Fiscal Deficit and Inflation: Cointegration and Causality Analysis

Abstract

This study, using annual data covering the period 1980-81 to 2011-12, investigates the long run relationship and causal link between fiscal deficit and inflation in India. Study uses unit root tests along with Engel- Granger and Johansen co integration techniques to investigate presence of long run equilibrium between the two. Results showed that equilibrium condition is sensitive to econometric model chosen for analysis, while causality test established direction of causality from fiscal deficit to inflation only. Thus results are in support of monetarist approach which supports curtailment in deficits to control inflation. As such for over all macroeconomic stability involving controlled rise in prices, any monetary policy in isolation cannot be effective unless goals of fiscal policy are also brought in line with monetary policy targets.