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Global Crisis, Fiscal Response and Medium-term Risks to Inflation in India

Khundrakpam, Jeevan Kumar and Pattanaik, Sitikantha (2010): Global Crisis, Fiscal Response and Medium-term Risks to Inflation in India. Published in: Reserve Bank of India Occasional Papers , Vol. 31, No. No.2, Monsoon (April 2010): pp. 1-30.

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Contagion from the global crisis necessitated use of fiscal stimulus measures in India during 2008-10 in order to contain a major slowdown in economic growth. Given the usual downward inflexibility of fiscal deficit once it reaches a high level, as has been experienced by India in the past, there could be medium-term implications for the future inflation path, which must be recognised while designing the timing and speed of fiscal exit. Inflation, at times, may become effectively a fiscal phenomenon, since the fiscal stance could influence significantly the overall monetary conditions. As highlighted in this paper, fiscal deficit could be seen to influence the inflation process either through growth of base money created by the RBI (i.e. net RBI credit to the Government) or through higher aggregate demand associated with an expansionary fiscal stance (which could increase growth in broad money). Empirical estimates of this paper conducted over the sample period 1953-2009 suggest that one percentage point increase in the level of the fiscal deficit could cause about a quarter of a percentage point increase in the Wholesale Price Index (WPI). The paper emphasises that the potential inflation risk should work as an important motivating factor to ensure a faster return to the fiscal consolidation path in India, driven by quality of adjustment with appropriate rationalisation of expenditure, rather than waiting for revenue buoyancy associated with sustained robust growth to do the job automatically. The importance of fiscal space in the India specific context needs to be seen in terms of not only the usual output stabilisation role of fiscal policy but also the occasional need for use of fiscal measures to contain such inflationary pressures that may arise from temporary but large supply shocks.

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