A REPORT ON

THE EFFECT OF FISCAL DEFICIT ON WHOLE SALE PRICE INDEX IN INDIA

Submitted by, Group 7 Sec A Ankit Rout (U111007) Chinmaya Swain (U111017) Kavindra Sharma (U111027) Nikhil Lukose (U111037) Samik Bhattacharjee (U111047) Swarup Kumar Mishra (U111057)
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ACKNOWLEDGEMENT

We would like to express our whole-hearted gratitude to all those who have helped with the report or have been associated with the report in any way and made it a worth-while experience.

We are greatly indebted to our batch mates and our seniors for having shared their invaluable thoughts and opinions that went a long way in helping us gather information and analyse issues for the report.

And, a special mention of Professor Latha Ravindran, whom we cannot thank enough for having given us the opportunity and her total support for working on this project and completing our report.

Thank you.

INTRODUCTION For the last several years the GDP of India has been growing rapidly. The real GDP growth of India averaged 8.5% in the five years ending March 2010. But at the same time food price inflation and consumer price inflation too have been on the increasing curve. The relationship between fiscal deficit and inflation which is measured by WPI in India is an important issue in macroeconomics study. The main purpose of the study is to analyze the relationship between budget deficit and Whole Sale Price Index. The fiscal deficit influences demand and thereby inflation management of any country. So any increase in fiscal deficit will impact the management of inflation and WPI. FISCAL DEFICIT It is government's total expenditures minus the total revenue that it generates (excluding money from borrowings). Deficit is different from debt, which is an accumulation of yearly deficits. The total borrowing requirement from all the sources of the government can be found out from the fiscal deficit figure. Primarily, the government can go to RBI to get the money required. RBI can either increase the money supply by issuing new notes, or it can raise the amount required from the market by issue of bonds. Issuing these instruments will decrease the liquidity in the country and it will in turn increase the interest rates. In both the cases, the increase in fiscal deficit causes the interest rates to rise in an economy. As a result it will discourage the private investment in the economy due to the rise in the cost of capital. Wholesale Price Index (WPI) WPI is an index which is used to calculate the change in the price level of goods which are traded in wholesale market. Not all goods are included for measuring WPI. A total of 435 commodities price information is used for calculating the WPI. WPI traces the movement in prices of all commodities which traded and transacted in the market. Whole sale price index is published on a weekly basis by RBI. To measure the rate of inflation the Indian government has taken WPI as a parameter for inflation in the economy. WPI was first published in 1902, and is used as one of the economic indicators by countrys policy makers. WPI is used to measure inflation and hence important monetary and fiscal policy changes are often associated with it. The WPI indices are also used for price correction through escalation clauses in the supply of raw materials, capital goods and construction work. The weekly published figure of wholesale price index has gained much importance over time, since this is a direct indication of the week-to-week variations in the prices of all the commodities which are traded in the open market. RELATION BETWEEN MACROECONOMIC VARIABLES The relation between fiscal deficit and macroeconomic variables- monetary base, money supply and inflation helps us to understand how the price index is influenced by budget deficit. The correlation between budget deficit, money supply and inflation is a macroeconomic phenomenon and it is observed across the world. In other words, while budget deficit may lead to higher inflation, more government spending and less revenue and hence government budget deficit is itself affected by the inflation. Therefore, inflation and budget deficit are both considered as interrelated variables. In most developing countries, like India, increase in budget deficit results in increase of monetary base, thus resulting in
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increase in money supply which in turn raises the inflation rate. In a similar manner, as inflation increases, budget deficit increases and therefore the process of self-generating inflation is carried on as long as budget deficit continues in the economy. Deficit can be financed either by borrowing or through creation of money. The relationship between fiscal deficits and inflation will depend on the monetary policy which can be independent or dependent of fiscal policy. GOVERNMENT DEFICIT FINANCING The mode of financing the fiscal deficit determines its impact on inflation. It is generally known that creation of money leads to inflation. If government decides to fund deficit through domestic borrowing, it results in increase in demand for available credit. As demand increases, with supply remaining constant the price of credit (interest rate) should go up. This will result in a fall in private investments. Alternatively, it can be said that government budget deficits decreases the net quantum of productive private investment. Financing through external borrowing will lead to a current deficit and has the possibility of resulting in an external debt crisis. In developing economies, where money creation is the sole way of financing government budget deficit, it becomes a key factor determining money growth and inflation. A constant and positive government budget deficit can be maintained for a long time and without inflation if the deficit is financed by issuing bonds rather than creating money. The increased budget deficit significantly alters inflation in a developing country. For a country prevailing under inflationary conditions, this will lead to an increase in the governments budget deficit. Consequently financing of the fiscal deficit will result in an increased money supply and this tends to fuel inflation which is nothing but an increase in WPI. The phenomenon of budget deficit is often linked to the Keynesian model of expenditure led growth theory of the 1970s. Most of the governments adopted this theory that government has to increase the aggregate demand in the economy in order to support and stimulate economic growth. However, its effects on macroeconomic variables cannot be ignored in most countries of the world. In India over the years, there has been a consistent rise in private consumption expenditures and developments in the external sector have also influenced strongly on the budget deficit. It is expected that lower budget deficits will decrease real interest rates, attract investments, and thereby increase growth, productivity and real income. A government experiences deficit in its budget when its total expenditure exceeds its total revenue while budget deficit financing indicate the means of handling budget deficit of the country. However, the source of financing has different impact of a budget deficit on inflation index. The major outcomes of empirical studies examining the relationship between budget deficits and inflation showed strong proof that financing budget deficits through monetization and increased money supply can cause inflation. DEFICIT FINANCING AND MONEY SUPPLY The total money supply, M3, (sum of currency with the public and bank deposits) depends on the supply of reserve money, people's willingness to hold cash vis-a-vis bank deposits and the cash reserve ratio set by the RBI:

M3 = (1 + a) R (a + r) Where R = reserve money; a = ratio of currency to bank deposits people want to hold; and r = cash reserve ratio. It is through changes in reserve money that budgetary deficits exert their influence on the aggregate supply of money. Indeed, as the relation suggests, the increase in M3 will in general will be a multiple of the overall budget deficit so long as the deficit generates an equivalent amount of reserve money. In India the overall budget deficit stands for the excessof aggregate expenditure (including transfers) of the government over its total receipts under Revenue and Capital Accounts. What is relevant in this connection is the net increase in the Reserve Bank credit to the government and this is likely to be different from the deficit in the union government's budget. The reasons for the discrepancy are generally two fold: (i) Both the Reserve Bank and commercial banks deal in Treasury Bills and in medium and long-term government securities. Hence the net change over the year in the amount of total government securities held by the Reserve Bank may be quite different from additional Treasury Bills issued; and (ii) Deficit financing includes net credit (including overdrafts) extended by the Reserve Bank to the union and state governments taken together. If the government borrows from the Reserve Bank in order to repay some foreign loan, the amount of high power money remains unaltered. The fall in foreign exchange reserves is offset by rise in government securities on the asset side of the Reserve Bank's balance sheet. When the government takes loans from the domestic market in order to make payments abroad, the reserve money registers a decline. Opposite is the effect of financing the domestic expenses of the government through borrowing from external sources. Hence, even apart from the budget deficit, the excess of net external borrowing by the government over its payments abroad raises the amount of reserve money in the economy. The assumption is that banks are fully loaned up and are unable to meet the requirements of all borrowers at the given rates of interest. But if the banks have been operating with excess reserves, the supply of bank credit becomes demand and the money multiplier assumes a value of unity. There will be no secondary expansion of money supply following the expansion of reserve money. Even when bank credit is supply determined, there are difficulties in predicting the additional amount of money generated. This is because of budgetary operations. First, the demand for currency on the part of the public depends not on relatively long-term factors like banking habit and other institutional arrangements, and aggregate income and its composition. The greater the share in total output of agriculture and the unorganised sector (where payments through cheques are minimal) and the larger the volume of black income and transactions, the higher will be the demand for currency. Hence the impact of deficit financing on the aggregate supply of money is smaller. In fact, given the supply of reserve money and the rules under which commercial banks function, M3 is the outcome of an interaction between the commodity and the money markets. It is required to know a good deal regarding the non-monetary sectors in order to estimate the value of the money multiplier. Second, the impact of overall budgetary deficits depends on the policies pursued by the Reserve Bank. The most important of which are changes in the cash reserve ratio and
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imposition of ceilings on bank credit. Reserve Bank's policies in respect of the distribution of credit have an important impact on M3. Diversion of bank loans to sectors, where cash transactions are predominant, tends to reduce the supply of money through a rise in the demand for currency. By the same logic a larger allocation of plan expenditure in favour of Rural Employment Generation or similar programmes will be result in a smaller money multiplier for a given level of deficit financing. MONEY SUPPLY AND PRICES So far we have seen the effect of budgetary operations on the aggregate supply of money and came up with the conclusion that this effect cannot be estimated from the overall fiscal deficit alone. However the rise in M3 consequent upon deficit financing does not necessarily lead to inflation. The elementary point to note in this connection is that, changes in money supply can affect prices only through the demand and the supply sides of the commodity market. There are basically three reasons which may mislead estimation of the inflationary potential of deficit financing. First, the growth rate of real output is taken to be independent of changes in money supply in general, and the size and composition of the Budget in particular. Second, both the credit and the commodity markets are assumed to be competitive with relevant prices adjusting to clear the markets. Third, no account is taken whatsoever of the nonmonetary factor affecting the demand conditions in the economy. IDENTIFYING DEMAND AND SUPPLY-SIDE EFFECTS OF FISCAL DEFICIT The inflationary impact of budgetary operations is to be found by identifying their effects (direct or indirect) on the demand and the supply sides of the commodity market. On the expenditure side of the Budget it is customary to distinguish between (i) government consumption and capital formation; (ii) income transfers, eg, pension, subsidy or interest payments; and (iii) repayment of loans or other transfers on capital account. The basis of the distinction is their differential impact on aggregate demand. The impact (or the multiplier) is the largest for government expenditure on final goods, somewhat less (because of positive marginal propensity to save) for income transfers; and nil for transfers on capital account. Again, government expenditure abroad under even (i) and (ii) is taken to have no expansionary effect on the demand side of the commodity market. In respect of the modes of financing government expenditure, the conclusion is that taxation is the least and deficit financing the most inflationary, while borrowing comes in between the two as sources of non- inflationary finance. Thus the conventional (Keynesian) analysis clearly suggests that the demand expansionary potential of a budget is not indicated by deficit financing. Even with no deficit the inflationary potential of a Budget will be greater, (a) the larger the absolute size of the Budget; (b) the higher the levels of government consumption and investment in relation to transfer payments; and (c) the lesser the importance of tax collections relative to borrowing. Deficit financing and the associated change in money supply are considered important only to the extent people try to use part of the additional money to buy bonds or physical assets. This is because it will result in a reduction in interest rates or a rise in prices of capital goods.

The elementary point to note in connection with different modes of financing government expenditure is that, their inflationary or deflationary impact is felt only as the rest of the economy reacts to these measures. In India, given the interest rates fixed by the monetary authorities, people hold their financial savings mostly in the form of cash, bank deposits and other forms of "safe" financial assets with little possibility of capital gains and losses. The nature of portfolio choice is thus quite at variance with the traditional theory, both Keynesian and monetarist. Under these conditions the impact of deficit financing operations through an expansion of bank credit enables the borrowers to register their demand in the commodity market. The inflationary consequence of an increase in money supply in our economy can be traced almost entirely to the associated rise in the supply of bank credit and hence in expenditure. The fiscal deficit will thus be devoid of any expansionary effect to the extent bank credit is demand determined or the rise in money supply (representing additional loans granted by the Reserve Bank and commercial banks to the public and the private sectors) reduces the scale of gross credit extended outside the banking sector. When commercial banks operate with excess cash reserves, there is no crowding out effect of government borrowing from banks or the public. Such borrowings stand on exactly the same footing as deficit financing. If, however, banks are fully loaned up, it becomes important to distinguish between loans taken from the public or those from commercial banks. The reason is that, when the government issues high yielding financial assets (like National Saving Certificates or Railway bonds) that find their way into the portfolio of households, there is generation of additional credit outside the banking sector with no corresponding diminution in commercial bank credit (as the money withdrawn by the people to buy NSC, etc, flows back into the banking system). Hence borrowing from households does not generally have any crowding-out effect in our economy. Sale of government securities to banks constitutes a more effective instrument for controlling inflation in the short run, since in a credit constrained situation the former causes an equivalent decrease in expenditure through a reduction in bank credit to other sectors. In assessing the implications of taxes we consider the following factors. First, for given levels of plan expenditure, there is no deflationary effect of corporate taxes paid by public sector enterprises. Second, resources released in real terms are larger for personal income tax than for indirect taxes. Third, in-direct taxes as an instrument of resource mobilisation will be less effective as greater is the reliance on duties on capital goods or on intermediate inputs that are used primarily in investment goods. Given the insignificance of the personal income tax as a source of revenue and the overwhelming importance of duties on capital goods and intermediate inputs, it is easy to see that taxes have not been an effective non-inflationary means of financing development expenditure (deficit) in our country. The foregoing results do not imply that the corporation tax and duties on capital goods have the same effect in respect of the inflationary potential of a Budget. To the extent the government assumes the responsibility of meeting the investment targets of public sector enterprises, it does not matter whether these units pay part of their profits to the union government or not. There may however be indirect disinflationary effects of such tax collections. When government enterprises are left with a smaller part of their surplus, they have to rely more heavily on bank credit for financing their working capital requirements so that there will in general be a squeeze on private investment. The short run effects of such taxes are thus similar to those of borrowing from commercial banks. In the case of corporate tax collections from enterprises, the fall in capital accumulation in the private sector will be supplemented by a decline in consumption (with a reduction in the amount of dividend declared). The initial impact of
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duties on capital goods is on their prices, as they are administered and fixed on a cost-plus basis. Hence such taxes are invariably inflationary and can reduce demand in real term only if funds earmarked for investment are not adjusted to neutralise the hike in prices, i.e., only if there is a fall in capital accumulation in the public or the private sector. Even when indirect taxes effect a cut in consumption, the fall in demand is forced through a rise in prices. We thus come full circle and end up with the conclusion that, from the viewpoint of both equity and control of inflation, a properly administered personal income tax ranks higher than other instruments of resource mobilisation. Indeed, the conclusion appears reinforced when the supply-side effects of these instruments are taken into account.

SUPPLY-SIDE EFFECTS Economists distinguish between the short- and the long-run effects of investment projects on the supply side of the commodity market. A similar distinction is called for in respect of the various budgetary measures for raising resources. To the extent taxes or borrowing curb expenditure on consumption or investment, they are no doubt anti-inflationary in the short run. But a fall in investment reduces the growth of productive capacity in the economy and hence makes it more inflation -prone in the medium and the long run. Since both market borrowing and taxes in India are not very effective in curbing consumption, these measures do not seem to contribute significantly towards the objective of growth with price stability. Second, taxes on intermediate inputs account for the major part of revenue of both the union and state government, and such taxes, as is well known, tend to promote inefficiency in the productive system through a misallocation of resources and hence generate a negative supply-side effect. Finally, in respect of the crowding-out or crowding-in effect operating through credit, it is important to distinguish between different categories of borrowers. When additional bank credit is extended to finance investment in working capital, the effect may in fact be disinflationary. The reason is that, if credit constraint is in force, the (short-term) supply-side impact of the expansion of bank credit dominates the effect operating on aggregate demand. By the same logic market borrowing, by crowding-out production loan, may in fact serve to stoke the fire of inflation.

CONCLUSION It can be concluded that Inflation and Fiscal deficit have a strong positive correlation. However, depending on the mode of financing used to bridge this deficit, its impact on money supply can vary and hence the inflation. But most forms of financing results in increase in money supply in the form of printing of currency notes by RBI or the government issuing of bonds to raise the money. This leads to the alteration of the demand supply equilibrium and thus leads to inflationary situations.

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Appendix 1: WPI & Fiscal deficit data of India for the period 1991-92 to 2010-11

Financial year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

Fiscal deficit as a percentage of GDP 5.55% 5.34% 6.96% 5.68% 5.05% 4.85% 5.82% 6.47% 5.36% 5.65% 6.19% 5.91% 4.48% 3.88% 3.97% 3.32% 2.55% 6.04% 6.39% 5.09%

WPI 13.74% 10.06% 8.35% 12.60% 7.99% 4.61% 4.40% 5.95% 3.27% 7.16% 3.60% 3.41% 5.46% 6.48% 4.50% 6.60% 4.67% 8.06% 3.81% 9.56%

Appendix 2: Graphical representation of WPI and fiscal deficit

16.00%

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

Fiscal deficit as a percentage of GDP

WPI

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