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)

2 . a special mention of Professor Latha Ravindran. 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. 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.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. And.

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

GOVERNMENT DEFICIT FINANCING The mode of financing the fiscal deficit determines its impact on inflation. productivity and real income. there has been a consistent rise in private consumption expenditures and developments in the external sector have also influenced strongly on the budget deficit. 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. it results in increase in demand for available credit. In developing economies. Alternatively. 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. 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. The phenomenon of budget deficit is often linked to the Keynesian model of expenditure led growth theory of the 1970s. as inflation increases. this will lead to an increase in the government’s budget deficit. M3. (sum of currency with the public and bank deposits) depends on the supply of reserve money. However. it can be said that government budget deficits decreases the net quantum of productive private investment. In a similar manner. However. As demand increases. with supply remaining constant the price of credit (interest rate) should go up. where money creation is the sole way of financing government budget deficit. The relationship between fiscal deficits and inflation will depend on the monetary policy which can be independent or dependent of fiscal policy. it becomes a key factor determining money growth and inflation. budget deficit increases and therefore the process of self-generating inflation is carried on as long as budget deficit continues in the economy. 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. 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. This will result in a fall in private investments. DEFICIT FINANCING AND MONEY SUPPLY The total money supply. If government decides to fund deficit through domestic borrowing. people's willingness to hold cash vis-a-vis bank deposits and the cash reserve ratio set by the RBI: 4 . its effects on macroeconomic variables cannot be ignored in most countries of the world. The increased budget deficit significantly alters inflation in a developing country. attract investments. In India over the years. For a country prevailing under inflationary conditions. It is expected that lower budget deficits will decrease real interest rates. Financing through external borrowing will lead to a current deficit and has the possibility of resulting in an external debt crisis. Deficit can be financed either by borrowing or through creation of money. It is generally known that creation of money leads to inflation. the source of financing has different impact of a budget deficit on inflation index.increase in money supply which in turn raises the inflation rate.

There will be no secondary expansion of money supply following the expansion of reserve money. Even when bank credit is supply determined. as the relation suggests. But if the banks have been operating with excess reserves. The most important of which are changes in the cash reserve ratio and 5 . the impact of overall budgetary deficits depends on the policies pursued by the Reserve Bank. Opposite is the effect of financing the domestic expenses of the government through borrowing from external sources. the amount of high power money remains unaltered. a = ratio of currency to bank deposits people want to hold.M3 = (1 + a) R (a + r) Where R = reserve money. 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. 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. there are difficulties in predicting the additional amount of money generated. Second. and (ii) Deficit financing includes net credit (including overdrafts) extended by the Reserve Bank to the union and state governments taken together. In fact. the higher will be the demand for currency. the demand for currency on the part of the public depends not on relatively long-term factors like banking habit and other institutional arrangements. First. the reserve money registers a decline. Hence the impact of deficit financing on the aggregate supply of money is smaller. the excess of net external borrowing by the government over its payments abroad raises the amount of reserve money in the economy. the supply of bank credit becomes demand and the money multiplier assumes a value of unity. Indeed. 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. 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. If the government borrows from the Reserve Bank in order to repay some foreign loan. It is through changes in reserve money that budgetary deficits exert their influence on the aggregate supply of money. This is because of budgetary operations. given the supply of reserve money and the rules under which commercial banks function. When the government takes loans from the domestic market in order to make payments abroad. The fall in foreign exchange reserves is offset by rise in government securities on the asset side of the Reserve Bank's balance sheet. and aggregate income and its composition. even apart from the budget deficit. 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. 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. It is required to know a good deal regarding the non-monetary sectors in order to estimate the value of the money multiplier. and r = cash reserve ratio. 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. Hence. M3 is the outcome of an interaction between the commodity and the money markets.

pension. Second. subsidy or interest payments.imposition of ceilings on bank credit. Reserve Bank's policies in respect of the distribution of credit have an important impact on M3. First. 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. The elementary point to note in this connection is that. the growth rate of real output is taken to be independent of changes in money supply in general. no account is taken whatsoever of the nonmonetary factor affecting the demand conditions in the economy.inflationary finance. somewhat less (because of positive marginal propensity to save) for income transfers. Diversion of bank loans to sectors. The impact (or the multiplier) is the largest for government expenditure on final goods. eg. Third. 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. tends to reduce the supply of money through a rise in the demand for currency. and nil for transfers on capital account. Thus the conventional (Keynesian) analysis clearly suggests that the demand expansionary potential of a budget is not indicated by deficit financing. and the size and composition of the Budget in particular. and (c) the lesser the importance of tax collections relative to borrowing. government expenditure abroad under even (i) and (ii) is taken to have no expansionary effect on the demand side of the commodity market. (ii) income transfers. On the expenditure side of the Budget it is customary to distinguish between (i) government consumption and capital formation. However the rise in M3 consequent upon deficit financing does not necessarily lead to inflation. and (iii) repayment of loans or other transfers on capital account. 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 basis of the distinction is their differential impact on aggregate demand. while borrowing comes in between the two as sources of non. 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. the conclusion is that taxation is the least and deficit financing the most inflationary. 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. changes in money supply can affect prices only through the demand and the supply sides of the commodity market. where cash transactions are predominant. This is because it will result in a reduction in interest rates or a rise in prices of capital goods. Even with no deficit the inflationary potential of a Budget will be greater. (a) the larger the absolute size of the Budget. There are basically three reasons which may mislead estimation of the inflationary potential of deficit financing. 6 . In respect of the modes of financing government expenditure. Again.

however. In India. there is no crowding out effect of government borrowing from banks or the public. 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. there is no deflationary effect of corporate taxes paid by public sector enterprises. for given levels of plan expenditure. flows back into the banking system). 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). To the extent the government assumes the responsibility of meeting the investment targets of public sector enterprises. 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. since in a credit constrained situation the former causes an equivalent decrease in expenditure through a reduction in bank credit to other sectors. given the interest rates fixed by the monetary authorities. 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. There may however be indirect disinflationary effects of such tax collections. In the case of corporate tax collections from enterprises. First.The elementary point to note in connection with different modes of financing government expenditure is that. bank deposits and other forms of "safe" financial assets with little possibility of capital gains and losses. 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. Hence borrowing from households does not generally have any crowding-out effect in our economy. When government enterprises are left with a smaller part of their surplus. Third. it does not matter whether these units pay part of their profits to the union government or not. Sale of government securities to banks constitutes a more effective instrument for controlling inflation in the short run. If. when the government issues high yielding financial assets (like National Saving Certificates or Railway bonds) that find their way into the portfolio of households. 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. it becomes important to distinguish between loans taken from the public or those from commercial banks. 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 short run effects of such taxes are thus similar to those of borrowing from commercial banks. In assessing the implications of taxes we consider the following factors. Second. When commercial banks operate with excess cash reserves. their inflationary or deflationary impact is felt only as the rest of the economy reacts to these measures. people hold their financial savings mostly in the form of cash. Such borrowings stand on exactly the same footing as deficit financing. 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. banks are fully loaned up. The nature of portfolio choice is thus quite at variance with the traditional theory. etc. it is easy to see that taxes have not been an effective non-inflationary means of financing development expenditure (deficit) in our country. both Keynesian and monetarist. The initial impact of 7 . The reason is that. resources released in real terms are larger for personal income tax than for indirect taxes. 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.

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

27% 7.41% 5.48% 3.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 5.04% 6.61% 4.60% 4.81% 9.85% 5.05% 4.40% 5.55% 6.60% 7.34% 6.48% 4.96% 5.50% 6.60% 3.56% 9 .06% 3.32% 2.88% 3.74% 10.06% 8.82% 6.65% 6.46% 6.36% 5.99% 4.19% 5.55% 5.16% 3.35% 12.09% WPI 13.95% 3.39% 5.68% 5.97% 3.47% 5.91% 4.67% 8.

00% 6.00% 8.00% 14.Appendix 2: Graphical representation of WPI and fiscal deficit 16.00% 4.00% 12.00% Fiscal deficit as a percentage of GDP WPI 10 .00% 10.00% 0.00% 2.