Fiscal deficit targeting alongside flexible inflation targeting: India’s fiscal policy transmission

Abstract

India is at the cusp of a macroeconomic policy upgrade: the government has opted for a fiscal deficit targeting rule in partial acceptance of the recommendations of the 2017 Fiscal Responsibility and Budget Management Review Committee while at the same time the central bank has adopted a flexible inflation targeting framework. This paper investigates the impact of these rules on one another using a dynamic stochastic general equilibrium (DSGE) model calibrated for the Indian economy. The study first ascertains that under a high degree of interest rate smoothing, a passive monetary policy is consistent with the fiscal deficit targeting rule in that determinacy of the price level is assured. Having established the central bank’s parameter space, the study next investigates the effect on fiscal policy transmission of varying the degree of monetary policy activeness. For positive fiscal spending shocks, more active monetary policy blunts the expansionary impact while reducing inflationary spillovers. The reverse holds for fiscal stimulus measures involving tax reductions, which are disinflationary, so that more active monetary policy amplifies the expansionary impact and mitigates the disinflationary impetus. The results highlight the need for coordination between fiscal intervention and monetary policy.