Fiscal policy and macroeconomic effects: structural macroeconometric model and simulation analysis

Abstract

Though an accumulating body of work has analysed fiscal policy and macroeconomic relationship in Indian context, the framework adopted is largely single-equation one and the analysis is conducted mostly at the aggregate level, resulting in the documentation of conflicting results. The study develops a structural macroeconometric model which is primarily eclectic in nature. The generalised method of movements is used for estimation of behavioural equations, while Gauss–Seidel algorithm is used for model simulation purpose. The paper presents results of two policy simulations from the estimated model that highlight the impact of fiscal policy and resulting fiscal deficit under two financing options such as Reserve Bank credit to government and commercial bank credit to government. We find that under both the financing scenarios public investment crowds in private investment with long-run cumulative multiplier equal to 1.64 and 1.30, respectively. First, real output under both options also witnesses an increase in the long run with cumulative multipliers equal to 3.48 and 2.72, respectively. Second, under monetary financing scenario, aggregate deflator along with overall price level witnesses an increase of about.4.01 and 3.84%, respectively, in the long run, while a reversal under commercial bank credit to government (− 2.72 and − 2.61). Thus, we find an evidence of Sargent and Wallace (1981) view of price level. Third, we find evidences of twin-deficit hypothesis in case of monetary financing scenario and twin divergence in case of commercial bank credit to the government. Further, we find that deficit interest rate linkage also varies under the two financing scenarios, negative relationship in case of the first, while positive relationship in case of the second.