Exploring price level trajectory in India: Does it validate the fiscal theory of price level?

Abstract

The fiscal policy’s impact on the price level is theorized as the Fiscal Theory of Price Level (FTPL) and has been popularized since the 1980 s. Developing countries often face the problem of prolonged deficits in fiscal management and depend on public debt. Studies on the FTPL in these countries are pertinent but scarce. This paper explores the price level trajectory in the Indian economy for 1985–2019 on the premise of FTPL. Empirical assessment involves both fiscal variables (deficit, debt, public spending) and money supply. The results of the cointegrated vector autoregression model followed by an impulse response analysis reveal that fiscal deficit stimulates the price level, while public spending has a stabilizing impact. Public debt is rather inflationary, but its impact is not robust. Besides, the money supply amplifies the price level. In the price level trajectory, neither the fiscal dominance nor the monetary dominance, that is, indeterminacy, is ascertained. The proactive role of fiscal and monetary policies in the price level trajectory suggests that if the Reserve Bank of India’s stance on price-level stabilization is abreast, the fiscal authority might accomplish the appropriate strategy.