Understanding the relationship between fiscal policy and inflation in India

Abstract

Rapid monetary expansion is generally said to influence inflation across nations. Even though money supply is deemed as an instant cause of inflation, in India the fiscal imbalances are argued to have played an important role in price fluctuations. There are two strands representing the link between fiscal policies and inflations as given by empirical literature, one is to look at the longer term, the extent of effect of large and persistent levels of fiscal deficits have on inflation and other is to look at a shorter term, impact of changes in fiscal policies like Seventh pay commission, wage hikes, called as fiscal shocks, have on inflation. These fiscal shocks can be both on supply side as well as demand side. Other exogenous variables like Oil prices also have an impact on inflation. [1] There is also a strong empirical evidence of relationship of fiscal and monetary policies and consequently, their effect on inflation. One link is through a dependent Central Bank in which government has a strong say in formulation of monetary policies, there is a high chance that government might put pressure on Central bank to monetise the growing fiscal deficit or keep the interest rates low so as to reduce their borrowing costs. Fiscal deficit affects growth of monetary base and money supply affects interest rate and hence inflation. This fiscal view of inflation is more common in a developing country like India where there are certain other problems like inefficient tax collection mechanisms, political instability, undeveloped markets for raising money and limited access to external borrowings and hence more dependence on monetising the deficits. Macroeconomic theory postulates that if there is excess demand in the country, it leads to increases In price and called as “demand pull inflation”. This excess demand can be contributed by the increased spending of Govt and hence “fiscal view” is valid in India which suggests that there is a positive relationship between inflation & fiscal deficit. However, fiscal policies are decided and implement at an annual basis, their impact on annual inflation rates are difficult to ascertain if the monetary policies are more flexible and react to counter the effect. Hence the impact may just show only for a limited period after which it is neutralised by monetary policies.