Revisiting the role of fiscal policy in determining interest rate in India

Abstract

The issue of fiscal policy affecting interest rates is ever-evolving that depends on the structure of the economy and the strength of the financial markets. Hence, it is necessary to continuously validate this relationship between fiscal policy and interest rates. Towards this, the present paper tries to empirically examine and understand the transmission channels through which fiscal policy could affect short, medium, and long-term interest rates in India using Structural Vector Autoregression (SVAR) and Toda-Yamamoto causality approaches. Our results suggest that fiscal policy has a marginal impact on interest rates in the short run, while it has a larger positive impact on interest rates in the long run through the inflation route. In terms of the policy, in the long run, there is a need for containing the structural part of the fiscal deficit within the fiscal consolidation (Fiscal Responsibility and Budget Management Act) framework in India.

Keywords:

• Fiscal policy
• fiscal deficit
• interest rate
• structural vector autoregression (SVAR)

Disclosure statement

No potential conflict of interest was provided by the author(s).

Notes

1 In the standard neoclassical model, fiscal deficits (other things being given) reduce national savings and increase aggregate demand. This creates an excess supply of government debt, leading to higher real interest rates. Bond financing of fiscal deficit causes a supply of fresh government securities in the securities market. The increased supply of government securities (ceteris paribus) would put downward pressure on prices of these government securities. Hence, it drives up domestic interest rates.

2 The global financial crisis has considerably changed the adaptations of macroeconomics policy by the global economy. It is found that fiscal policy can be used more effectively to generate additional economic activity at the zero lower bound (Shambaugh 2019). Fiscal rules should not interfere when an economy does need fiscal stimulus for its revival (Blinder 2016).

3 However, the linkage between fiscal deficit and interest rates may become weaker due to free capital mobility among economically integrated countries as interest rate does not increase as a result of fiscal expansions because foreign savings replace domestic savings. In an open economy, reduction in national savings may be complemented over a period of time by capital inflows leading to real exchange rate appreciation rather than higher real interest rates (Gale and Orszag 2002). If economic agents behave like ‘Ricardian Equivalence’ manner, i.e., their savings increase in anticipation of future tax hikes to fulfill the inter-temporal budget constraint, then it may reduce the impact of fiscal deficit on interest rates. Similarly, if an economy has excess capacity, high domestic savings, highly developed financial market or passing through a severe recession, then fiscal deficit-interest rates linkage may become weaker.

4 The selected studies on this issue are given in the appendix section (Table 1).

5 It is to be noted that seigniorage financing of fiscal deficit has been neglected in India especially after the mid-1990s. It happened due to phasing out of automatic monetization of fiscal deficit through adhoc treasury bills beginning in 1st April 1997.

6 Fisher relation elucidates that the nominal interest rates will tend to change at the same rate as change in expected inflation.

7 Note: Q1, Q2, Q3 and Q4 denote April to June, July to September, October to December and January to March quarters, respectively. The co-relationship between selected variables are shown in the Table 2 (appendix).

8 The GDP deflator, the most comprehensive measure of inflation, is often considered to be broader than the consumer price index (CPI) and wholesale price index (WPI). The CPI measures the retail prices of goods and services using a fixed basket of goods, while the WPI measures the wholesale price of a representative basket of only goods especially for manufacturing, industry, etc. The fixed basket used by these indices is static and sometimes misses changes in the prices of goods outside the basket. However, the GDP deflator measures the general price pressures of all goods and services produced in an economy and also allows the basket of goods to change over time as the composition of GDP changes. Thus, GDP deflator is an economic wide measure, while WPI/CPI are segmented and incomplete measure for the price level. Thus, the GDP deflator has an advantage over the CPI and WPI. Further, there are significant changes in the way CPI and WPI indices are estimated over the years that lacks comparability.

9 The order of the unrestricted VAR has been determined as six according to the Akaike Information Criterion (AIC) and stability condition is satisfied.

10 ε_t and U_t are vectors of observed (reduced form) residuals and unobserved structural shocks respectively_. A and B are 5x5 matrix which fix the linear relationship between structural shocks and the VAR residuals.

11 Many Indian studies such as Pradhan, Ratha, and Sarma (1990), Mitra (2006), Mundle, Bhanumurthy, and Das (2011), Mohanty (2019), etc. found that public investment/fiscal deficit crowd out private investment.

12 Following the referee’s suggestion, we have also re-estimated the selected SVAR model by including the global financial crisis dummy. The results are very similar to the reported results which can be available upon request from authors. Further, following the referee’s suggestion for checking the sensitivity of the results to different orderings, we have re-estimated the selected models using the Cholesky ordering. It may be noted that Cholesky ordering also gives a very similar results like the estimated SVAR which can be available upon request from authors.

13 3-month Federal Treasury bill rates is used as a proxy for foreign interest rate in the YTBR SVAR model, while 1-year Federal Reserve Treasury bill rate is used in the YLDO SVAR model.

14 5-year Federal Reserve Treasury bill rate are is used as a proxy for foreign interest rate in the YLDF model.

15 10-year Federal Reserve treasury bill rate are is used as a proxy for foreign interest rate in the YLDF model.

16 The advantage of this test is that it can be applied to all series, i.e., I (0), I (1) or I (2), and whether these series are cointegrated or not-cointegrated. This approach fits a standard vector autoregressive (VAR) model in the levels of the variables, irrespective of their level of integration. Thus, the risk associated with the possibility of wrongly identifying the integration order of the series is minimized. The first step is that the order of integration (d_max) of the series under consideration and the optimal lag, k has to be determined. Then a (k + d_max) order of VAR is estimated, and the coefficients of the last lagged d_max vector are ignored. The application of the Toda and Yamamoto (1995) procedure ensures that the usual test statistic for Granger causality has the standard asymptotic distribution, where valid inference can be made.

17 It finds no causality between inflation and fiscal deficit in the pre-crisis period.

18 The issue of FTPL in India will be addressed in the future study.

Additional information

Notes on contributors

Ranjan Kumar Mohanty

Ranjan Kumar Mohanty is an Assistant Professor at the Xavier Institute of Management Bhubaneswar (XIMB), Odisha, India. Prior to this, he worked as an Assistant Professor and Economist at National Institute of Public Finance and Policy (NIPFP), New Delhi, and also as a Jr. Consultant at the Institute of Economic Growth (IEG), Delhi. He did his Ph.D. from Jawaharlal Nehru University, New Delhi, India. His research interests include Macro Economics, Public Finance, Development Economics, Health Economics and Applied Econometrics. He has published in various refereed journals such as Singapore Economic Review, Journal of Public Affairs, Asian Economic Journal, Journal of Quantitative Economics, Economics Bulletin, Economic and Political Weekly, Margin-The Journal of Applied Economic Research, International Review of Economics, etc. He has contributed various chapters in the edited book published by Springer Publication, Regal Publication, Macmillan Publication, CODESRIA, etc. He has also worked on various projects sponsored by Bill and Melinda Gates Foundation (BMGF), World Health Organization (WHO) and NITI Aayog. Email: [email protected]; [email protected].

N. R. Bhanumurthy

N R Bhanumurthy is currently working as Vice Chancellor, Bengaluru Dr BR Ambedkar School of Economics (BASE) University, Karnataka, India. Prior to this he worked as Professor at National Institute of Public Finance and Policy, New Delhi, and also as Associate Professor and Assistant Professor at Institute of Economic Growth, Delhi, India. He did his M.A and M.Phil from University of Hyderabad, and Ph.D. from Institute for Social and Economic Change, Bangalore. His research areas are macro-monetary economics, fiscal policy, international money & finance, macroeconomic modelling and development economics. In these areas he has authored nearly 70 research papers and five books. He had brief stints at UNESCAP, Bangkok and at UNDP Regional Centre for Asia-Pacific region at Colombo as Macroeconomist. He was Visiting Fellow at MSH, Paris, and at Mcgill University, Montreal, Canada. Besides this he has been a consultant to UN-DESA (New York), UN-ESCWA (Beirut), UNDP-Nepal, UNDP-Bhutan, UNESCAP-SSWA (New Delhi), ILO, the World Bank, and Asian Development Bank. He has served on eleven government committees constituted by Ministry of Finance, Ministry of Statistics, National Statistical Commission, and erstwhile Planning Commission of India. Twice he has been invited to Finance Minister’s Pre-Budget Consultation with Economists. Dr Bhanumurthy has been the Secretary of the Indian Econometric Society since 2006 and also Managing Trustee of Indian Economic Association Trust for Research and Development since 2010. Recently he has received two prestigious awards: Mahalanobis Memorial Medal (National) Award for the year 2014 from the Indian Econometric Society for his outstanding contributions to the field of quantitative economics in India; and Prof VKRV Rao Award for Social Sciences (Economics) for the year 2015 from ICSSR and ISEC Bengaluru. Email: [email protected]