Monetary versus Fiscal Policy in India? An SVAR Analysis of their Efficacy and Co-ordination
Indira Gandhi Institute of Development Research (IGIDR)
June 21, 2013
Conventionally, policy makers relied on three policy options to manage business cycles - debt financed government spending, debt financed tax rebate and interest rate. While the first two are fiscal policy instruments, the latter is a monetary policy instrument. This paper aims to capture interactions among the policies and the effect on macro-variables in response to the policy shocks to understand Indian monetary and fiscal policy coordination for the period 1990Q1-2011Q4. Policy shocks are identified using the novel method of sign restrictions combined with magnitude restrictions in an SVAR framework, and interpreted using impulse responses and variance decomposition. Results show that monetary policy responds to tax rebate and expenditure shocks differently. In the case of a tax rebate shock, monetary policy responds by reducing interest rates thereby accommodating fiscal expansion. On the opposite, monetary policy seems not to accommodate expenditure shocks. Interestingly, monetary policy shock is accompanied by a fiscal expansion which threatens the credibility of central bank actions, thus indicating towards fiscal policy dominance. A comparison of the efficacy of policies suggests that interest rate is more effective in stimulating output. Out of the two fiscal policy instruments analyzed, tax cut seems to be the better option for stimulating output considering output-debt trade-off.
Keywords: Monetary policy, Fiscal policy, SVAR, Sign restrictions, India
JEL Classification: E52, E62
Date posted: June 22, 2013