A REPORT ON

THE EFFECT OF FISCAL DEFICIT ON WHOLE SALE PRICE INDEX IN INDIA

Submitted by, Group 7 ± Sec A Ankit Rout (U111007) Chinmaya Swain (U111017) Kavindra Sharma (U111027) Nikhil Lukose (U111037) Samik Bhattacharjee (U111047) Swarup Kumar Mishra (U111057)

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We are greatly indebted to our batch mates and our seniors for having shared their invaluable thoughts and opinions that went a long way in helping us gather information and analyse issues for the report. Thank you. whom we cannot thank enough for having given us the opportunity and her total support for working on this project and completing our report.ACKNOWLEDGEMENT We would like to express our whole-hearted gratitude to all those who have helped with the report or have been associated with the report in any way and made it a worth-while experience. 2 . a special mention of Professor Latha Ravindran. And.

inflation and budget deficit are both considered as interrelated variables. the increase in fiscal deficit causes the interest rates to rise in an economy. capital goods and construction work. In most developing countries. or it can raise the amount required from the market by issue of bonds. To measure the rate of inflation the Indian government has taken WPI as a parameter for inflation in the economy.monetary base. RBI can either increase the money supply by issuing new notes. Issuing these instruments will decrease the liquidity in the country and it will in turn increase the interest rates. the government can go to RBI to get the money required. In other words. But at the same time food price inflation and consumer price inflation too have been on the increasing curve. Deficit is different from debt. WPI was first published in 1902. since this is a direct indication of the week-to-week variations in the prices of all the commodities which are traded in the open market. more government spending and less revenue and hence government budget deficit is itself affected by the inflation. The fiscal deficit influences demand and thereby inflation management of any country. and is used as one of the economic indicators by country¶s policy makers. The main purpose of the study is to analyze the relationship between budget deficit and Whole Sale Price Index.INTRODUCTION For the last several years the GDP of India has been growing rapidly. while budget deficit may lead to higher inflation. increase in budget deficit results in increase of monetary base. Therefore. FISCAL DEFICIT It is government's total expenditures minus the total revenue that it generates (excluding money from borrowings). money supply and inflation helps us to understand how the price index is influenced by budget deficit. Wholesale Price Index (WPI) WPI is an index which is used to calculate the change in the price level of goods which are traded in wholesale market.5% in the five years ending March 2010. The real GDP growth of India averaged 8. like India. WPI is used to measure inflation and hence important monetary and fiscal policy changes are often associated with it. So any increase in fiscal deficit will impact the management of inflation and WPI. The total borrowing requirement from all the sources of the government can be found out from the fiscal deficit figure. In both the cases. thus resulting in 3 . A total of 435 commodities price information is used for calculating the WPI. As a result it will discourage the private investment in the economy due to the rise in the cost of capital. WPI traces the movement in prices of all commodities which traded and transacted in the market. RELATION BETWEEN MACROECONOMIC VARIABLES The relation between fiscal deficit and macroeconomic variables. money supply and inflation is a macroeconomic phenomenon and it is observed across the world. The WPI indices are also used for price correction through escalation clauses in the supply of raw materials. The weekly published figure of wholesale price index has gained much importance over time. Not all goods are included for measuring WPI. The correlation between budget deficit. which is an accumulation of yearly deficits. Whole sale price index is published on a weekly basis by RBI. The relationship between fiscal deficit and inflation which is measured by WPI in India is an important issue in macroeconomics study. Primarily.

its effects on macroeconomic variables cannot be ignored in most countries of the world. As demand increases. It is expected that lower budget deficits will decrease real interest rates. This will result in a fall in private investments. A government experiences deficit in its budget when its total expenditure exceeds its total revenue while budget deficit financing indicate the means of handling budget deficit of the country. Consequently financing of the fiscal deficit will result in an increased money supply and this tends to fuel inflation which is nothing but an increase in WPI. budget deficit increases and therefore the process of self-generating inflation is carried on as long as budget deficit continues in the economy. The increased budget deficit significantly alters inflation in a developing country. Deficit can be financed either by borrowing or through creation of money. The relationship between fiscal deficits and inflation will depend on the monetary policy which can be independent or dependent of fiscal policy. If government decides to fund deficit through domestic borrowing. productivity and real income. The major outcomes of empirical studies examining the relationship between budget deficits and inflation showed strong proof that financing budget deficits through monetization and increased money supply can cause inflation. and thereby increase growth. people's willingness to hold cash vis-a-vis bank deposits and the cash reserve ratio set by the RBI: 4 . GOVERNMENT DEFICIT FINANCING The mode of financing the fiscal deficit determines its impact on inflation. DEFICIT FINANCING AND MONEY SUPPLY The total money supply. M3. In developing economies. with supply remaining constant the price of credit (interest rate) should go up. Alternatively. as inflation increases. (sum of currency with the public and bank deposits) depends on the supply of reserve money. there has been a consistent rise in private consumption expenditures and developments in the external sector have also influenced strongly on the budget deficit. it can be said that government budget deficits decreases the net quantum of productive private investment. In a similar manner. The phenomenon of budget deficit is often linked to the Keynesian model of expenditure led growth theory of the 1970s. Financing through external borrowing will lead to a current deficit and has the possibility of resulting in an external debt crisis. A constant and positive government budget deficit can be maintained for a long time and without inflation if the deficit is financed by issuing bonds rather than creating money. the source of financing has different impact of a budget deficit on inflation index. it results in increase in demand for available credit. Most of the governments adopted this theory that government has to increase the aggregate demand in the economy in order to support and stimulate economic growth.increase in money supply which in turn raises the inflation rate. attract investments. However. For a country prevailing under inflationary conditions. it becomes a key factor determining money growth and inflation. It is generally known that creation of money leads to inflation. this will lead to an increase in the government¶s budget deficit. where money creation is the sole way of financing government budget deficit. In India over the years. However.

Hence the impact of deficit financing on the aggregate supply of money is smaller. The most important of which are changes in the cash reserve ratio and 5 . the supply of bank credit becomes demand and the money multiplier assumes a value of unity. the higher will be the demand for currency. as the relation suggests. What is relevant in this connection is the net increase in the Reserve Bank credit to the government and this is likely to be different from the deficit in the union government's budget. This is because of budgetary operations. If the government borrows from the Reserve Bank in order to repay some foreign loan. M3 is the outcome of an interaction between the commodity and the money markets. the excess of net external borrowing by the government over its payments abroad raises the amount of reserve money in the economy. The reasons for the discrepancy are generally two fold: (i) Both the Reserve Bank and commercial banks deal in Treasury Bills and in medium and long-term government securities. It is required to know a good deal regarding the non-monetary sectors in order to estimate the value of the money multiplier. there are difficulties in predicting the additional amount of money generated. The greater the share in total output of agriculture and the unorganised sector (where payments through cheques are minimal) and the larger the volume of black income and transactions. Indeed. the increase in M3 will in general will be a multiple of the overall budget deficit so long as the deficit generates an equivalent amount of reserve money. given the supply of reserve money and the rules under which commercial banks function. There will be no secondary expansion of money supply following the expansion of reserve money. the demand for currency on the part of the public depends not on relatively long-term factors like banking habit and other institutional arrangements. a = ratio of currency to bank deposits people want to hold. In fact. and aggregate income and its composition. and (ii) Deficit financing includes net credit (including overdrafts) extended by the Reserve Bank to the union and state governments taken together. Hence. When the government takes loans from the domestic market in order to make payments abroad.M3 = (1 + a) R (a + r) Where R = reserve money. the reserve money registers a decline. Hence the net change over the year in the amount of total government securities held by the Reserve Bank may be quite different from additional Treasury Bills issued. It is through changes in reserve money that budgetary deficits exert their influence on the aggregate supply of money. and r = cash reserve ratio. First. the impact of overall budgetary deficits depends on the policies pursued by the Reserve Bank. even apart from the budget deficit. Opposite is the effect of financing the domestic expenses of the government through borrowing from external sources. The assumption is that banks are fully loaned up and are unable to meet the requirements of all borrowers at the given rates of interest. In India the overall budget deficit stands for the excessof aggregate expenditure (including transfers) of the government over its total receipts under Revenue and Capital Accounts. The fall in foreign exchange reserves is offset by rise in government securities on the asset side of the Reserve Bank's balance sheet. But if the banks have been operating with excess reserves. Even when bank credit is supply determined. the amount of high power money remains unaltered. Second.

However the rise in M3 consequent upon deficit financing does not necessarily lead to inflation. the conclusion is that taxation is the least and deficit financing the most inflationary. MONEY SUPPLY AND PRICES So far we have seen the effect of budgetary operations on the aggregate supply of money and came up with the conclusion that this effect cannot be estimated from the overall fiscal deficit alone. The impact (or the multiplier) is the largest for government expenditure on final goods.inflationary finance. subsidy or interest payments.imposition of ceilings on bank credit. 6 . Second. First. tends to reduce the supply of money through a rise in the demand for currency. On the expenditure side of the Budget it is customary to distinguish between (i) government consumption and capital formation. both the credit and the commodity markets are assumed to be competitive with relevant prices adjusting to clear the markets. (b) the higher the levels of government consumption and investment in relation to transfer payments. changes in money supply can affect prices only through the demand and the supply sides of the commodity market. pension. Again. IDENTIFYING DEMAND AND SUPPLY-SIDE EFFECTS OF FISCAL DEFICIT The inflationary impact of budgetary operations is to be found by identifying their effects (direct or indirect) on the demand and the supply sides of the commodity market. The elementary point to note in this connection is that. while borrowing comes in between the two as sources of non. Even with no deficit the inflationary potential of a Budget will be greater. and the size and composition of the Budget in particular. Deficit financing and the associated change in money supply are considered important only to the extent people try to use part of the additional money to buy bonds or physical assets. and nil for transfers on capital account. and (iii) repayment of loans or other transfers on capital account. Reserve Bank's policies in respect of the distribution of credit have an important impact on M3. where cash transactions are predominant. the growth rate of real output is taken to be independent of changes in money supply in general. There are basically three reasons which may mislead estimation of the inflationary potential of deficit financing. (a) the larger the absolute size of the Budget. no account is taken whatsoever of the nonmonetary factor affecting the demand conditions in the economy. In respect of the modes of financing government expenditure. government expenditure abroad under even (i) and (ii) is taken to have no expansionary effect on the demand side of the commodity market. eg. Third. The basis of the distinction is their differential impact on aggregate demand. Diversion of bank loans to sectors. and (c) the lesser the importance of tax collections relative to borrowing. (ii) income transfers. somewhat less (because of positive marginal propensity to save) for income transfers. Thus the conventional (Keynesian) analysis clearly suggests that the demand expansionary potential of a budget is not indicated by deficit financing. This is because it will result in a reduction in interest rates or a rise in prices of capital goods. By the same logic a larger allocation of plan expenditure in favour of Rural Employment Generation or similar programmes will be result in a smaller money multiplier for a given level of deficit financing.

In the case of corporate tax collections from enterprises. bank deposits and other forms of "safe" financial assets with little possibility of capital gains and losses. their inflationary or deflationary impact is felt only as the rest of the economy reacts to these measures. there is no crowding out effect of government borrowing from banks or the public. in-direct taxes as an instrument of resource mobilisation will be less effective as greater is the reliance on duties on capital goods or on intermediate inputs that are used primarily in investment goods. Second. both Keynesian and monetarist. To the extent the government assumes the responsibility of meeting the investment targets of public sector enterprises. given the interest rates fixed by the monetary authorities. banks are fully loaned up. The fiscal deficit will thus be devoid of any expansionary effect to the extent bank credit is demand determined or the rise in money supply (representing additional loans granted by the Reserve Bank and commercial banks to the public and the private sectors) reduces the scale of gross credit extended outside the banking sector. The inflationary consequence of an increase in money supply in our economy can be traced almost entirely to the associated rise in the supply of bank credit and hence in expenditure. since in a credit constrained situation the former causes an equivalent decrease in expenditure through a reduction in bank credit to other sectors. people hold their financial savings mostly in the form of cash. When commercial banks operate with excess cash reserves. The foregoing results do not imply that the corporation tax and duties on capital goods have the same effect in respect of the inflationary potential of a Budget. for given levels of plan expenditure. they have to rely more heavily on bank credit for financing their working capital requirements so that there will in general be a squeeze on private investment. however. The short run effects of such taxes are thus similar to those of borrowing from commercial banks. Given the insignificance of the personal income tax as a source of revenue and the overwhelming importance of duties on capital goods and intermediate inputs. when the government issues high yielding financial assets (like National Saving Certificates or Railway bonds) that find their way into the portfolio of households. Such borrowings stand on exactly the same footing as deficit financing. The reason is that. there is no deflationary effect of corporate taxes paid by public sector enterprises. it is easy to see that taxes have not been an effective non-inflationary means of financing development expenditure (deficit) in our country. First. Under these conditions the impact of deficit financing operations through an expansion of bank credit enables the borrowers to register their demand in the commodity market. it does not matter whether these units pay part of their profits to the union government or not. In assessing the implications of taxes we consider the following factors. The nature of portfolio choice is thus quite at variance with the traditional theory. flows back into the banking system). The initial impact of 7 . When government enterprises are left with a smaller part of their surplus. There may however be indirect disinflationary effects of such tax collections. the fall in capital accumulation in the private sector will be supplemented by a decline in consumption (with a reduction in the amount of dividend declared). In India. Hence borrowing from households does not generally have any crowding-out effect in our economy. If. there is generation of additional credit outside the banking sector with no corresponding diminution in commercial bank credit (as the money withdrawn by the people to buy NSC.The elementary point to note in connection with different modes of financing government expenditure is that. Sale of government securities to banks constitutes a more effective instrument for controlling inflation in the short run. etc. Third. it becomes important to distinguish between loans taken from the public or those from commercial banks. resources released in real terms are larger for personal income tax than for indirect taxes.

Hence such taxes are invariably inflationary and can reduce demand in real term only if funds earmarked for investment are not adjusted to neutralise the hike in prices. SUPPLY-SIDE EFFECTS Economists distinguish between the short. By the same logic market borrowing. But most forms of financing results in increase in money supply in the form of printing of currency notes by RBI or the government issuing of bonds to raise the money. the (short-term) supply-side impact of the expansion of bank credit dominates the effect operating on aggregate demand. Even when indirect taxes effect a cut in consumption. the fall in demand is forced through a rise in prices. CONCLUSION It can be concluded that Inflation and Fiscal deficit have a strong positive correlation. tend to promote inefficiency in the productive system through a misallocation of resources and hence generate a negative supply-side effect. However. the effect may in fact be disinflationary. by crowding-out production loan. The reason is that. they are no doubt anti-inflationary in the short run. if credit constraint is in force. We thus come full circle and end up with the conclusion that. Second. from the viewpoint of both equity and control of inflation.duties on capital goods is on their prices.and the long-run effects of investment projects on the supply side of the commodity market. But a fall in investment reduces the growth of productive capacity in the economy and hence makes it more inflation -prone in the medium and the long run. the conclusion appears reinforced when the supply-side effects of these instruments are taken into account. To the extent taxes or borrowing curb expenditure on consumption or investment. as they are administered and fixed on a cost-plus basis. it is important to distinguish between different categories of borrowers. A similar distinction is called for in respect of the various budgetary measures for raising resources. Finally. a properly administered personal income tax ranks higher than other instruments of resource mobilisation. and such taxes. only if there is a fall in capital accumulation in the public or the private sector. Indeed. in respect of the crowding-out or crowding-in effect operating through credit. taxes on intermediate inputs account for the major part of revenue of both the union and state government. This leads to the alteration of the demand supply equilibrium and thus leads to inflationary situations. Since both market borrowing and taxes in India are not very effective in curbing consumption. its impact on money supply can vary and hence the inflation. ----------88-------------88------------ 8 . these measures do not seem to contribute significantly towards the objective of growth with price stability. i. may in fact serve to stoke the fire of inflation.e.. depending on the mode of financing used to bridge this deficit. as is well known. When additional bank credit is extended to finance investment in working capital.

48% 4.61% 4.39% 5.05% 4.96% 5.74% 10.46% 6.27% 7.48% 3.82% 6.99% 4.06% 8.09% WPI 13.60% 4.60% 3.91% 4.85% 5.97% 3.95% 3.67% 8.55% 5.68% 5.32% 2.19% 5.60% 7.35% 12.47% 5.41% 5.Appendix 1: WPI & Fiscal deficit data of India for the period 1991-92 to 2010-11 Financial year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 Fiscal deficit as a percentage of GDP 5.34% 6.50% 6.40% 5.88% 3.36% 5.55% 6.06% 3.81% 9.65% 6.16% 3.04% 6.56% 9 .

00% 0.00% 10.00% 14.00% 12.00% 4.00% 6.00% 2.00% Fiscal deficit as a percentage of GDP WPI 10 .00% 8.Appendix 2: Graphical representation of WPI and fiscal deficit 16.