Money Supply, Fiscal Policy and Price Instability - A Cointegration Analysis for India

Sadananda Prusty

The IUP Journal of Applied Economics, 2004, vol. III, issue 2, 43-64

Abstract: The cointegration result shows that money supply and fiscal policy of various state governments positively and real GDP negatively influences price instability in India during the period from 1960-61 to 1999-2000, which supports the findings of most of the earlier empirical studies and the proposition of weak-form fiscal theory. Lack of capital coupled with the urge for development compels the Central Government to follow the deficit budget policy year after year resulting in monetary expansion as budget deficit was automatically financed and monetised by the Reserve Bank of India (RBI) till end-March 1997. As most part of the government (central as well as state governments) expenditures is non-plan in nature and on Revenue Account in recent years, it results in expansion of aggregate demand through the increase in the purchasing power of the people. Aggregate supply (or real output) is not increasing at par with the increase in aggregate demand due to relatively less government (central as well as state governments) expenditure on Capital Account (i.e., expenditure which creates productive assets in the economy). This is the cause of price instability in India in recent years. However, this is not the only cause of price instability in India. The cointegration result also reveals that indirect taxation positively influences price instability in India during the period, thus supports the proposition of strong-form fiscal theory. As Indian economy is increasingly become an open economy in recent years, the role of current account deficit and degree of openness cannot be ignored while studying price instability. The cointegration result shows that current account deficit and degree of openness positively responsible for price instability in India through withdrawal of funds in the share market and hampering investment activities. The bi-directional causality between index for money supply and index for fiscal policy of centre and unidirectional causality flowing from index for fiscal policy of states to index for money supply suggests that monetary policy itself is influenced by fiscal policies of the central as well as state governments. The causality result also reveals that there exists a bi-directional causality between index for fiscal policy of central government and index for fiscal policy of state governments. Thus, the present study suggests a policy-mix, i.e. a rational monetary policy and prudent fiscal policies (centre as well as states), to tackle the problem of price instability in India in recent years.

Date: 2004
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