Narrowing fiscal deficit relevant for stabilisation: RBI

Last Updated: Friday, August 7, 2009 - 22:26

Mumbai: At a time when fiscal deficit is
burgeoning at 6.8 per cent of GDP, an occasional paper from
the RBI says narrowing the deficit is relevant for
stabilisation as money supply expansion leads to inflation.

The paper studied the impact of government deficit on
money in India between 1951 and 2007, and said targeting
fiscal deficit as tool for stabilisation continues to remain
valid.

The study found strong evidence of government deficit
leading to reserve money creation, which in turn creates
increase in money supply.

The paper has been authored by economic analysis and
policy department directors Jeevan K Khundrakpam and Rajan
Goyal. The views expressed are personal and not those of the
Reserve Bank of India.

The paper also revisited causal relationships between
government deficit and money, and money with real output and
prices in the country.

It argued that the deficit will now cause reserve money
expansion through an incomplete sterilisation of net foreign
assets accumulation.

Further, there is no evidence of money causing changes
in real output both in the long-run and short-run, the study
said.

However, money causes inflation both in the long-run and
short-run, while real output dampens inflation.

There is also some evidence of output and price leading
to money creation, that is, bi-directional causality between
money and prices rendering money targeting a complicated
exercise, the paper said.

The study said the negative impact of real output on
long-run inflation in India is tenable, as supply factors are
understood to play an important role in determination of
prices.

Thus, improvement in supply position reflected in higher
real output leads to fall in inflation, while increase in
money supply causes inflation, it said.

Though the growth of reserve money would normally be
induced by the demand emanating from movement in output and
price levels, in India, government deficit supplements these
factors in determining the rate of reserve money expansion,
the paper said.

Bureau Report



First Published: Friday, August 7, 2009 - 22:26

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