At a time when fiscal deficit was burgeoning at 6.8 per cent of GDP, a RBI's occasional paper has made it clear that the government deficit is relevant for stabilisation as expansion of money supply leads to inflation.
The paper which studied impact of government deficit on money in India from 1951-2007, felt that targeting fiscal deficit as tool for stabilisation continues to remain valid.
The study found that there was strong evidence of government deficit leading to reserve money creation with consequent increase in money supply.
The Reserve Bank occasional paper has been authored by economic analysis and policy department directors Jeevan K Khundrakpam and Rajan Goyal. The views expressed are personal and not that of the Central Bank.
The paper also revisited casual relationships between government deficit and money, and money with real output and prices in the country.
It argued that the government deficit will now cause reserve money expansion through the incomplete sterilisation of Net Foreign Assets (NFA) accumulation intended to enable adequate market subscription to government borrowings, replacing the erstwhile channel of net RBI credit to the government. Further, there was no evidence of money causing changes in real output both in the long-run and short-run, the study said.
However, money causes inflation both in the long-run and short-run, while real output dampens inflation.
There is also some evidence of output and price leading to money creation, that is, bi-directional causality between money and prices rendering money targeting a complicated exercise, the paper said.
The study said that the negative impact of real output on long-run inflation in India is tenable, as supply factors is understood to play an important role in determination of prices.
Thus, improvement in supply position reflected in higher real output leads to fall in inflation, while increase in money supply causes inflation, it said.
Though the growth of reserve money would normally be induced by the demand emanating from movements in output and price levels, in India, government deficit supplements these factors in determining the rate of reserve money expansion, the paper said.
Sources of reserve money have been observed to be intimately linked with the process of financing fiscal deficit, it said.
