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Fiscal Consolidation, Budget Deficits and the Macro Economy

Fiscal Consolidation, Budget Deficits and the Macro Economy

  • Lekha S. Chakraborty - Associate Professor, National Institute of Public Finance and Policy, New Delhi

© 2016 | 220 pages | SAGE India

An in-depth analysis set in the context of the ongoing debate on fiscal policy vis-à-vis monetary policy

Is fiscal deficit detrimental to growth rate? Does it create macroeconomic imbalance? If so, is deficit containment a prerequisite for sustained reduction in inflation? Does fiscal deficit crowd out private investment and, if so, to what extent? Does fiscal deficit affect rate of interest?

This book analyses such debates and impacts of fiscal deficit in India, empirically, through macro econometric exercise.  Filling an existing gap, it revisits the debate on the macroeconomic effects of deficit by taking India as a case study based on a long-time series analysis from 1980–81 to 2012–13. 

Fiscal Deficit and Macroeconomic Activity of Central and Subnational Governments
Fiscal Deficit, Capital Formation and Crowding Out
Deficit–Interest Rate Link and Financial Markets
Monetary–Fiscal Policy Coordination: Fiscal Rules and Testing for Monetary Seigniorage
Fiscal Seigniorage: Composition of Deficits
Fiscal Deficit and Seigniorage Link: Monetary Policy Regimes and Empirical Analysis
Fiscal Deficit and Inflation
Policy Takeaways: The Revival of Fiscal Activism

[The author] analyses the impact fiscal deficit has on macroeconomic outcomes in this book…. This is a thorough and detailed effort, which puts a wide range of issues into perspective. It's a contribution that comes at an important time in our economic growth.


Civil Society, January 2017

Dr. Lekha Chakraborty’s new book, Fiscal Consolidation, Budget Deficits and the Macro Economy, adds new insight to the venerable topic of how to conduct fiscal policy in the context of a developing economy. Her specific applications to India’s complex case is especially welcome, in the face of India’s rapidly changing landscape in its conduct of monetary and financial policy, its struggle to fund its government adequately, and its complex and ever-changing arrangements of fiscal federalism. Her book presents a comprehensive look at critical topics, including the relationship between fiscal policy and capital investments, the interplay of fiscal and monetary policies and interest rates and inflation, and the role of fiscal federalism in influencing optimal fiscal policy. She employs a combination of theoretical discussion and empirical testing. Her analysis is readable and interesting and she draws on state-of-the-art research in the d iverse fields of fiscal, monetary, and financial policies. 
Dr. Lekha Chakraborty’s new book, “Fiscal Consolidation, Budget Deficits and the Macro Economy,” adds new insight to the venerable topic of how to conduct fiscal policy in the context of a developing economy. Her specific applications to India’s complex case is especially welcome, in the face of India’s rapidly changing economic structure and in its conduct of fiscal, monetary, and financial policy. The challenges of India to fund its multi-tiered government adequately, undertake the critical investments it needs in public services, inject just the right amount of stimulus into a slowing economy, and devise a fair balance in its complex and ever-changing arrangements of fiscal federalism can only benefit from a book that lays out the issues so well. 
Her book presents a comprehensive look at critical topics, including a welcome focus on the impact of India’s fiscal deficit on macroeconomic developments, and especially, whether the rules-based approach to reducing the deficit has been beneficial. Her effort in capturing the latest thinking and research in international public finance, monetary, and financial economics in the Indian situation is noteworthy. She examines in detail the impact of fiscal deficits on capital investments, interest rates, inflation, and balance of payments developments, as well as the interplay of fiscal and monetary developments, and the role of fiscal federalism in influencing optimal fiscal policy. She employs a combination of theoretical discussion and empirical testing, all the while interweaving with research from the general domain but applied to the Indian case. Her analysis is readable and interesting.  
She draws some interesting conclusions. Most notably, she finds that fiscal deficits have been less harmful than some have argued, and there is little evidence for the crowding out of private capital investments or of pressure on interest rates. She expresses concern about the constraints of reducing fiscal deficits on longer-run economic growth of India, an important consideration in the context of India’s growth challenges recently. 
Her book raises relevant questions and provides a solid basis for further examination. I would recommend any student or scholar of India’s macroeconomic add it to his or her reading list.
Janet Stotsky, former advisor in the International Monetary Fund, is an expert on fiscal and macroeconomic policies, and fiscal federalism. She has taught at Rutgers University and American University, and worked at the U.S. Treasury. She consults with numerous organizations.
Janet Stotsky

For close to twenty five years now the fiscal deficit has had a central place in the economic policy of the central government in India. In particular, as Lekha Chakraborty in her book titled, Fiscal Consolidation, Budget Deficits and the Macro Economy puts it “fiscal consolidation has become the norm”. Consolidation here invariably means the reduction of the deficit to some numeric target. Though the academic branch of the economics profession has been debating the consequences of deficits for close to four decades by now the policy discourse has not been particularly constrained by the evidence. It appears to have simply been assumed that fiscal consolidation is always and everywhere a desirable. Lekha Chakraborty takes us back to these useful academic debates of a few decades ago, with the explicit intention of testing the main propositions that have been advanced with regards to the economic consequences of deficits. In her words the intention of writing this book is “to fill this gap through applied macroeconometrics”. It may be said at the outset that she has done a fairly thorough job of it.
Among the findings of this study are that there is no evidence of the displacement of the private sector by public spending or of the existence of classical ‘crowding out’ whereby public deficits crowd out private investment ‘dollar for dollar’. Neither is there evidence of ‘financial’ crowding out. As for the impact of the deficit on the interest rate, it is found that the interest rate is influenced by inflationary expectations but not the deficit itself. Finally, while arguing that the macroeconomic impact of the fiscal deficit depends upon how it is financed Lekha Chakraborty concludes from her investigations that seigniorage financing “per se” is not inflationary. These are the core results of the study, and they may be considered significant enough to merit attention. On the basis of these findings the author speculates that “Given that fiscal deficit per se has less adverse macroeconomics consequences, has the move from “discretion’ to ‘rules’ – both fiscal rules and inflation targeting rules - been a transformation of macroeconomic policies to a New Macroeconomic Consensus in India? Would the disappearing deficits through fiscal rules have adverse long-run consequences on economic growth?” Two comments may be made here. First the author is right to flag that there appears to have been an uncritical acceptance of the main propositions of the new Classical macroeconomics in policy circles in India. In particular, inflation targeting has come to roost in India at time when it has lost its charm in the circle of Anglo-American economics. But the suggestion that the nature, as in the composition, of fiscal deficits in India may have had no impact on growth is not something that emerges from this study as it does not address the issue of the impact of persistent deficits on growth in India. And, finally, while there may well be an ‘obsession’ with numeric fiscal targets – which was Krugman’s characterisation of contemporary macroeconomic policy in India reportedly made at the 4th SBI Banking & Economics Conclave in Mumbai in July of this year - surely it would be wrong to speak of “disappearing deficits” as the fiscal consolidation in progress in India does not intend the elimination of deficits but confining them.
Arguably, three issues with regards to the practice of fiscal policy in India are of interest. First, what is the basis of the figure 3 percent that has been adopted as the target for the deficit? It has been rationalised as being based on the availability of household financial savings. But public finance  economists in India have shown that household financial saving is actually increasing. Secondly, the direct contribution of the deficit to accumulating debt cannot be ignored. Even if the deficit has no adverse macroeconomic consequences we would want to reckon with the fact that we could be passing on debt to future generations without compensating them with a higher capital stock. Finally, there is the issue of hysteresis, whereby today’s output can affect the economy’s potential output. Delong and Summers (“Fiscal Policy in a Depressed Economy”, ‘Brookings Papers on Economic Activity’, Spring 2012 issue) have shown that in the presence of the ‘shadow of hysteresis’ it would be appropriate to raise the current fiscal deficit or suffer an increase in the long-run debt-GDP ratio. Though conceived of as a possibility in a depressed economy it is not without relevance in India today when the economy is found to be slowing. One would hope that now that she has cleared so much of the ground for us Lekha Chakraborty study would now turn her considerable research skills to investigating these important questions.
Pulapre Balakrishnan

The 2016 book titled “Fiscal Consolidation, Budget Deficits and the Macro Economy”, by Lekha Chakraborty,  is a welcome addition to the growing literature that deals with fiscal policy in specific countries, focusing on the longer run and on fiscal consolidation, rather than on a short run and countercyclical perspective. The book is focused on developments over recent decades in India, an important, emerging  country undergoing fast growth. In spite of India’s importance, its fiscal experience had not attracted until now the full and sophisticated attention that it deserved.
Dr. Chakraborty’s book is both a useful description of macroeconomic, fiscal theory and an application of prevalent theory to Indian fiscal developments. The book consists of nine chapters. They address issues at both the Central and the subnational government level, in a country that is highly decentralised and where subnational governments have played a significant and distinct fiscal role.
Several hotly debated relationships are analysed theoretically and are tested empirically. Among these are: the connection that exists between fiscal deficits and capital formation. Do fiscal deficits finance or crowd out public and private capital formation? What links are there between fiscal deficits and financial markets? Do fiscal deficits cause interest rates to rise? Has monetary policy become dependent on fiscal policy? Did monetary  “seigniorage” help finance public spending? Was there a connection between the composition of deficits and monetary seigniorage; and, what about that between the size of fiscal deficits and the rate of inflation?
All these important relationships are discussed theoretically and tested empirically. The analysis is always sophisticated and relevant for the specific conclusions reached; and the conclusions are not always obvious.
A final chapter addresses the recent revival of fiscal activism, an activism that in earlier decades had challenged the arguments that had been used to challenge the use of Keynesian fiscal policy that had been based on theoretical considerations such as Rational Expectations, the Ricardian Equivalence hypotheses and others. The debate is still raging. Dr. Chakraborty describes what is called the “new view on fiscal policy”.
To conclude this is an interesting and useful book by a sophisticated economist that will be welcome by many readers. Not all will agree with all its conclusions, but all with be informed and will learn from it.
The author is Vito Tanzi, Former director of the IMF Fiscal Affairs Department is an expert economist with extensive experience in academia, government and international institutions. In addition to serving as a senior consultant to the Inter-American Development Bank from 2003-2007, Tanzi has consulted for the World Bank, the United Nations, the European Commission, the European Central Bank, the Asian Development Bank, the Economic Commission for Latin America and the Organization of American States. Click here for detailed profile.
Vito Tanzi

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Lekha S. Chakraborty

Lekha S. Chakraborty is an Associate Professor at National Institute of Public Finance and Policy, New Delhi, and a Research Associate at Levy Economics Institute of Bard College, New York. She has received a number of awards, including Shastri Indo-Canadian Institute (SICI) fellowship from the Department of Foreign Affairs and Trade, Canada, and the national (best) thesis award from Indian Institute of Science (IISc), Bangalore. She worked for International Monetary Fund (IMF), World Bank, United Nations Development Programme (UNDP), UN Women and the Commonwealth Secretariat on short stints. She was also Visiting Professor at Carleton... More About Author

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ISBN: 9789351509899