Wednesday, 11 May 2011

Recession and Recovery -Role of Monetary and Fiscal Stimulus-


We begin our analysis of  Indian macroeconomic stabilization with a broad theoretical analysis of the various concepts and issues which have to be studied with regard to it. (Dornbush, 2004;DeSouza, 2008). We consider the main elements of the key dimensions of macroeconomic policy in a closed economy-fiscal and monetary policy.A caveat at this stage which must be mentioned is that most of the growth in recent period has been because of open economy consequences.Finally we work out the the sustainable deficit calculations  for the last few years of recession and recovery including stimulus years and analyze them.

Effectiveness of Fiscal and Monetary Policy

 Let us look at the effectiveness of Fiscal and Monetary Policy first
(DeSouza, p. 255). Prior to the 1990’s increases in government expenditure-fiscal policy were financed through two main mechanisms, the increased government borrowing was accommodated by hikes in the Statutory Liquidity Ratio imposed on commercial banks. So commercial banks had to keep a certain proportion of their assets in the form of the holding of government securities and this proportion was constantly being increased prior to the nineties. So because of this government securities could be placed with commercial banks at below market rates of interest. By 1990 the SLR was 39%.

The second mechanism which was routinely used in the 1980’s to meet the government’s requirements of funds was the government unilaterally accessing the Central Bank (the RBI) through the medium of ad-hoc Treasury bills, this led to monetization of the deficit which in turn expanded reserve money. So, there was an automatic monetization of the deficit circumscribing the scope for discretionary monetary policy severely.

Fiscal Adjustment-

The issue of fiscal adjustment (DeSouza, p. 255) was seen to be difficult to sustain over the 90’s and was sought to be achieved through the enactment of the Fiscal Responsibility and Budget Management Act in 2003 that institutionalized fiscal consolidation through a legislative mandate, this was because the growing fiscal deficit had raised concerns about its sustainability and its impact on the economy.

Autonomy of Monetary Policy-

Autonomy of monetary policy (DeSouza, p. 255) was instituted through the phasing out of adhocs and shifting government borrowing towards market rates of interest. As the suppression of the allocative role of interest rates in the money market was removed, the central bank could begin to conduct open market operations better. This raised the ability of the central bank to influence liquidity and removed the constraint on discretionary monetary policy.

IS-LM Approach and Fiscal and Monetary Policy

Monetary Policy is accommodating(Dornbush,p. 283) when, in the course of fiscal expansion, the money supply is increased in order to prevent interest rate from increasing. Monetary accommodation is also referred to as monetizing budget deficits, meaning that the Reserve Bank prints money to buy bonds with which the government pays for its deficit. When the RBI accommodates a fiscal expansion, both the IS and the LM schedules shift to the right. Output will clearly increase, but interest rates need not rise. Accordingly, there need not be any adverse effects on investment.

Given the decision to expand aggregate demand (Dornbush, pp. 287-8), who should get the primary benefit? Should the expansion take place through a decline in interest rates and increased investment spending, or should it take place through a cut in taxes and increased personal spending, or should it take the form of an increase in the size of government. Conservatives will argue for a tax cut anytime. They will favour stabilization policies that cut taxes in a recession and cut government spending in a boom. The counterpart view belongs to those who believe that there is a broad scope for government spending on education, the environment, job training and rehabilitation, and the like, and who, accordingly, favour expansionary policies in the form of increased government spending and higher taxes to curb a boom. Growth minded people and the construction lobby argue for expansionary policies that operate through low interest rates or investment subsidies. Recognition that monetary and fiscal policy changes have different effects on the composition of output is important. It suggests that policy makers can choose a policy mix-a combination of monetary and fiscal policies. We now discuss the policy mix in action.

The Policy Mix in Action

The IS-LM approach informs us(DeSouza, pp. 255-6) that the interest rate rises when the IS curve shifts to the right(fiscal policy).Also, an increase in income(output)raises the demand for money for transaction purposes and raises the interest rate in the money market as well. The interest rate declines, however, if there is an increase in real money supply that shifts the LM curve to the right. From 1995-96 to 2000-2001 both fiscal and monetary policy were expansionary with a rise in the fiscal deficit and an increase in the real money supply growth rate. However the impact of fiscal policy was larger than that of monetary policy in this period. The large government borrowing programs in the period upto 2000-01 shifted the IS curve more than the rightward shift of the LM curve and raised the real interest rate of the economy. The high interest rate dampened the output increase in the period with a trend deceleration in output growth.

In a latter period from 2001-02 to 2005-06, government borrowing retreated whereas the expansionary character of monetary policy was not curtailed extensively. During this period the LM curve shifted more to the right than the IS curve. As a result an interest rate decline accompanied the rise in output. An easy monetary policy that accommodated the output increases and a gradual reigning in of fiscal policy thus accompanied the boom in the Indian Economy  till 2008.

What has happened in 2008-2010 is that the IS curve has shifted to the right due to the expansionary fiscal policy or the fiscal stimulus(since January 2009), this has been accompanied by the LM curve shifting to the right due to expansionary monetary policy which has led to accommodation of the fiscal stimulus, but presently the fiscal stimulus needs to be reined in because further growth in fiscal spending or shift in the IS curve would lead to rise in interest rate and private investment expenditure being crowded out.

Deficits and Inflation

There is a two-way interaction between budget deficits and inflation. (Dornbush 2004, pp. 467,470). Large budget deficits can lead to rapid inflation by causing governments to print money to finance the deficit. In turn, high inflation increases the measured deficit. There are two counter mechanisms through which inflation affects budget deficits:tax collection effects and increases in real payments on the national debt. As the inflation rate rises, the real revenue raised from taxation falls The reason is that there are lags in both calculation and payment of taxes and so real value of taxes because of inflation tends to decrease and so budget deficit can go out of hand. On the other hand the measured budget deficit includes the interest payments on the national debt, thus often what is calculated is the inflation adjusted deficit:

Inflation adjusted deficit=total deficit-(inflation rateXnational debt).
So as inflation increases the inflation adjusted deficit tends to decrease.

Sustainability of the deficit

Using the usual closed economy macro economic framework ( One can use a sort of closed economy framework because less than 5 per cent of the debt is external debt. Most is internal debt.)
Consider(Desouza, pp.329-30):
bt=Bt/Yt ,the debt-GDP ratio.
dt=Dt/Yt, the primary deficit/gdp ratio.
And the one period growth rate of GDP be g=Yt-Yt-1/Yt-1=Yt/Yt-1-1
Or 1+g=Yt/Yt-1
Then we can rewrite the Government Budget Constraint as = Bt=(1+r)Bt-1+Dt
Where r=interest rate, Bt=Debt and Dt=Primary Deficit,
:bt=(1+r/1+g)bt-1+dt                         (Equation 1)
If g>r, the debt/GDP ratio will not increase and in that sense the debt/GDP ratio is sustainable.
One can ask at any point in time that(DeSouza, p. 337), if the historically given debt at that time is to be continued at that constant level forever, and if there is no change in interest rates and the growth of GDP-the current configuration of the economy continues to prevail-what is the primary deficit that can sustain this time path of the economy?
This gives the Primary deficit/GDP ratio that is required in order to sustain the existing level of debt in the economy. The sustainable primary deficit/GDP ratio has been below the actual primary deficit/GDP ratio for most of the nineties After 96-97, till 2002-03, the fiscal situation worsened and the increased primary deficits during this period required substantial fiscal correction afterward.

This answer is derived from equation 1
:bt=(1+r/1+g)bt-1+dt                         (Equation 1)
Or, 1-(1+r/1+g) bt-1= dwhen :bt= bt-1
Or, dt=(g-r/1+g) bt-1(Equation 2)
This gives the primary-deficit/GDP ratio that is required in order to sustain the existing level of debt in the economy.It is worth mentioning that this is a long run concept – This is derived for a steady state where interest rates and GDP growth do not change. There is no necessity that the growth rate in a period is the steady state growth rate of the economy.

We determine the value of Equation 2 for the period 2006-07 to 2008-09.
                                                            2006-07     2007-08  2008-09
Primary Deficit/GDP
Real Rate of Interest
Growth Rate of GDP
Sustainable Primary-Deficit/GDP ratio=

Explanatory Note
1.)debt-GDP=Selected Debt Indicators of Central and State Governments as percentage of GDP.-Table 247 Handbook of Statistics on the Indian Economy 2008-09.The figure for 2008-09 is Budget Estimate but the Revised Estimate for the Total Liabilities of Government of India is according to RBI Bulletin October 2009 page 1880 only slightly higher 57.8(RE) from 57.75(BE).The BE for 2009-10 for the same figure from the same source is is 59.7%.The latest revised estimate for primary deficit/gdp for 2009-10 is also only slightly higher at 3.2%
2.)Primary-Deficit/GDP=RBI Monthly Bulletin October 2009 Page 1869 Statement 1-Budget at a Glance.
3.)Rate of Interest=2006-07,07-08=TABLE 121 : INTEREST RATES ON CENTRAL AND STATE GOVERNMENT DATED SECURITIES,Handbook of Statistics on the Indian Economy 2008-09.2008-09=pg 254 .
4.)Growth Rate of GDP-TABLE 233 : SELECT MACRO-ECONOMIC AGGREGATES - GROWTH RATES AND INVESTMENT RATES (At Constant Prices) Handbook of Statistics on the Indian Economy 2008-09.


We note that the primary deficit/GDP ratio has been sustainable in these years (2006-09) because the growth rate of GDP has been high in these years and the real rate of interest has been low. However if we take the concept of fiscal deficit instead then we will introduce the concept of government expenditures particularly borrowing and the crowding out resulting therein.Note that  we may write the Budget Constraint as t-Tt+rBt-1where B=Public Debt, G=Government Expenditures , T=Government revenue and r is the real rate of interest, with high inflation as in the present scenario the real value of Taxes becomes less. But the Debt in the present Indian scenario largely consists of borrowing, with inflation the real repayable value of the borrowing for the government becomes less so for the short run we could say that we are not in an emergency situation as far as sustainability of deficit is concerned we will still not go so far as to suggest Fiscal Profligacy however because of the long run crowding out effect of these expenditures.It can also be further explained why permanent deficits cause concern, whereas we are assuming future primary deficits as given and a historically given level of debt, if actually the national debt is growing relative to GNP, then ultimately the government will be forced to raise taxes or raise the inflation rate via money financing to meet their debt obligations.This is what leads people to worry about deficits.


Macroeconomics, Errol De Souza, Pearson Education, 2008
Macroeconomics, Dornbush Rudiger, Fischer Stanley and Richard Startz, Tata McGraw Hill, 2004.
Handbook of Statistics on the Indian Economy 2008-09
RBI Monthly Bulletin October 2009

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