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Fiscal deficit, capital formation, and crowding out: Evidence from India

Lekha cHAKRABORTY

Working Papers from National Institute of Public Finance and Policy

Abstract: Theoretical literature identifies two variants of crowding out in an economy-real and financial. The real (direct) crowding out occurs when the increase in public investment displaces private capital formation broadly on a dollar-for-dollar basis, irrespective of the mode of financing the fiscal deficit. The financial crowding out is the phenomenon of partial loss of private capital formation, due to the increase in the interest rates emanating from the pre-emption of real and financial resources by the government through bond-financing of fiscal deficit. The paper analysed the real and financial crowding out in India during 1970-71 to 2002-03. Using asymmetric vector autoregressive model, the paper finds no real crowding out between public (in particular, infrastructure) and private investment; rather complementarily is observed between the two. The dynamics of financial crowding out is captured through the dual transmission mechanism via real rate of interest; that is, whether private capital formation is interest rate sensitive and in turn whether the rise in real rate of interest is induced by fiscal deficit. The study found empirical evidence for the former, but not the latter, reinforcing no financial crowding out in India.

Keywords: Fiscal deficit; Capital formation (search for similar items in EconPapers)
JEL-codes: E62 C32 H6 (search for similar items in EconPapers)
Pages: 53
Date: 2006-12
Note: Working Paper 43, 2006
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Working Paper: Fiscal Deficit, Capital Formation, and Crowding Out: Evidence from India (2007) Downloads
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