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Tracking the Transmission Channels of Fiscal Deficit and Food Inflation

Linkages: A Structural VAR Approach

Article  in  Indian Journal of Economics and Development · July 2020

DOI: 10.35716/IJED/19129

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 Indian Journal of Economics and Development NAAS Score: 4.82
Volume 16 No. 2, 2020, 165-172 www.naasindia.org

DOI: https://doi.org/10.35716/IJED/19129 UGC Approved

Indexed in Clarivate Analytics (ESCI) of WoS UGC-Care List Group II

Tracking the Transmission Channels of Fiscal Deficit and Food

Inflation Linkages: A Structural VAR Approach

Amritkant Mishra

Assistant Professor, Department of Economics, CHRIST (Deemed to be University), Delhi NCR Campus, Marium Nagar,
Ghaziabad-201003 (Uttar Pradesh)

E-mail: amritkant.mishra@christuniversity.in

Received: November 01, 2019 Manuscript Number: MS-19129 Revision Accepted: April 05, 2020
ABSTRACT
This empirical analysis aspired to unearth the transmission channels of fiscal deficit and food inflation linkages in the Indian
perspective by reasonably exerting the data for 1991 to 2017. The precise results of structural vector autoregressive (SVAR) analysis
proffered that there were three different mechanisms of transmission such as consumption, general inflation, and import channels that
led to food inflation in response to the high fiscal deficit. The first channel revealed that government deficit spending had a positive
impact on income which further led to food inflation through surging the household consumption expenditure. It was concluded that
fiscal deficit passed through general inflation finally leading to a food price surge in the economy and seemed to work as cost-push
inflation for the food and agricultural industry. The outcome also revealed that the impact of fiscal deficit passed to food inflation
through external linkages such as import and export.

Keywords
Fiscal deficit, food inflation, SVAR.

JEL Codes
E52, E60, H61, H63.

INTRODUCTION of the country. This economic trouble arises because the

Fiscal policy has a crucial influence on the
macroeconomic variables. In India, after the economic
reform in 1991, it is used as a relevant component for
framing the economic policy. In the economic history of
India since independence, fiscal policy was used for the
development perspective. Since economic reform in
1991, the government reduced control in multiple sectors
of the economy and opened for the global world. Despite
that, the many-core sector of the economy such as
defense, rural development, and railways is still under
government control. As a compulsion of mixed economic
structure government cannot relinquish the fiscal policy
and hence it is used for poverty reduction, creation of
employment as well as redistribution of national income.
The country like India with 20 percent population living
below the poverty line bound the government to incur a
huge amount of expenditure education, health care, food
security, and many more. These expenditures are essential
for uplifting the condition of the underprivileged section
of the society. However, it is also a fact that the high non-
productive expenditure leads to a surge in the fiscal deficit
government is not able to recover the enormous non-
productive spending through the tax. The recent data of
finance ministry observed that only one percent of the
population gives the income tax, it means for covering the
considerable expenditure government relies on the
indirect tax, but indirect tax has its limitation and that
leads to the high fiscal deficit. The continuous rising of the
fiscal deficit leads to an increase the borrowing which
future creates the massive burden of high-interest
payment. The status of the fiscal deficit of India is always
more than three percent of the GDP since the 1980s. The
government is still endeavouring to control it. The Central
Government made efforts to control fiscal deficit by
placing a cap on it constitutionally. However, the result of
this effort is still awaited because of the fiscal deficit of
the country still more than three percent. There are shreds
of evidence in the existing literature that high fiscal deficit
would negatively impact the other macroeconomic
variables such as inflation, rate of interest and the balance
of payment, etc. The results of some other empirical
studies did not agree with this empirical result. It can be

Copyright ©2020 The Society of Economics and Development, except certain content provided by third parties.

165
 Indian J Econ Dev 16(2): 2020 (April-June)
said that there is no consensus on the outcome of the
effectiveness of fiscal deficit on the macroeconomic
variables. Many studies were conducted for finding the
impact of fiscal deficit on inflation and its transmission
channel in the Indian economy. In India, 330 million
people live below the poverty line, a little variation in
food price cause the impact of a large proportion of the
population of the nation. A small hike in the price of food
items becomes the measure economic issue for the
government and at the same time the government bears
the substantial fiscal deficit for the uplifting condition of
the underprivileged section of the society. The result of
many empirical studies showed that fiscal deficit had a
positive impact on the overall inflation through various
macroeconomic linkages. It was fascinating to note that
one side government bear a high fiscal deficit for the
development of the underprivileged section of the nation
and at the same time high fiscal deficit caused more
inflation, which is undesirable for the poor people of the
country. There are undoubtedly a few research articles,
which scrutinized the possible impact of fiscal deficit on
inflation. Besides, those published articles which
carefully explored the impact of fiscal deficit on food and
agricultural cost are uniquely related to western territories
or independent countries. Therefore, the current empirical
research intends to make an addition to the existing
wisdom of the above theme in two ways. To begin with by
exploring the impact of fiscal deficit, especially on food
inflation; this was not done in previous literature so far.
Moreover, this examination also endeavours to
progressively expand the comprehensive investigation by
considering the various channel through which fiscal
deficit get transmitted on the food inflation in Indian
context while a substantial amount of prior study in this
context was inclined towards fiscal deficit, economic
growth, and general inflation.The current study attempted
to reveal the impact of fiscal deficit on food inflation and
its transmission channel in the Indian economy and to
bridge the existing gap in the Indian context by focusing
on the mechanism through which fiscal deficit is passing
through and affecting the level of food inflation in India.
REVIEW OF LITERATURE
The theoretical knowledge about the fiscal deficit and
its impact on the macroeconomic variables revealed that
there was no consensus on the above issue among the
empirical studies. Each school of thought had its
philosophy about the effectiveness of fiscal deficit. The
classical believed that there is no need for fiscal policy for
economic stabilization. Accordingly, the inflexible wage
system, the economy reaches equilibrium automatically.
The famous Say's Law of supply argued that supply can
create its demand. The idea of the classical school of
thought was entirely rejected by Keynes in 1939 after the
great depression in the world. Keynes addressed the
demand side management and argued that expansionary
fiscal policy could stimulate the economy with multiplier
effects. The multiplier effect could take place through
166
direct increase the government expenditure as well as a
cut in the tax rate. This would further lead to expanding
the aggregate demand of the economy, and raising the
output with an increase in price till the point where the
economy was in full employment level, and after that, an
expansionary policy would lead to rising in price with
constant output.
Friedman, Marshall, and others observed that price
level in the economy directly varied with the quantity of
money supply in the economy. A recent contribution to
inflation theory was the newly developed Fiscal Theory of
Price Policy (FTPL) founded by Leeper (1991); Sims
(1994); Woodford (1994) argued that in the economy, the
government debt and fiscal policy were main factors of
the price level and the monetary policy had an indirect
role in surging the price level in the economy. This theory
was contradicted to the monetarists' theory. The current
existing approaches did not have any unanimity on the
relation between fiscal deficit and inflation. One side
Keynesian theory suggested that fiscal deficit affected the
price level only when the economy reached full
employment. On the other hand, monetarists advocated
that inflation is always a monetary phenomenon but in
newly developed Fiscal Theory of Price Policy (FTPL)
said that fiscal policy and government debt was the main
factors of price level rise in the economy.
Most of the empirical studies about the effect of fiscal
shock on inflation and other macroeconomic variables
belonged to developed countries such as the US, United
Kingdom, European Union, Canada, and another western
world. Blanchard and Perotti (2002) studied the impact of
government spending shock and taxes on the US
economy. For this empirical research the quarterly data
from 1947 to 1997 was taken. The macroeconomic
variables, such as government expenditure, net taxes and
GDP were considered for the analysis. The structural
vector autoregressive analysis showed that there was a
positive impact of government spending on the output and
negative impact of tax on the output which validated
Keynesian wisdom. Perotti (2007) used the dummy
variable approach and structural VAR (SVAR) analysis in
the four developed countries like the USA, UK, Canada
and AUS. The separate period was taken for each country
for the analysis. The variables were taken for the analysis
were government spending, marginal income tax rate,
real gross domestic product, final private consumption on
non-durables, investment, etc. The results revealed that
when unexpected fiscal events like wars were taken for
the analysis, private consumption and real wage fell due
to government spending shock. At the same time, if the
effect of the external event is removed, the results would
be opposite. Four methods were available for analysis of
the transmission mechanism of any shock. These were
structural VAR approach, sign restriction, recursive
approach, and event study approach. Each approach had
its limitations. Caldara and Kamps (2008) utilized all four
approaches to trace the transmission mechanism of
 Mishra: Tracking the transmission channels of fiscal deficit and food inflation linkages
government spending shock. The quarterly data of the
United States for 1995 to 2006 concerning government
expenditure, per capita income, net taxes as well as GDP
deflator and interest rate was used. The results of all the
methods were almost the same concerning government
expenditure. It was concluded that there was a positive
impact of government spending shocks on real GDP, real
private consumption and the real wage. At the same time,
it was also found that all variables increased significantly;
however private employment did not react. Auerbach and
Gorodnichenko (2012) studied to trace the variation of the
effects of fiscal policy in the business cycle. The quarterly
data from 1947 to 2008 in the US were taken. Based on
empirical results it was found that government
expenditure multiplier was between 0 and 0.5 percent in
expansions and from 1 to 1.5 percent in recessions. It was
concluded that fiscal policy was more effective in
recessions than in expansions. Blanchard and Fischer
quoted a common criticism of this stress on the budget
deficit was that the data rarely showed a strong positive
association between the size of the budget deficit and the
inflation rate. There was an adequate amount of analysis
that centered on the fiscal deficit and inflation linkages
(Dornbusch, Sturzenegger & Wolf, 1990; Alesina &
Drazen, 1991; Cukierman Edwards & Tabellini, 1992;
Calvo & Vegh, 1999; Pesaran, Shin & Smith, 1999;). The
study revealed the impact of the fiscal deficit on the
inflation in Indian perspective (Khundrakpam &
Pattanaik, 2010; Tiwari & Tiwari, 2011), while much
empirical analysis also tried to uncover the path through
which the impact of fiscal deficit spillover to the general
price level of the country (Ramu & Gayithri, 2017).
Mountford and Uhlig (2009) estimated the effects of fiscal
policy shocks on the GDP, private consumption, real
wages, private investment, interest rate, and GDP deflator.
It was exerted the quarterly data from 1955 to 2000 of the
USA and applied the sign restriction method for the
analysis. The deficit spending could positively impact the
economy for the first four quarters only. Both types of
spending scenario had the effect of investment crowding
out. The response of consumption was minimal to
spending shock. The real wage did not rise as a response to
an increase in government spending. Hondroyiannis and
Papapetrou (1997) investigated the direct and indirect
consequences of fiscal deficit on inflation in the context of
Greece. The result documented that the budget deficit led
to an advance in the general price level. Peeters and
Albers (2013) strived to explore the consequences of
world food prices on food inflation and government
subsidies in the MENA region for the period 2002-11. The
outcome of the investigation documented that rising
world food prices led to increased domestic food inflation
and deteriorated the fiscal space of governments due to
the high food subsidy. Milo (2012) examined the impact
of budget deficit on price and currency valuation in
Albania, Bulgaria, and Romania. The variables like
narrow money supply growth, retail price, economic
167
growth and fiscal deficit to GDP ratio by application of
cointegration technique were considered. Based on
empirical results it was concluded that an increase in
deficit to GDP ratio by one percent caused 0.2 percent rise
in the money supply. The result showed that inflation
transmission depended on, how the budget deficit was
financed. Using the data over the period 1954 to 1970,
Barro (1978) analyzed the interrelationship among fiscal
deficits, money supply growth and inflation for the US
economy. It was found that it was governmental
expenditure rather than deficits that influenced monetary
growth. There was little empirical research conducted on
the fiscal deficit transmission mechanism in the context of
India. Mohanty and John (2014) used quarterly data from
1996-1997 to 2013-2014 and found that economy
inflation increased by 106 basis points due to one percent
increase in the fiscal deficit of government in the GDP.
The SVAR, as well as recently developed time-variant
structural VAR methodology used showed identical
results. The Reserve Bank of India (2012) also advocated
positive relation between fiscal deficit and inflation in
India. Yadav, Upadhyaya, and Sharma (2012)
investigated the effectiveness of fiscal policy in India by
applying the structural vector autoregression (SVAR)
method. The quarterly data from 1997 (Q1) to 2009 (Q2)
with the consideration of variables like private
consumption, output, government spending, tax revenue,
and WPI were used. The consequences indicated that a
fiscal shock that increased government revenues by one
rupee would result in a decrease in real GDP by 0.53). Tax
shock adversely affected the components of GDP. The
consequence of the government spending shock on output
was favourable. As far as the impact of tax shock on
private consumption was concerned, the results followed
Keynesian tradition. Khan and Ahmed (2014) found that
oil price shocks harmed the production, appreciation in
the real effective exchange rate positively affected
inflation, either the shocks were positive or negative using
the SVAR approach for analysis. Khundrakpam and
Pattanaik (2010) investigated the inflation and fiscal
deficit in Indian between 1953 and 2009. The results
revealed that one percentage surge in fiscal deficit led to
0.25 percent advance in the WPI in India. Tiwari and
Tiwari (2011) investigated the nexus between fiscal
deficit and inflation and revealed the factors which led to a
high fiscal deficit from the perspective of India. Based on
the empirical outcome, it was concluded that inflation was
not a significant factor in the fiscal deficit, while
government expenditure and money supply seemed to be
a factor advancing the fiscal deficit in India. Ramu and
Gayithri (2017) analyzed the transmission mechanism of
fiscal deficit in the context of India. The data from 1980-
1981 to 2012-2013 were analyzed using the SVAR
approach. The fiscal deficit to GDP ratio, broad money
supply, interest rate, inflation, and consumption
expenditure as well as capital inflow as a variable was
considered. The results showed that the fiscal deficit
 Indian J Econ Dev 16(2): 2020 (April-June)

transmission mechanism was seen with respect to
consumption, money supply, and import channels but not
the interest rate channel.
METHODOLOGY
For the current empirical analysis, the gross
budgetary deficit of centre, as well as state to GDP, was
taken as a fiscal deficit to GDP ratio, change in WPI of
food commodity was proxy of food inflation, broad
money supply (M3), per capita GDP at purchasing power
parity term, foreign exchange rate in terms of one US
dollar, consumption expenditure and finally India's total
Ft = α+1Ft-1 + 1Ft-2 + nFt-n +ϵt (3)
-1 -1 -1
Where α = A β, 1 = A ∂1 and ϵt= A ϵt
Thus, the relationship between structural shocks
and the reduced form shocks is given by
-1
ϵt= A ↋t or ϵA = ϵt (4)
Here ϵt is the observed error term, and ϵt is the
unobserved structural innovation. For finding the
structural disturbances ϵt from VAR's innovations ϵt,
elements of matrix A need to be recognized. To recognize
the structural form parameters, there is a need to put
restrictions on the parameter matrices. For a
2

food import. All the data were annual data, collected for mdimensional system m 2– m , restrictions are necessary for
27 years from the fiscal year 1990-91 to 2016-17. The data orthogonal zing the shocks. 'm' represents the number of
of gross fiscal deficit to GDP ratio, WPI of food endogenous variables in the matrix.
commodity, broad money supply (M3), per capita GDP at A detailed description of restriction imposition
purchasing power parity term, foreign exchange rate were separately for each transmission channel
collected from Reserve Bank of India (RBI) database. The Transmission Channel-1: Fiscal Deficit - Per Capita
data on consumption expenditure and India's total food Income - Consumption Expenditure - Food inflation
import was collected from the National Sample Survey Matrix A was restricted as an upper triangular
Organization (NSSO) database. All the data were in log matrix with ones on the main diagonal.
form except for the data of gross fiscal deficit to GDP
ratio, WPI of food commodity. For processing any time   tFOODINE  1 A12 A13 0    tFOODINE 
 IndCONEXP    IndCONEXP 
series data it was necessary to check the whether data  t  0 1 A23 A24  t  ......(5)
were stationary or not. For that purpose, the Augmented   InPCI   0 0 1 A34   InPCI 
Dickey-Fuller test (ADF test) was applied. The results of  t     t 
the analysis showed that WPI of food, per capita GDP, as   tdFDGDP   0 0 0 1    tdFDGDP 
well as FOREX rate, were stationary. The rest of the
variables were stationary at the first difference (Table 1). Transmission Channel-2: Fiscal Deficit - Money Supply
To tackle the issues related to fiscal deficit shocks on - Inflation- Food inflation
food inflation, the SVAR modelling method was applied.   tFOODINE  1   tFOODINE 
A12 A13 0 
The merits of the SVAR approach over the VAR method  dlNF    dlNF 
were that in the SVAR method the model was empirically  t  0 1 A23 A24  t  ......(6)
fitted and allowed recognising the structural shocks   dlnMS3   0 0 1 A34   dlnMS3 
concerning economic theory. Tracing the endogenous  t     t 
shocks of the variable through the VAR approach gave the   tdFDGDP   0 0 0 1    tdFDGDP 
results based on data only, and there was no scope of the
theory at all. A VAR was helpful in examining the Transmission Channel-3: Fiscal Deficit - Foreign
relationship between a set of economic variables (Enders exchange rate - Import-Food inflation
2004). The limitation of the VAR model was that was not
considered theoretical. This criticism could be avoided   tFOODINE  1 A12 A13 0    tFOODINE 
 dlnIMPORT    dlnIMPORT 
using SVAR as it used economic theory to sort out  t  0 1 A23 A24  t  ......(7)
contemporaneous relation among the variables (Goyal &  dlnFOREX    0 0 1 A34  dlnFOREX 
Sharma, 2015).  t     t 
Aft = β + ∂1Ft-1 + ∂2Ft-2+ ∂nFt-n+ ϵt (1)   tdFDGDP   0 0 0 1    tdFDGDP 
Where Ft = (F1t ... ..... Fmt) is a (m  1) vector
endogenous variables. β and ∂s are the coefficient of In the above models dFDGDP is the first difference
structural form matrices. ϵt is the error term of the model. of fiscal deficit to GDP ratio, InPCI shows the log of per
A is an (m  m) invertible matrix of coefficients of capita income, IndCONEXP is the first difference of log
contemporaneous relations on the endogenous variables. of per capita consumption expenditure, lnINF is log of
If we look the Equation 1 showed that ϵt is error term and general WPI, FOODINE is the food inflation, InFOREX
untraceable and very complex to estimate the parameters. is the log of the foreign exchange rate, dlnMS3 represents
For estimation of the equation, we will have to convert it first difference log of money supply the and finally
on the reduced form and that can be done by multiplying dlnIMPORT represents the first difference log of food
Equation 1 with A-1. import by the country. The ϵts are the structural
Ft = A-1 β + A-1∂1Ft-1 + A-1∂2Ft-2 + A-1∂nFt-n +A-1 ϵt (2) disturbances and the ϵt are the reduced form error term.
For the convenience, we can write the equation 2 as A is the matrix of contemporaneous relations. In the
follows first transmission channel model, it shows the restriction

168
 Mishra: Tracking the transmission channels of fiscal deficit and food inflation linkages

Table 1. Result of unit root test Keynesian phenomenon. The fiscal deficit in the
Variables ADF unit root test economy led to an increase the income through the
At level At first difference multiplier effect. The increase in per capita income forced
**
the people to increase the consumption expenditure and
WPI of food -3.171 - an increase in per capita consumption expenditure led to
FD to GDP -2.934NS -5.065*** the demand for food commodities in India. Due to the
Ln (M3) -2.474NS -5.077** sudden increase in demand in food commodities with
Ln (Per capita GDP) -3.743** - short-run constant supply, food inflation increases.
The perusal of Table 2 revealed that an increase in
Ln (FOREX rate) -4.011** - fiscal deficit in the economy led to a rise in per capita
Ln (cons Exp) -2.686NS -4.70** income. The per capita income increased within one lag
Ln (import of food) -2.809NS -8.03*** period and after lag 2.5 periods it started to fall. The
Source: Author's Calculation. impact of increasing the per capita income was observed
***, and ** Significant at 1 and 5 percent level. in consumption expenditure. The consumption
NS: Non-significant. expenditure started rising among people of the lower class
implies that first variable, namely food inflation, is as marginal propensity to consume was lower. Food
depended on the food import, rate of foreign exchange as inflation also started growing because of high pressure
well as money supply in the economy. Food import from the demand side. Channel-1 showed that fiscal
depends upon the rate of foreign exchange; money supply deficit passed through consumption expenditure, finally
as well as a fiscal deficit in the economy. The rate of leading to a food price surge in the economy. The
foreign exchange depends upon the money supply as well multiplier effect of the rise in government deficit
as fiscal deficit, and finally, the money supply depends spending had a positive impact on the income. When the
upon the fiscal deficit in the economy. The fiscal deficit per capita income increased, people tend to spend to
directly affects the money supply, import of food and the consume more and the demand for the same increased
foreign exchange rate which impacts the food inflation of consequently leading to food inflation.
the nation. So here we can see that the impulse in fiscal Channel-2
deficit gets transmitted the food inflation through money Channel-2 is a little complex in nature because this
supply, exchange rate as well as food import. We can mechanism depends upon the monetary view. According
interpret the transmission models two and three to the monetarist inflation is a monetary phenomenon.
accordingly. The total number of restriction should be This argument was challenged by many other schools of
equal to m (m-1) . However, in our model, it is more than thought. Theoretically, when the government monetized
2
that. This scenario is called, and it is called an over- the fiscal deficit or finance it through borrowing led to the
identified system. In this case, we can utilize the over- increase in the money supply in the economy. The
identified system; Chi-squared (χ2) test can be used to test government borrowing would lead the change in reserve
the significance of the restricted system (Enders, 2004). 2 money of the central bank and also change the broad
test statistics follow money supply M3. The various empirical researches
suggested this phenomenon. There is a long history of
2  R 
Where Σ is unrestricted variance/covariance matrix,
and R is the number of restrictions. If the χ is get
2 Table 2. Result of the impulse response of the first
significant the restricted get rejected and the same was channel
used to test the significance of a restricted system. Within Lags The response The response The response
an SVAR model, the dynamic effects of structural shocks of PCI to of CONEXP to of FOODINF
are typically investigated by an impulse response FDGDP PCI to CONEXP
analysis. The lag length of the above model selected based 1 0.05 0.000 0.000
on the Akaike information criteria (AIC). 2 0.053 0.011 0.048
RESULTS AND DISCUSSION
The perusal of Table 1 revealed that some of the 3 0.056 0.009 0.042
variables were stationary at their level and remaining were 4 0.049 0.009 0.025
stationary at first difference. The outcome also revealed 5 0.047 0.007 0.010
that none of the variables were stationary at the second 6 0.044 0.001 0.002
difference, which was required for the continuation of
7 0.0423 0.001 0.002
analysis. After getting the desired outcome of the unit root
test, the channels of transmission were identified based on 8 0.042 0.001 0.001
the theory and previous empirical research. 9 0.0402 0.001 0.000
Channel-1 10 0.04001 0.000 0.000
This transmission channel is according to the Source: Author's Calculation.

169
 Indian J Econ Dev 16(2): 2020 (April-June)

financing the government fiscal deficit in India. When the Table 3. Result of the impulse response of the Channel-2
government tried to finance its deficit through public Lags Response of Response of Response of
borrowing and the rate of return on government securities MS3 to FDGDP INF to MS3 FOODINF to INF
were not attractive than public did not hold it, and in this 1 0.000 0.000 0.001
scenario, the central bank held the government security,
and that created change in reserve money in the economy. 2 0.531 1.067 1.870
This situation was advocated by Khundrakpam and Goyal 3 1.003 0.007 3.960
(2009). 4 0.495 0.056 -0.913
As an impulse response outcome described that an 5 0.003 0.001 0.489
increase in fiscal deficit in the economy led to an increase
in the money supply. The response of the broad money 6 -0.002 0.000 1.886
supply (M3) was positive. The money supply started to 7 0.004 -0.067 1.931
surge gradually as the fiscal deficit increased and touches 8 0.467 0.000 -1.834
at the peak level in the third lag, and after that, it starts to 9 0.001 -0.089 -1.885
converge. The response of overall inflation to the money
10 0.254 0.092 -1.835
supply is presented in Table 3. The general inflation
Source: Author's Calculation.
increased gradually due to increasing n money supply in
the economy. The surge in general inflation finally
Table 4. Result of the impulse response of the Channel-3
impacted the food inflation in the economy. Due to the
slight surge in general inflation, food inflation also Lags Response of Response of Response of
responded and started to surge and it reached its peak level FOREX to IMPORT to FOODINF to
FDGDP FOREX IMPORT
in third lag and started to fall gradually. This happened
because when the general inflation in the economy raised 1 -0.002 0.021 0.000
it to increase the cost of production of the food-producing 2 0.041 0.012 0.232
unit as well as the expected inflation also increased in the
3 0.000 0.016 -0.004
mind of these producing units. Channel-2 showed that
fiscal deficit passed through general inflation finally 4 -0.021 0.038 0.231
leading to a food price surge in the economy and it was a 5 -0.009 0.019 -0.022
type of cost-push inflation for the food and agricultural 6 -0.007 0.009 -0.017
industry.
7 0.032 0.021 0.101
Channel-3
Channel-3 is the explanation of the impact of fiscal 8 0.033 0.391 -0.002
deficit to food inflation through external linkage. The 9 0.034 0.013 -0.001
fiscal deficit led to an increase in general inflation in the 10 0.041 0.006 0.000
economy. Increase in the general price level caused fall in Source: Author's Calculation.
export. A large quantum decrease in export caused plunge
in the supply of foreign currency in the foreign exchange perusal of Table 4 revealed that in response to the increase
market. When the supply of foreign exchange decreased the exchange rate the import of food items fall gradually
that led to an increase in the exchange rate in terms of the and affected the supply of imported food commodity in
domestic currency. When the exchange rate increased it the domestic market. The food inflation also surged in
made the import of food as well as crude oil costlier. India response to the fall in the quantum of import of food
met almost 90 percent crude demand through import, and commodity in India.
a large quantum of crude oil was used for various The Diagnostic Test of the Models
agricultural processes like irrigation, food processing, There are various diagnostic tests available for
etc. These two factors ultimately pushed the cost of food checking the reliability of the selected models. After
prices up and caused food inflation in India. The fall in the checking the unit root property stability test was used. The
value of domestic currency made export cheaper, and that Langrage multiplier (LM) test was used for testing the
caused increase the high quantum of food to the foreign stability condition of the above model (Table 5). For this
country, and that also led the food inflation because of test, the null hypothesis is the model was assumed to be
decline in supply in the domestic market. This scenario stable. If null hypothesis was rejected then it was
was witnessed many times in the Indian economy. concluded that the model was stable and vice versa.
The outcome of impulse response documented that The outcome of the LM test revealed that none of the
an increase in fiscal deficit in the economy led to increase statistics were significant at either 5 or 1 percent level of
foreign exchange rate meaning that fall in the value of the significance. With the above outcome of the LM test, it
domestic currency (Table 4). The rising fiscal deficit could be inferred that none of the models had the
caused an increase in the exchange rate and started autocorrelation problem. The results of the LM test
surging and reached a high level in the lag period 2. The supported the robustness of the model.

170
 Mishra: Tracking the transmission channels of fiscal deficit and food inflation linkages
Table 5. The Langrage Multiplier (LM) test for stability
Lags Statistics p-value
Model 1
1 13.2 0.23
2 16.5 0.35
3 14.6 0.15
Model 2
1 6.25 0.18
2 8.5 0.09
3 5.63 0.15
Model 3
1 23.6 0.47
2 26.9 0.16
3 25.8 0.26
CONCLUSIONS
Three different mechanisms of transmission were
found were the consumption, general inflation, and
import channels. The Channel-1 revealed that
government deficit spending had a positive impact on
income. When the per capita income increased, people
tend to append to consume more and the demand for the
same increased consequently and led to food inflation. In
the second mechanism the fiscal deficit passed through
general inflation finally leading to a food price surge in
the economy and it was the type of cost-push inflation for
the food and agricultural industry. Based on the Channel-
3 the impact of fiscal deficit was passing through external
linkage (import of food). Fiscal deficit in the economy led
to increase foreign exchange rate meaning that fall in the
value of the domestic currency. In response to the increase
the exchange rate the import of food items fall gradually,
and affecting the supply of imported food commodity in
the domestic market, and the food inflation also surged in
response to the fall in the quantum of import of food
commodity in India.
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