Fiscal Policy & Economic Environment (part-4)

Monetary Policy & Economic Environment (part-1)

Ranjan Kumar Mohanty

Economics Area
Xavier Institute of Management, Bhubaneswar (XIMB)
 Macro Economic Impact of Fiscal Deficit in India
 Major Concern of Indian Economy:
➢ Persistence of large fiscal deficit during the last five decades
➢ The share of revenue deficit in fiscal deficit has been enhanced.
➢ Total outstanding liabilities of the Central Government have increased due to soaring of fiscal deficit.
➢ Fiscal deficit in India is mostly financed by internal sources rather than external sources.
➢ Market borrowing constitutes a major portion of internal financing of fiscal deficit.
➢ Financing pattern has been shifted from seigniorage financing to bond financing of fiscal deficit.
➢ Revenue expenditure as per cent of GDP (also per cent of total expenditure) has also burgeoned.
➢ Capital expenditure as per cent of GDP (also per cent of total expenditure) has fallen.
➢ Impact of Fiscal Deficit:- Theoretical Arguments

➢ Classical or traditional (Easterly and Rebelo, 1993; Bleaney et al., 2001; Roy and Berg, 2009)

➢ Keynesian (Eisner and Pieper, 1984; Taylor et al., 2012).

➢ Ricardian Equivalence (Nelson and Singh, 1994; Tan, 2006; Van and Sudhipongpracha, 2015)

➢ Non-linear (Osinubi et al., 2010; Afonso and Jalles, 2013)

Analytical Framework of the Study
 The Data
 Annual time-series data from 1970-71 to 2018-19
 Economic growth- GDP,
 Gross investment- GFC,
 Employment: organized public and private sectors.
 Inflation rate
 Gross fiscal deficit, revenue deficit, capital expenditure & revenue
expenditure
 Trade Openness
 Exchange rate
 Bank credit
 Current account deficit
 Domestic interest rate: yield of long term government of India securities
 Foreign interest rates: USA’s real interest
 Source: Domestic variables: RBI & CSO; Foreign variable: Board of
Governors of the Federal Reserve System
 Estimated Long Run Coefficients (ARDL)
Model (1) Model (2) Model (3) Model (4)
LGDP LGFC FDG CADG
Variables Coefficients Coefficients Coefficients Coefficients
LGFC 0.245*** - - -
(3.43)
LGDP - 1.77*** -11.894*** 12.774**
(9.76) (-4.62) (2.52)
FDG -0.013** 0.006 - 0.658**
(-2.43) (0.77) (2.62)
EMPG 0.020** - - -
(2.83)
INF -0.005** - - -
(-2.42)
RINT - -0.006** 0.188*** -
(-2.37) (3.22)
LBCG - 0.180** - -
(2.22)
CADG - - 0.669*** -
(4.73)
LTO - - - 1.117
(0.66)
REX - - - -0.053**
(-2.54)
C 10.838*** -12.73*** 167.701*** -173.320**
(12.49) (5.17) (4.79) (-2.46)
TREND 0.041*** -0.032*** 0.593*** -0.780**
(7.45) (-3.30) (4.00) (-2.70)
Notes: ***, ** and * denote statistical significance at the one, five and ten per cent levels respectively. The figures in parentheses are the t-statistics. For Model (1), ARDL (1, 0, 1, 0, 1) selected based on
the AIC. Model (2), ARDL (1, 0, 0, 0, 0) selected based on the SBC. Model (3), ARDL (1, 0, 1, 0) selected based on SBC. Model (4), ARDL (1, 0, 0, 1, 0) selected based on SBC.
 Estimated 2SLS Coefficients for Model (5)
Dependent Variable: RINT
Method: Two-Stage Least Squares
Variable Coefficient Std. Error t-Statistic P-value
RINT(-1) 0.240* 0.137 1.744 0.088
FDG 0.638* 0.363 1.758 0.086
FINT 0.390* 0.231 1.685 0.099
BCG 0.500** 0.157 3.177 0.003
C -10.119** 3.082 -3.283 0.002
TREND 0.114** 0.042 2.728 0.009
R-squared: 0.47; F-statistic: 9.142 (Prob: 0.00). Normality Test: 0.47 (Prob: 0.79). Heteroskedasticity
Test: 0.456 (Prob: 0.50). Ramsey RESET Test: 0.876 (Prob: 0.0.36)

Note: ** and *denote 5 and 10 per cent level of significance respectively.

 Estimated Short Run Coefficients (FIML)
Model (1) Model (2) Model (3) Model (4)

ΔLGDP ΔLGFC ΔFDG ΔCADG

Coefficients Coefficients Coefficients Coefficients
Variables
ΔLGFC 0.134** - - -
(2.26)
ΔLGDP - 1.227** - 9.521
(2.86) (1.26)
ΔLGDP_1 0.296** - -13.684* -
(2.36) (-2.15)
ΔFDG -0.028** -0.036 - -0.406
(-2.26) (-1.20) (-0.694)
ΔEMPG 0.007*** - - -
(4.99)
ΔINF -0.003*** - - -
(-6.00)
ΔRINT - -0.004* - -
(-1.74)
ΔRINT_1 - - 0.109** -
(2.34)
ΔLBCG - 0.162 - -
(1.32)
ΔLBCG_1 - 0.391** - -
(2.61)
ΔCADG - - 0.233* -
(1.79)
ΔLTO - - - 4.263**
(2.63)
ΔREX - - - -0.007
(-0.351)
C 0.030*** -0.016 0.717* -0.644
(3.71) (-0.64) (1.98) (-1.36)
ECMt-1 -0.985*** -0.707*** -0.248* -0.785***
(-4.92) (-4.77) (-1.92) (-5.22)

Notes: ***, ** and * denote statistical significance at the one, five and ten per cent levels respectively. The figures in parentheses are the t-
statistics.
 Robustness Check with Revenue Deficit and Composition of
Expenditure
Long Run Estimation Short Run Estimation
Dependent Variable: LGDP Dependent Variable: ΔLGDP
Model (1.1) Model (1.2) Model(1.1) Model(1.2)
Variables Coefficients Coefficients Variables Coefficients Coefficients
LGFC 0.164* 0.210*** ΔLGDP_1 -0.345*** -0.200**
(1.75) (3.42) (-3.41) (-2.10)
RDG -0.023*** - ΔLFC 0.056 0.092**
(-3.10) (1.32) (2.16)
LRE - -0.213*** ΔEMPG 0.008*** 0.008***
(-4.06) (3.90) (4.52)
LCE - 0.009 ΔRDG -0.008*** -
(0.32) (-3.04)
INF -0.007** -0.008*** ΔLRE - -0.168***
(-2.96) (-3.14) (-4.04)
EMPG 0.023** 0.018** ΔLCE - 0.004
(2.57) (2.81) (0.32)
C 11.756*** 11.665*** ΔINF -0.002*** -0.003***
(10.37) (14.62) (-3.86) (-4.92)
TREND 0.049*** 0.045*** C 0.017*** 0.020***
(6.26) (9.08) (6.35) (5.58)
ECMt-1 -0.338*** -0.440***
(-4.20) (-4.46)
Results of Bounds Test
Model (1.1) F-Statistics: 14.376***
Model (1.2) F-Statistics: 16.155***
Notes: ***, ** and * denote statistical significance at the one, five and ten per cent levels respectively. The figures in parentheses are the t-statistics. RDG is the revenue deficit of the central government as per
cent of GDP. LCE is the log of capital expenditure of the central government as per cent of GDP and LRE is the log of revenue expenditure of the central government as per cent of GDP. For Model (1.1), ARDL (2,
0, 0, 0, 0) selected based on the SBC. Model (1.2), ARDL (2, 0, 1, 0, 0, 0) selected based on the AIC.
 Concluding Remarks
 Fiscal deficit and revenue deficit have an adverse effect on economic growth (both
in the long run and in the short run).
 There exists a bi-directional relationship between fiscal deficit and economic
growth.
 Fiscal deficit influences economic growth both directly, and indirectly through the
routes of investment, interest rate, current account deficit and composition of
government expenditure.
 Further, gross investment has a positive and inflation rate has a negative impact on
economic growth.
 Policy Implications
 The government should Control fiscal deficit and revenue deficit as suggested by
the FRBM Act.
 The composition of government expenditure should be altered to devote more
resources for the formation of productive capital in India.
 Practice Questions
1. During a recession, which of the following is likely to occur?
a. an increase in real wages
b. an increase in production
c. and increase in the GDP growth rate
d. an increase in the unemployment rate
Answer: d
2. Taxes that are levied on any Intra-State purchase are?
a. IGST
b. CGST and SGST
c. SGST
d. UTGST
Answer: b
3. Pick out the factor which is not a demerit of indirect taxes.
a) Unjust to poor
b) Inflationary in nature
c) A tool of economic policy
d) High administrative cost
Answer: c
4. Which one of the following body will decide the tax rates for goods and services under GST regime?
a. Central and State government
b. Finance Commission
c. NITI Aayog
d. GST Council
Answer: d
 Monetary Policy &
Economic Environment
 Basic Concepts
 Functions of Money
 Medium of exchange, store of value, unit of account, differed
payment
 Demand for Money
 Transaction, precautionary and Speculative
➢ Supply of Money
➢ M0, M1, M2, M3

➢ Money Multiplier
➢ Liquidity Trap
 MONETARY AGGREGATES
Currency 'Other'
Demand Time Reserve Narrow Broad Money
Year With the Deposits with
Deposits Deposits Money (M0) Money (M1) (M3)
Public RBI
1951-52 1287 566 322 21 1416 1874 2196
1960-61 1956 750 1177 18 2132 2725 3902
1970-71 4143 2703 3423 57 4578 6903 10326
1980-81 12364 8290 30075 237 17253 20891 50966
1990-91 49772 36422 162276 1023 80243 87217 249493
2000-01 201581 151826 867499 3182 282678 356588 1224087
2010-11 850449 686531 4473638 4546 1210801 1541527 6015165
2011-12 968975 660120 5337563 2148 1381046 1631242 6968805
2012-13 1085374 699034 6122631 1903 1463829 1786311 7908942
2013-14 1194454 759490 7024884 3386 1592672 1957330 8982214
2014-15 1318623 839596 7886635 6902 1753773 2165121 10051756
2015-16 1474220 920949 8720173 15020 1966142 2410190 11130363
2016-17 1382482 1105316 9658102 15385 1940597 2503182 12161285
2017-18 1546543 1258041 10279353 21503 2126550 2826086 13105439
2018-19 1910260 1357885 11153372 25321 2541894 3293466 14446838
2019-20 2161297 1500699 12215282 32433 2854814 3694429 15909711
2020-21 2617807 1691483 13499361 41838 3259360 4351129 17850490
 Monetary Policy
 Monetary policy refers to the use of monetary instruments under the control of the
central bank to regulate magnitudes such as interest rates, money supply and
availability of credit with a view to achieving the ultimate objective of economic
policy.
 To control the supply of money, availability of money, and cost of money or rate of
interest.

 Central Banks:
 India: Reserve Bank of India; USA – Federal Reserve,
 UK – Bank of England, Switzerland- Swiss National Bank,
 Japan- Bank of Japan, Australia- Reserve Bank of Australia etc.
 RBI was established on 1st April, 1935; nationalised in 1949, the Reserve
Bank is fully owned by the Government of India.
 Key variables in this policy area include interest rates, credit, money
supply, and the exchange rate.
  Price/Financial Stability:
 avoidance of inflationary & deflationary
pressures, long run average stability of
prices. Price stability is a necessary
Objectives of precondition to sustainable growth.
Monetary Policy  Economic Growth

 Full Employment
 Credit Availability
 Stable Exchange Rate & BOP
 MONETARY POLICY INSTRUMENTS

Quantitative Qualitative
➢ Reserve Ratio (CRR,
SLR) ➢ Rationing of Credit
➢ OMO: Open Market ➢ Margin Requirements
Operation ➢ Moral Suasion
➢ Rates (Repo, Reverse ➢ Direct Action
Repo, Bank Rate, MSF, ➢ Consumer Credit Control
LAF)
 Quantitative Measures
 Cash Reserve Ratio (CRR):
 Certain percentage of bank deposits which banks are
required to keep with RBI in the form of reserves or
balances. Higher the CRR with the RBI lower will be the
liquidity in the system and vice versa.

 Statutory Liquidity Ratio (SLR):

 The share of NDTL that a bank is required to maintain in
safe and liquid assets, such as, government approved
securities, gold etc. Changes in SLR often influence the
availability of resources in the banking system for lending
to the private sector.
 Quantitative Measures
 Repo Rate:
 The (fixed) interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government
and other approved securities.
 Reduction in Repo rate helps the commercial banks to get money
at a cheaper rate and increase in Repo rate discourages the
commercial banks to get money as the rate increases and becomes
expensive.

 Reverse Repo Rate:

 The (fixed) interest rate at which the Reserve Bank absorbs
liquidity, on an overnight basis, from banks against the collateral
of eligible government securities.