Fiscal deficit and inflation linkages in India: tracking the transmission channels

Abstract

Fiscal deficit and inflation are the two major macroeconomic problems confronting the Indian economy. Although it had manifested in various degrees earlier, these problems escalated after the recent global financial crisis. It has always been criticized that fiscal deficit will adversely impact the level of inflation. This critique has been proved and validated by many existing studies in the context of India. This paper strives to track the channels of transmission through which fiscal deficit has passed on and impacted the level of inflation in India. Based on theoretical and empirical literature, this study identifies four transmission channels, namely consumption expenditure channel, money supply channel, import channel and interest rate channel. By adopting structural vector autoregression model, it has been found that the fiscal deficit transmission mechanism is clearly evident with regard to consumption channel, money supply channel and import channel but not the interest rate channel.