmetric paradigm. This method has been applied because of its potential merits over the other conventional linear approaches. Second, the nature of causality between fiscal deficit and INF is examined in time domain and FD frameworks to portray precisely the casual interactions between these two variables in both the short-run and long run.
The studies so far conducted, have primarily based their analysis within a linear or symmetrical framework and have ignored the possibility of any asymmetric nature of the association between the two variables. The severe repercussions of this practice of assuming a symmetric association may lead to incorrect policy actions as may be needed for overall macroeconomic stability. The choice of an emerging economy, India, for the asymmetric investigation of deficit-INF nexus is motivated by the prevalence of a large section of liquidity constrained population together with persistent inequalities (Mazumdar et al., 2017; Bhat and Sharma, 2018). The lack of purchasing power, liquidity tightening and a distorted credit allocation system as prevalent in India together with the operation of consumption/investment downward inflexibility makes it likely that the response of INF to fiscal deficit may not be symmetric.
The remaining part of the paper is arranged as follows. Section 2 specifies the theoretical debate. A cursory summary of the relevant literature is reported in Section 3. Section 4 narrates the nature of variables and exposition of the econometric method to be used, followed by result discussion in Section 5. Finally, the paper conclusion and associated policy recommendations are highlighted in Section 6.
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Theoretical debate
Theoretically, various views have been advocated about the impact of fiscal deficit on INF. Neoclassical theory asserted a positive relationship between the two through higher money demand. When the income of the economic agents rise, more money is needed to facilitate the transactions due to increased incomes. Demand for real balances increase because of the rise in level of real income and hence leads to hike in the price level (Ball, 2017). The Keynesians also provide another channel for a direct association between fiscal deficit and INF like those of Elmendorf and Mankiw (1999)[4] through aggregate demand augmentation. The collapse of Bretton woods system in 1971, which resulted in the era of flexible exchange rate (EXR) regime and the oil price shock of 1970s led to the breakdown of celebrated Philips curve hypothesis. This lead to the development of Monetarist school and the pioneer of which, Milton Friedman, maintained that INF is always and everywhere a monetary phenomenon and that money supply growth that may result because of deficit financing causes INF.
The impact of fiscal deficits on INF has also been discussed in the celebrated work of Sargent and Wallace (1981) in a framework of "monetary dominance" and "fiscal dominance" regimes. The deficit is financed either through bond sales to the public or through the seigniorage created by monetary authority or by a combination of both. In the case of an independent monetary authority framework, fiscal authority is constrained in the formulation of its policy. In this regime of monetary dominance, money supply is regulated and fiscal deficits would tend to be non-inflationary. On the contrary in a fiscal dominance regime, the regulation of money supply by the monetary authorities becomes less effective and fiscal authorities satisfy the inter-temporal budget constraints through the excess money creation, in the process leading to INF. While the monetarists ascribe the tag of the monetary phenomenon to INF, Fischer and Easterly (1990) regarded the inflationary tendencies as being a fiscal phenomenon. In reality, fiscal authorities have often preferred seigniorage to finance the fiscal imbalances, thereby triggering the inflationary pressures.
There is yet another recent theoretical premise arguing for the nature of the relationship between fiscal deficit and INF, namely, the FTPL, given by Woodford (1994, 1995, 2001), McCallum (2001), Cochrane (2001, 2005) and Leeper and Yun (2006). According to FTPL, the price level in an economy is not determined individually by monetary authorities alone, but complementarity of both monetary and fiscal policies is operative. When the fiscal authorities make an adjustment to the present value of its future surpluses, the price level will rise to lower the real value of debt[5]. In FTPL, fiscal authorities are permitted to choose the surplus or deficit figures, not...
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