Identifying Fiscal Inflation in India - Some Recent Evidence from an Asymmetric Approach

Abstract

Maintaining a stable price level featured by low inflation rate has remained a prioritized objective of macroeconomic management of all the economies including India. Among many other determinants, this study examines the issue of inflation from the fiscal point of view. A unidirectional causality from fiscal deficits to inflation is reported in time domain causality framework, however only the long-run causality in the same direction is found in frequency domain design, validating the dynamic nature of the association between two variables. Under an asymmetric econometric framework, the existence of a long-run association is documented between deficits and inflation indicating the existence of fiscal dominance in India and the applicability of the fiscal theory of price level. The expansionary fiscal stance is found to be more inflationary and the decreases in fiscal deficits are found to affect the inflation with a lower magnitude. The possible asymmetry of fiscal deficits on inflation can be attributed to the existence of liquidity constraints and the downward price stickiness. The other control variables are found to report the theoretically plausible results. The study recommends the fiscal consolidation, monetary policy credibility, output growth and import substitution measures for a growth conducive and welfare-oriented price level in the economy.