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Interest Rate Determination in India: Empirical Evidence on Fiscal Deficit--Interest Rate Linkages and Financial Crowding Out

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  • Lekha S. Chakraborty

Abstract

Controlling for capital flows using the high-frequency macro data of a financially deregulated regime, this paper examines whether there is any evidence of the fiscal deficit determining the interest rate in the context of India. The period of analysis is FY 2006-07 (April) to FY 2011 (April). Contrary to the debates in policy circles, the paper finds that an increase in the fiscal deficit does not cause a rise in interest rates. Using the asymmetric vector autoregressive model, the paper establishes that the interest rate is affected by changes in the reserve currency, expected inflation, and volatility in capital flows, but not by the fiscal deficit. This result has significant policy implications for interest rate determination in India, especially since the central bank has cited the high fiscal deficit as the prime reason for leaving the rates unchanged in all of its recent policy announcements. The paper analyzes both long- and short-term interest rates to determine the occurrence of financial crowding out, and finds that the fiscal deficit does not appear to be causing either shorts and longs. However, a reverse causality is detected, from interest rates to deficits.

Suggested Citation

  • Lekha S. Chakraborty, 2012. "Interest Rate Determination in India: Empirical Evidence on Fiscal Deficit--Interest Rate Linkages and Financial Crowding Out," Economics Working Paper Archive wp_744, Levy Economics Institute.
  • Handle: RePEc:lev:wrkpap:wp_744
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    References listed on IDEAS

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    Cited by:

    1. Oseni O. Isiaq & Adesoye A. Bolaji, 2016. "Fiscal Policy and Term Structure of Interest Rate in Nigeria," Acta Universitatis Danubius. OEconomica, Danubius University of Galati, pages 70-83.
    2. Chakraborty, Lekha, 2015. "Fiscal Seigniorage "Laffer-curve effect" on Central Bank Autonomy in India," Working Papers 15/156, National Institute of Public Finance and Policy.
    3. repec:spr:jsecdv:v:19:y:2017:i:1:d:10.1007_s40847-017-0042-2 is not listed on IDEAS
    4. repec:dug:journl:y:2016:i:2:p:70-83 is not listed on IDEAS
    5. Martin Ravallion, 2016. "Toward better global poverty measures," The Journal of Economic Inequality, Springer;Society for the Study of Economic Inequality, pages 227-248.
    6. Asamoah, Lawrence Adu, 2016. "Fiscal Policy and Lending Rate Nexus in Ghana," MPRA Paper 80209, University Library of Munich, Germany.
    7. Chakraborty, Lekha S, 2014. "Macroeconomics of “NaMo” Budget 2014 in India," MPRA Paper 67045, University Library of Munich, Germany, revised 2014.

    More about this item

    Keywords

    Fiscal Deficit; Asymmetric Vector Autoregressive Model; Financial Crowding Out;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • H6 - Public Economics - - National Budget, Deficit, and Debt

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