Responsiveness of Output & Prices to Monetary & Fiscal Shocks in India.

AuthorGill, Harinder Kaur

Introduction

Monetary and fiscal policies are the two most central stabilisation tools in the economy having strong theoretical background. Since Classicals, large number of theories can be observed on the implementation and effectiveness of these two macroeconomic policies. Classicals firmly believed in full employment and argued that markets cleared on their own. But according to Keynes, less than full employment is a normal feature of the economy. During the Great Depression of 1930s, markets failed to get cleared and there was demand deficient unemployment in the economy. Keynes had suggested government intervention to overcome this problem of mass unemployment. There is downward inflexibility of wages that averts the clearing of markets (Miller & Pulsinelli, 1986). The crux of Keynesian economics is that it is the fiscal policy which plays a major role in the recession. Keynesians believe that during recession and unemployment, increase in aggregate demand does not cause inflation. It enhances the real output in the economy (Mankiw, 2007). Monetarism had called into question the Keynesian economics and its views are quite similar to those of the Classicals. In their opinion, aggregate supply curve is inelastic in the long run. If aggregate demand is more than aggregate supply, it may lead to increase in real output during short periods. But over a long period of time, output will revert back to the original level of real GDP and higher inflation in the economy. In this way, monetarists show the ineffectiveness of fiscal policy in the long run. Neo-classicals like Robert Lucas believe that people are quite rational and can anticipate policies. Their rational expectations lead to ineffectiveness of anticipatory monetary as well as fiscal polieies (Mukherjee, 2009). Neo-Keynesians like N.G. Mankiw and David Romer believe that automatic adjustment is not possible due to the presence of wage and price rigidities in the economy (Gordon, 2011). Although people have rational expectations, monetary policy will be effective in stabilizing the economy. Due to the existence of rigidities and gradual price adjustments in an economy, anticipated monetary policy has its effects on real variables like output and employment in the short run.

Review of Literature

Given the theoretical views in support of monetary and fiscal policies, let us have a look on the noteworthy contributions that have measured the effectiveness of macroeconomic policies all over the globe. Rangarajan and Arif (1990) analysed the linkages between money, output and prices from 1961-62 to 1984-85 in the Indian context. The study found that increase in money supply leads to increase in price levels more than output. If government expenditure exceeds government revenue, it results in widened resource gap and impacts the price level in the economy. When government increases capital expenditure, its impact on prices and output is a function of the resource gap financed by borrowings from the RBI. The trade-off between price level and output worsens with increase in borrowings from the RBI. Dixit (2001) examined the interaction of fiscal and monetary policies in European Monetary Union countries. Fiscal policies rather than discretionary monetary policy should start the game to receive higher payoff for European Central Bank. Spillover effects of productivity shocks in one country can be enjoyed by other countries too. Fiscal constraints are required for the monetary commitment. The more the fiscal freedom, the less the monetary commitment is. Parida et al. (2001) explored the linkages between fiscal deficit, money supply and price level from 1960-61 to 1999-2000 in India. The study showed that both money supply and fiscal deficits impact the price level, but price level impacts neither the fiscal deficits nor the money supply. Therefore, rising inflation does not provoke high fiscal deficits; whereas monetization of deficits is one of the major causes of inflation in India. Chadha and Nolan (2007) examined through a microfounded model that stabilization requires interaction of both fiscal and monetary policies in the USA and UK. When monetary policy is targeting inflation, fiscal policy should target output systematically so that automatic stabilizers can play their role in the optimal policy. Mikek (2008) investigated the role of fiscal policy in new member states (NMS) of European Union when monetary policy is targeting inflation and exchange rate stabilization. Even restrictive monetary policy leads to higher inflation if fiscal policy is expansionary. To stabilize the inflation and exchange rate, sustainable fiscal policy is required in open economies of NMS. Khundrakpam and Goyal (2009) analysed the relationship between money, price, government deficit and real output in India over the period of 1951-52 to 2006-07. The study found that both the real output and money have an impact on prices in the short as well as long runs. Government deficit is a major factor in the growth of money supply through the creation of reserve money; thus, it raises the price level in the economy. On the other hand, increase in real output leads to reduction in the price level. Money has no impact on real output both in the short as well as long runs and fiscal consolidation continuously remains too essential to stabilise the economy. Khundrakpam and Pattanaik (2010) estimated the linkages between fiscal deficit and inflation in India over the period 1953-2009. The study analyzed that one percent point addition in the level of fiscal deficit can raise the Wholesale Price Index (WPI) by about 0.25% point. Fiscal deficit determines the price level and vice-versa is not true. Davig and Leeper (2011) analyzed how active and passive monetary and fiscal policies switched in the United States from 1949: Q1 to 2008: Q4. Irrespective of monetary-fiscal regime, increase in government spending leads to increase in demand for goods, which further increases the demand for labor. Prasanna and Gopakumar (2011) analysed the relationship...

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