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Revisiting the Role of Fiscal Policy in Determining Interest Rates in India

Ranjan Kumar Mohanty () and N R Bhanumurthy ()
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Ranjan Kumar Mohanty: National Institute of Public Finance and Policy

Working Papers from National Institute of Public Finance and Policy

Abstract: The role of fiscal policy in affecting interest rates has been examined extensively in emerging market economies such as India. While the findings of the existing studies diverge, some suggesting crowding out while a few suggesting otherwise, the relationship is ever-evolving depending upon the structure of the economy and the strength of the financial markets. Hence, it is necessary to continuously validate some of the macro relations such as the relationship between fiscal policy and interest rates. Towards this, the present paper tries to revisit the empirical relationship by using the Structural Vector Autoregression and Toda-Yamamoto causality approach. The study tries to empirically examine and understand the transmission channel through which fiscal policy could affect short-term, medium-term and long-term interest rate in India. Our results suggest that the fiscal deficit has direct and indirect effects on the interest rates. While there appear to have a marginal impact in the short-term, however, through the indirect channel, i.e., through inflation, fiscal policy has a larger positive impact on interest rates in the long run. It also finds that shocks to foreign interest rate and inflation tend to increase interest rates in India. In terms of the policy, in the long run, there is a need for containing structural part of fiscal deficit within the Fiscal Responsibility and Budget Management (FRBM) framework.

Keywords: Fiscal Deficit; Interest Rate; Structural Vector Autoregression (SVAR); India (search for similar items in EconPapers)
JEL-codes: C32 E40 H62 (search for similar items in EconPapers)
Pages: 29
Date: 2020-02
New Economics Papers: this item is included in nep-mac
Note: Working Paper 296, 2020
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