Does Fiscal Deficit Affect Interest Rate in India? An Empirical Investigation

Abstract

Fiscal deficit above a certain limit is not good for the country because high government borrowings raise the interest rate and crowd out private investment. This article is an attempt to analyze the impact of fiscal deficit on real interest rate in India over the time period of 1980–1981 to 2013–2014. Autoregressive distributed lags bound testing approach for cointegration and vector error correction model for Granger casualty are used in a multivariate framework in which money supply and inflation are included as additional variables. Bound test results confirm the long-run equilibrium relationship among the competing variables. Further, the rate of interest and fiscal deficit are positively related with each other in long run, whereas money supply and inflation are found to be negative and statistical significant. In addition, results of vector error correction model showed that there is unidirectional causality running from inflation to real interest rate in short run. Based on the findings, it is suggested that that proper fiscal consolidation is required to control high fiscal deficit and burgeoning interest rate in India. Further, government should move from market borrowing to tax revenue to offset fiscal deficit.