Identifying fiscal inflation in India: some recent evidence from an asymmetric approach

Abstract

<jats:sec> <jats:title content-type="abstract-subheading">Purpose</jats:title> <jats:p>Among the many factors fueling the inflationary tendencies in an economy such as monetary shocks, structural shocks, demand shocks, external shocks and demographic changes, the issue of inflation (INF) has also been found to be related to fiscal policy decisions of the government. The purpose of this study is to investigate the inflationary tendencies in India particularly from the fiscal point of view. The study also examines the influence of other potential determinants such as output growth rate, interest rate, trade-openness (TO) and oil price inflation (OPI).</jats:p> </jats:sec> <jats:sec> <jats:title content-type="abstract-subheading">Design/methodology/approach</jats:title> <jats:p>To examine the dynamic nature of association between fiscal deficit and inflation, the study applies the Toda-Yamamoto (1995) test and Breitung and Candelon (2006) test to investigate the nature of causality in time and frequency domain frameworks. In addition, to scrutinize the possibility of a long-run association, that too from an asymmetric point of view, the study applies a Non-linear Autoregressive Distributed lag model (NARDL) given by Shin et al. (2014). Finally, non-linear cumulative dynamic multipliers are used to trace the traverse between disequilibrium position of short-run and subsequent long-run equilibrium of the system.</jats:p> </jats:sec> <jats:sec> <jats:title content-type="abstract-subheading">Findings</jats:title> <jats:p>The authors found a unidirectional causality from fiscal deficit to inflation in case of time domain analysis and no feedback causality is reported. However, in case of frequency domain design, causality from fiscal deficit to inflation is found at low frequencies only, i.e. no short-run causality is established and hence dynamic nature of the relationship between the two variables is vindicated. Using NARDL model, the results document the existence of an asymmetric long-run direct association between fiscal deficit and inflation. However, an increase in deficit is found to be more inflationary and a decrease affects the inflation with a lower magnitude. The asymmetric impact of fiscal deficit on inflation can be explained through the existence of liquidity constraints, consumption-investment downward inflexibility and the downward price stickiness. Contractionary monetary policy action is found to be more effective than an expansionary one, signifying the asymmetric influence of monetary policy actions on the inflation of India. Similarly, in a supply-constrained economy with downward price rigidity, the authors found an asymmetric impact of output growth and output decline on inflation. As regard to the trade-openness, although an asymmetry is reported, the signs refute the validation of Romer (1993) hypothesis. Finally, the impact of oil price inflation on the inflationary pressures is according to theory but the coefficients are devoid of statistical significance.</jats:p> </jats:sec> <jats:sec> <jats:title content-type="abstract-subheading">Practical implications</jats:title> <jats:p>These results indicate some important policy recommendations. Fiscal consolidation strategy should be executed in an appreciable manner to achieve the sound fiscal health and lower INF. The disciplined fiscal strategy would also be imperative for an effective monetary policy. Monetary authorities should possess noticeable credibility to manage the macroeconomic system and policy stances should be implemented according to requirements of the economy. Growth in output should be encouraged to have two-fold benefits to the economy – reducing INF on the one hand and fiscal deficits on the other.</jats:p> </jats:sec> <jats:sec> <jats:title content-type="abstract-subheading">Originality/value</jats:title> <jats:p>The study contributes to the existing literature in the following ways. First, taking note of dynamic nature of the relationship between these two variables, the study examined the deficit INF nexus in a dynamic and asymmetric framework. The novelty of the study is ensured by the very nature of it is the first study in case of India to identify the fiscal INF in an asymmetric configuration. The authors applied a NARDL model, given by Shin <jats:italic>et al.</jats:italic> (2014) to examine the existence of any cointegrating relationship in an asymmetric paradigm. Second, the nature of causality between fiscal deficit and INF has been examined in a time domain and FD framework to portray precisely the casual interactions between these two variables in the short-run and long run. The study will, therefore, enrich the existing literature along the asymmetric lines.</jats:p> </jats:sec>

Macroeconomic determinants of fiscal policy in East Africa: a panel causality analysis

“…Using the mean group and pooled mean group estimators within the panel Autoregressive Distributed Lag (ARDL) framework, results showed that budget deficits are significant drivers of inflation among high-inflation and developing country groups, but not among low-inflation advanced economies. These results are consistent with a wide range of literature that shows the positive dynamic relationship between budget deficits and inflation (Bhat and Sharma, 2020; Nguyen, 2015; Lin and Chu, 2013).…”

The Asymmetric Impact of Trade Openness on Inflation in Sudan

“…Granato et al (2007) and Abbaspour et al (2011). It is contradicted by Romer's hypothesis that inflation would decrease with openness (Alfaro, 2005;Gruben and McLeod, 2004); Bhat and Sharma, 2020;Lin et al, 2017 andAfzal et al, 2013). The positive relationship indicates that the Sudan economy depends on imports, especially luxury goods.…”

“…Additionally, positive effects were found on inflation and exchange rates, money supply and the consumer price index. Bhat and Sharma (2020) employed the nonlinear autoregressive distributed lag (NARDL) technique for the period from 1970 to 2015. They found that the positive coefficient of economic openness on inflation in the longterm was insignificant, and these results refuted those found by (Romer, 1993), while the negative coefficient of economic openness on inflation in the long-term was statistically significant.…”

Identifying Inflation Dynamics in India in the Post Reform Period

“…The study holds that the role of output gap via demand pressures in explaining price level is more significant than the money supply, interest rate and exchange rate. Bhat and Sharma (2020) in an asymmetric procedure shows that output growth and interest rate has inflation dampening effect which fiscal deficit and openness has inflationary impact in the Indian context over the period 1970-2016. Romer (1993 argues that economies that are more open tends to have low rate of inflation.…”