The inflation impact of bonds versus money financing of fiscal deficits in India: some theoretical and empirical perspectives

Abstract

It is generally believed that Government’s fiscal deficits, only when financed by central bank’s new money creation, will be inflationary in nature. In this paper, we demonstrate using a simplified comparative static model based on aggregate money supply, accounting that the inflation impact of fiscal deficits financed through bonds representing commercial banks’ credit to the Government can be similar to conventional monetized fiscal deficits. Our framework does not require stable money multiplier and other simplified assumptions pertaining to base money supply. We provide empirical evidence on fiscal deficits significantly affecting inverted broad money demand and thereby supporting our theoretical perspective. The findings emerging from the paper have implications for monetary and fiscal policies.

Keywords:

• inflation
• money supply
• bank credit
• monetary policy
• budget deficit
• public debt
• fiscal policy

JEL classification:

• E31
• E51
• E52
• E58
• E62
• E63
• H62
• H63

Acknowledgement

The author acknowledges two anonymous referees with sincere gratitude for their valuable suggestions.

Additional information

Notes on contributors

Sarat Dhal

Sarat Dhal is currently working as a visiting Associate Professor at the Indian Institute of Management, Rohtak-124001, Haryana, India.