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1 constor Mak Your Publications Visibl. A Srvic of Wirtschaft Cntr zbwlibniz-informationszntrum Economics Chakraborty, Lkha S. Working Papr Intrst rat dtrmination in India: Empirical vidnc on fiscal dficit. Intrst rat linkags and financial crowding out Working Papr, No. 744 Providd in Coopration with: Lvy Economics Institut of Bard Collg Suggstd Citation: Chakraborty, Lkha S. (2012) : Intrst rat dtrmination in India: Empirical vidnc on fiscal dficit. Intrst rat linkags and financial crowding out, Working Papr, No. 744, Lvy Economics Institut of Bard Collg, Annandal-on-Hudson, NY This Vrsion is availabl at: Standard-Nutzungsbdingungn: Di Dokumnt auf EconStor dürfn zu ignn wissnschaftlichn Zwckn und zum Privatgbrauch gspichrt und kopirt wrdn. Si dürfn di Dokumnt nicht für öffntlich odr kommrzill Zwck vrvilfältign, öffntlich ausstlln, öffntlich zugänglich machn, vrtribn odr andrwitig nutzn. Sofrn di Vrfassr di Dokumnt untr Opn-Contnt-Liznzn (insbsondr CC-Liznzn) zur Vrfügung gstllt habn solltn, gltn abwichnd von disn Nutzungsbdingungn di in dr dort gnanntn Liznz gwährtn Nutzungsrcht. Trms of us: Documnts in EconStor may b savd and copid for your prsonal and scholarly purposs. You ar not to copy documnts for public or commrcial purposs, to xhibit th documnts publicly, to mak thm publicly availabl on th intrnt, or to distribut or othrwis us th documnts in public. If th documnts hav bn mad availabl undr an Opn Contnt Licnc (spcially Crativ Commons Licncs), you may xrcis furthr usag rights as spcifid in th indicatd licnc.

2 Working Papr No. 744 Intrst Rat Dtrmination in India: Empirical Evidnc on Fiscal Dficit Intrst Rat Linkags and Financial Crowding Out by Lkha S. Chakraborty* Lvy Economics Institut of Bard Collg Dcmbr 2012 * Th author is a rsarch associat at th Lvy Institut and an associat profssor at th National Institut of Public Financ and Policy, Nw Dlhi, India. Th viws xprssd in this papr ar thos of th author and do not ncssarily rflct th position of th instituts to which sh is affiliatd. Th author is gratful to M. Govinda Rao for th discussion on intrst rat dtrmination, and to Luciano Grco, Pinaki Chakraborty, Sivaramakrishna Sarma, and slctd participants of th 68th Congrss of th Intrnational Institut of Public Financ in Drsdn, Grmany, August 16 19, 2012, for thir commnts. Thanks ar also du to Amita Manhas for compiling th Rsrv Bank of India high-frquncy data. Th usual disclaimr applis. Th Lvy Economics Institut Working Papr Collction prsnts rsarch in progrss by Lvy Institut scholars and confrnc participants. Th purpos of th sris is to dissminat idas to and licit commnts from acadmics and profssionals. Lvy Economics Institut of Bard Collg, foundd in 1986, is a nonprofit, nonpartisan, indpndntly fundd rsarch organization dvotd to public srvic. Through scholarship and conomic rsarch it gnrats viabl, ffctiv public policy rsponss to important conomic problms that profoundly affct th quality of lif in th Unitd Stats and abroad. Lvy Economics Institut P.O. Box 5000 Annandal-on-Hudson, NY Copyright Lvy Economics Institut 2012 All rights rsrvd ISSN X

3 ABSTRACT Controlling for capital flows using th high-frquncy macro data of a financially drgulatd rgim, this papr xamins whthr thr is any vidnc of th fiscal dficit dtrmining th intrst rat in th contxt of India. Th priod of analysis is FY (April) to FY 2011 (April). Contrary to th dbats in policy circls, th papr finds that an incras in th fiscal dficit dos not caus a ris in intrst rats. Using th asymmtric vctor autorgrssiv modl, th papr stablishs that th intrst rat is affctd by changs in th rsrv currncy, xpctd inflation, and volatility in capital flows, but not by th fiscal dficit. This rsult has significant policy implications for intrst rat dtrmination in India, spcially sinc th cntral bank has citd th high fiscal dficit as th prim rason for laving th rats unchangd in all of its rcnt policy announcmnts. Th papr analyzs both long- and short-trm intrst rats to dtrmin th occurrnc of financial crowding out, and finds that th fiscal dficit dos not appar to b causing ithr shorts and longs. Howvr, a rvrs causality is dtctd, from intrst rats to dficits. Kywords: Fiscal Dficit; Asymmtric Vctor Autorgrssiv Modl; Financial Crowding Out JEL Classifications: C32, E62, H6 1

4 Thortically, an analysis of th link btwn fiscal dficit and intrst rat assums importanc mainly for thr rasons. First, in th contxt of th growing global intgration of financial markts, th macroconomic ffcts of an incras in th domstic intrst rat du to th ris in th fiscal dficit can sprad globally. Scond, if th incras in th fiscal dficit lads to an incras in th intrst rat, it may lad to a crowding out of th intrst-snsitiv componnts of privat spnding, spcially privat corporat invstmnt. And third, if such a rlationship is vrifid, th fiscal and montary policy linkag in th macro managmnt of a country is stablishd. For instanc, a rduction of budgt balancs could modrat upward prssur on intrst rats and could thrfor provid montary policy with additional dgrs of frdom in intrst rat managmnt. 1 In th crdit policy announcmnt as rcnt as July 2012, th Cntral Bank of India (Rsrv bank of India RBI) kpt th intrst rats (rpo rats) unchangd and advisd th govrnmnt of India s Ministry of Financ to cut th fiscal dficit prior to cutting th intrst rats. Kping intrst rats high has dtrimntal ffcts on th conomic growth of th country. Globally, whn cntral banks hav procdd with th cutting of intrst rats, RBI has kpt th intrst rats unchangd in all rcnt policy announcmnts. This invits a compulsory rvisiting of th qustion of whthr fiscal dficit affcts th intrst rat in India. This papr prsnts a rar xamination of th link btwn th two. Chakraborty (2002) mad an attmpt to addrss this mpirical link and concluds that a dficit dos not induc a ris in th intrst rat in India; it is rathr th othr way around. Two yars latr, incorporating th montary variabls, th modl by Chakraborty (2002) was rxamind by a study from RBI, which found th rsults consistnt with th formr (Goyal 2004). Ths ar th two mpirical studis on th fiscal dficit and th intrst rat xclusivly concrning India. Though Chakraborty (2007) rvisitd th qustion of crowding out in India, th aspcts of th financial crowding out channl via th intrst rat mchanism was not analyzd in th contxt of capital flows; rathr, th focus of th papr was on dirct crowding out. Howvr, th study found that fiscal dficit is not a dtrminant of intrst rat in India. This papr taks th litratur forward by incorporating th capital flows in th macro modl of intrst rat dtrmination. Thortical litratur idntifis two variants of 1 In a larg numbr of industrial countris, actual fiscal imbalancs prvnt montary policy from proprly managing intrst rats. Thus, in ordr to stimulat conomic activity, th stting of both montary and fiscal policis nds to b rassssd within a comprhnsiv framwork of sound and stabl fiscal balancs ovr th mdium trm (Corria-Nuns and Stmitsiotis 1995). 2

5 crowding out in an conomy: ral and financial. 2 Th ral crowding out occurs whn th incras in public invstmnt displacs privat capital formation, which is also trmd dirct crowding out. 3 Th phnomnon of partial loss of privat capital formation in th conomy, du to th incras in th intrst rats manating from th prmption of ral and financial rsourcs by th govrnmnt through bond-financing of fiscal dficit, is trmd financial crowding out. Financial crowding out occurs du to th upward prssurs on th intrst rat inducd by th dbt financing of fiscal dficit (intrst rat ffct). Th phnomnon of financial crowding out is analyzd in this papr in th contxt of a drgulatd financial rgim in India. Th taxonomy of crowding out was discussd in dtail by Buitr (1990). According to Buitr, dirct crowding out (or crowding in) rfrs to substitution or complmntary rlationships btwn public and privat spnding that occur not through changs in prics, intrst rats, or rquird rat of rturn by changs in public sctor activity, but through public sctor consumption/invstmnt bing an argumnt in privat utility functions and through th public sctor capital stock bing an argumnt in privat sctor production functions Buitr (1990, p. 34). Buitr dfind indirct crowding out as th consquncs of public actions that affct privat bhavior ithr by altring budgt constraints or by influncing th prics facd by privat agnts, namly, th intrst rat. In othr words, crowding out occurring via intrst rat changs is rfrrd to as financial crowding out. 4 2 Blindr and Solow (1973), in thir sminal papr, Dos Fiscal Policy Mattr, discuss thr lvls of crowding out at th thortical lvl. Th first lvl of crowding out occurs whn public invstmnt displacs privat invstmnt broadly on a dollar-for-dollar basis. This lvl of crowding out occurs irrspctiv of th mod of financing th dficit. Th scond lvl of crowding out, as Blindr and Solow (1973) propos, is an intgral part of Kynsian tradition. It is basd on th notion that dficit spnding not accompanid by nw issuancs of mony carris with it th nd for govrnmnt to float dbt issus that compt with th privat dbt instrumnts in financial markts. Th rsulting upward prssur on intrst rats will rduc any privat xpnditur, which is intrst rat-snsitiv. In othr words, this financial sid ffct of crowding out occurs via th intrst rat (that is, bond financing of dficit causs markt intrst rats to ris and, in turn, crowds out privat invstmnt). As discussd by Blindr and Solow (1973), thr is no thortical controvrsy ovr this scond lvl of crowding out; th only contstd issus ar mpirical. Th rational for a third lvl of crowding out is that any govrnmnt dficit rquirs th issuanc of som sort of dbt instrumnt outsid mony or intrst baring bonds and this incras in privat walth will hav furthr rvrbrations in th conomy. In othr words, dbt financing of dficit simultanously rsults in th cration of bonds, which is considrd as nt walth in th privat sctor. It is a mattr of dbat whthr bonds ar considrd as nt walth in th contxt of India, and this third lvl of crowding out may b byond th scop of th study in th contxt of India. Th scond lvl of crowding out is th focus of this papr. 3 Ral crowding out is important to analyz in th contxt of dvloping countris lik India bcaus of th larg shar of public invstmnt in gross capital formation, and morovr, th natur of public invstmnt (whthr infrastructur or non-infrastructur) itslf can affct privat invstmnt diffrntly. 4 Kotlikoff (1984) also pointd out that financial crowding out is advancd in litratur through th tsting of a causal link btwn fiscal dficit and intrst rat. H furthr pointd out that much of th concrn with financial crowding out rvolvs around th transaction of slling bonds to financ fiscal dficit. As th argumnt gos, a govrnmnt s sal of bonds, rgardlss of its us of th procds, raiss th total supply of bonds in th markt. Th gratr supply of bonds, according to this viw, mans a lowr bond pric that is, a highr intrst rat, which rducs (crowds out) privat invstmnt. 3

6 Though Chakraborty (2007) stablishd no vidnc of dirct crowding out of privat corporat invstmnt in India, th absnc of dirct crowding out dos not ncssarily imply th absnc of financial crowding out. Th financial crowding out may occur du to th upward prssurs on th intrst rat inducd by th dbt financing of fiscal dficit. In othr words, vn if public sctor invstmnt dos not crowd out privat corporat invstmnt, th privat capital formation in th conomy may suffr du to th incras in th intrst rats occurring du to th prmption of ral and financial rsourcs by th govrnmnt to financ th incrasing fiscal dficits. In this papr, w xamin th plausibility of whthr fiscal dficit affcts intrst rat. It is all th mor important to xamin such a link in th prsnt contxt, as Chakraborty (2007) found that intrst rat is a significant dtrminant of privat corporat invstmnt. If incras in fiscal dficit incrass th intrst rat, it would imply financial crowding out. It is wll known that th Indian financial systm was charactrisd by administrd intrst rat structur until th 1990s. Th procss of financial drgulation sinc 1991 has bn aimd at making th financial sctor markt-orintd to improv allocativ fficincy. 5 Th dbatabl qustion is, as th intrst rat was administrd until th financial drgulation, how could a functional rlationship b justifid btwn fiscal dficit and th administrd intrst rat? Evn if it is assumd that th administrd intrst rat truly rflcts th markt signals, thr is a nd to stablish such a rlationship mpirically. Th task of stablishing such a rlationship is ambiguous and might b th rason that thwarts th analysis of this link prior to th drgulation of intrst rats. Howvr, contrary to th popular blif that an administrd intrst rat in dvloping countris is insnsitiv to markt prcptions, th litratur rvald that an administrd intrst rat dos accommodat markt signals, and in ordr to analyz that, th litratur has suggstd xamining th intrtmporal movmnt of th intrst rat and its variability (Gupta 1984). Th analysis of intrtmporal movmnts in th slctd intrst rats adjustd for inflationary xpctations also showd that th intrst rats in India, though administrd, hav shown variations ovr th yars, and ral intrst rats rmaind positiv in a 5 Th major highlights of financial libralization ar intrst rat drgulation, a phasd rduction of cash rsrv rquirmnts and statutory liquidity ratios, simplifying dirctd crdit programs, and dvlopmnt of mony markts, tc. Th administrd intrst rats wr simplifid bginning in A small numbr of fixd rats for priority sctor loans wr rtaind, whil larg commrcial borrowrs facd a floor-lnding rat. From , th markts for commrcial papr and crtificats of dposit wr drgulatd, allowing companis to accss crdit at markt trms that wr considrably blow th minimum lnding rat. In Octobr 1994, th minimum lnding rat was liminatd. Th drgulation of intrst rats has bn accompanid by th introduction of nw instrumnts lik 14-day and 182-day auction trasury bills in addition to th 91-day and 364-day auction trasury bills. It is to b notd that th 182-day trasury bill was rintroducd in mid

7 substantial numbr of yars. Chakraborty (2007), using th annual data, stablishd no vidnc of fiscal dficit causs in intrst rat dtrmination. Howvr, th modl was not controlld for th capital flows. This papr taks th dbat forward in th contxt of capital flows, focusing on th financially drgulatd rgim, using th rcnt high frquncy data of fiscal dficit and th intrst rat for th priods April to April This papr is organizd into fiv sctions. Sction 1 discusss various thortical paradigms on th rlationship btwn fiscal dficit and intrst rats and critically valuats th mpirical litratur. Sction 2 discusss th thortical modl of th intrst rat in an opnconomy framwork. Sction 3 intrprts data, and Sction 4 dals with conomtric mthodology adoptd and rports th rsults obtaind. Sction 5 concluds. 1. THEORETICAL PARADIGMS AND EMPIRICAL LITERATURE At th thortical lvl, an xtnsiv dbat has dvlopd to xplain th link btwn dficit and intrst rat. Thr ar thr diffrnt thortical paradigms undr which this rlationship can b viwd and mpirically tstd: noclassical, Kynsian, and Ricardian. According to th noclassical viw, a ris in th dficit lads to an incras in th intrst rat and, in turn, crowds out privat invstmnt. Th Kynsians visualiz that though an incras in th dficit lads to an incras in th intrst rat, such an incras stimulats savings and capital formation. In btwn th noclassical and Kynsian viw, thr xists th obsrvation of th Ricardian Equivalnc Thorm (RET), which argud that dficits mrly postpon taxs and, thrfor, tax financing and dbt financing of dficit hav qual impacts on th conomy; thus, dficit dos not hav any impact on th intrst rat (Barro 1974). Many authors hav mpirically tstd this rlationship and found contradictory rsults. Evans (1985), Tanzi (1985), Dalamagas (1987), Ahmad (1994), Kulkarni and Erickson (1996) found no positiv link btwn intrst rat and dficit, whil Cbula (1990), Corria and Stmitsiotis (1995), Ostrosky (1979) did find vidnc for th link btwn dficit and intrst rat. 5

8 Tabl 1 Slctd mpirical vidncs on link btwn fiscal dficit and intrst rat Study Evans (1985) Rsults Dficit dos not hav an impact on th intrst rat in th contxt of th US for th priod Ahmad (1994) No variabl xcpt inflation is significant. Montary and fiscal policy variabls do not hav any impact in th contxt of Pakistan for th priod Tanzi (1985) Snsitivity of th intrst rat to fiscal dficit has dcrasd in th rcnt yars of th study ( ) in th contxt of th US. Th ntir tim priod of th study was Balkan and Erol (1995) Significant and positiv impact of govrnmnt dficit on th ral intrst rat in th contxt of th UK for th priod Cbula (1997) Grangr-causd dficit affcts th intrst rat in th contxt of th US for th priod Corria-Nuns and Stmitsiotis (1995) Dficit affcts th long-run intrst rat in th contxt of 10 OECD (Organisation of Economic Co-opration and Dvlopmnt) countris for th priod of Gupta (1992) RET is rjctd for Sri Lanka, India, Indonsia, Philippins among 10 Asian countris for th priod of Kulkarni and Erickson (1996) Dficit dos not affct th intrst rat in th contxt of India for th priod of Elmndorf and Mankiw (1998) Fiscal dficits (ctris paribus) rduc national savings and incras aggrgat dmand. This crats an xcss supply of govrnmnt dbt, lading to highr ral intrst rats. Gal and Orszag (2002) Of 60 countris, around on-half found a prdominantly positiv significant ffct of fiscal dficits on intrst rats, and th othr half a mixd or prdominantly insignificant ffct. Th common analogy of lattr st of studis is that, in a growth conomy with accumulation, incrasing budgt dficits may crat a shortag of funds availabl for invstmnt ovr th long trm. If this potntial imbalanc btwn th supply of funds and intndd invstmnt is not addrssd, th long-trm intrst rat racts as conomic agnts anticipat th shortag of funds. Th formr st of studis, which obsrvd no link btwn 6

9 th intrst rat and fiscal dficit mphasizs that in th contxt of global intgration of financial markts, th supply of funds curv is infinitly lastic. Also, som studis undr this catgory trid to xplain thir findings undr th paradigm of RET. It is to b notd that th mpirical litratur on th fiscal dficit and intrst rat link is largly confind to dvlopd countris. To start with, in th contxt of th US, Tanzi (1985) xamind th rlationship btwn fiscal dficit and th intrst rat. H obsrvd that for th priod , th snsitivity of th intrst rat to fiscal dficit dcrasd ovr th yars. Tanzi pointd out that th plausibl xplanation of this phnomnon was th growing global intgration of financial markts in rcnt yars and corrspondingly incrasing flow of global capital to financ th domstic dficit. On th basis of th multivariat loanabl funds modl (which incorporats th ffct of trm structur on intrst rat ), 6 Cbula (1990) and Corria-Nuns and Stmitsiotis (1995) showd that dficit, inflation, short-run intrst rat, prcntag chang in GDP, and capital flows Grangr-caus th nominal long-trm intrst rats, and hnc crowding out of privat invstmnt occurs. In Corria-Nuns and Stmitsiotis s (1995) study, which was basd on cross-country data of 10 OECD countris, thr was vidnc of crowding out as th intrst rat was positivly linkd to th dficit. Furthr, Cbula (1997) xamind th dirction of causality btwn long-trm intrst rats and structural budgt dficits in th US for th priod , and found that thr is bi-dirctional causality btwn th intrst rat and th dficit. Gal and Orszag (2002) argud that intrst rats do not incras as a rsult of fiscal xpansions du to forign capital savings rplacing domstic savings. Howvr, conomic prformanc may still b ngativly affctd by prsistnt fiscal imbalancs as capital stock accumulation dclins ithr bcaus of a dclin in domstic or forign nt invstmnt. In th contxt of dvloping countris, studis ar fw on th link btwn budgt dficit and th intrst rat. In th contxt of Pakistan, Ahmad (1994) found that thr is no link btwn intrst rats and dficit. In India, paucity of data on markt intrst rats might b th rason for no spcific studis on th causal rlationship btwn th dficit and intrst rats. Sundararajan and Thakur (1980), Pradhan, Ratha, and Sarma (1980), and Parkr (1995) addrssd th issu of dirct crowding out btwn public and privat invstmnt in India, but ths studis did not analyz th macroconomic link of fiscal 6 Th advantag of th loanabl funds modl is that in addition to capturing th montary and fiscal variabls lik ral dficit, ral mony stock, govrnmnt spnding, xpctd inflation rat, tc., it also capturs th trm structur of intrst rats. In othr words, th loanabl funds modl s framwork allows for th combination of th charactristics of th trm-structur with th fiscal and montary policy variabls, influncing th intrst rat. 7

10 dficit and intrst rats through which th crowding out phnomna should thortically b oprating. 2. ANALYTICAL FRAMEWORK Th analytical framwork for th study is drivd from an xtndd vrsion of Sargnt s (1969) papr Commodity Pric Expctations and th Intrst Rat. Th xtndd vrsion of Sargnt s modl is flxibl nough to incorporat th macroconomic link that may oprat in th dtrmination of intrst rats. Sargnt (1969) xprssd th nominal intrst rat as a combination of thr componnts: th quilibrating intrst rat, th sprad btwn markt intrst rat and th quilibrating ral intrst rat, and th sprad btwn nominal intrst rat and markt intrst rat. It can b xprssd as follows. r r r r ] [ r r ] (1) n( t) ( t) [ m( t) ( t) n( t) m( t) In quation (1), r n(t) is th nominal intrst rat, r (t) is th ral intrst rat that quilibrats dsird savings and dsird invstmnt, and r m(t) is th nominal intrst rat adjustd for th xpctd rat of inflation. Each of th thr spcific componnts is dtrmind in turn by spcific macroconomic variabls. Th logical stp that follows is to idntify th dtrminants of ach of th thr trms in quation (1). 7 On of th significant dtrminants of th first trm, r (t), which is th ral intrst rat that quilibrats dsird savings and dsird invstmnt, is th dficit of th govrnmnt. 8 r 1( ) ( t) dft t (2) Th dtrminant of th scond trm, [ r m (t) r (t) ], is dtrmind by th growth rat of high-powrd mony. 9 In th opn conomy modl, capital flows also dtrmin th sprad btwn th markt rat and th quilibrium ral intrst rat. Th ral xchang rat can also b insrtd into th quation (3) to captur th ffct on th intrst rat in an opn conomy macro modl. Assuming linarity, w thus hav: 7 Th drivations of dtrminants of ach trm in th modl ar drawn from Gupta and Moazzami (1996). But as th objctiv of thir study was to tst th validity of altrnativ paradigms of th link btwn dficit and intrst rat noclassical, Kynsian, and Ricardian Equivalnc Thorm across countris and to distinguish btwn th short-trm and long-trm impact of dficits on intrst rat, w hav not drawn havily on th drivations of th dtrminants of th modl; rathr w improvis th spcification according to our purpos to undrtak th impact of fiscal dficit on th intrst rat in th contxt of India, irrspctiv of th paradigm-spcific dtails and th dichotomy of transitory and prmannt ffcts of dficits on th intrst rat. 8 Th othr dtrminants of trm (1) in th Gupta-Moazzami modl constitutd govrnmnt consumption xpnditur, national incom, privat consumption xpnditur, privat savings, tc., which w omit in our spcification du to multicollinarity problms, and morovr, ths xplanatory variabls ar not rquird for our analysis as w hav not gon into th tsting of validity of ach of th altrnativ paradigms of fiscal dficit and intrst rat in th contxt of India; rathr, our prim concrn was to assss th rol of fiscal dficit in th intrst rat to undrstand th transmission channl of th crowding out phnomnon. 9 For dtails, s Sargnt (1969). 8

11 r ) m( t) r ( t) 2( M 3) t 3( Kr t t (3) whr ( M 3 ) t = changs in high powrd mony and ( K r ) t = nt capital flows. Th last trm of quation (1) is assumd to dpnd linarly and positivly on th inflationary xpctations. whr, r ) n( t) rm ( t) 4 ( t t (4) t Expctd Rat of Inflation Now by substituting quation (2), (3) and (4) in quation (1), w gt quation (5): r ) n( t) 1( dft ) 2 ( M 3) t 3( r ) t 4 ( t t (5) According to quation (5), intrst rat is a function of fiscal dficits, chang in highpowrd mony, capital flows and xpctd inflation. Capital flows ar an important variabl for th modl, spcially whn th priod undr study xprincs volatility in capital flows; thrfor, controlling for this fluctuation in liquidity, whthr fiscal dficit affcts intrst rat or not is an intrsting aspct to xamin. Th abov thortical drivation is conomtrically stimatd. Each of ths dtrminants is linkd to th intrst rat through various macroconomic channls; a fw ar attmptd as follows. Th unsttld rlationship btwn mony supply and intrst rat is rviwd xtnsivly by Nachan, Karnik, and Hatkar (1997). Ths ar mainly unanticipatd montary announcmnt ffct, Kynsian liquidity ffct, financial ffct, pric xpctations ffct (Fishr ffct), and incom ffct. Du to unanticipatd montary announcmnt ffct, prmannt highr mony growth rat inducs an incras in xpctd inflation and a rsulting incras in intrst rats to rflct an inflation prmium (Girton and Nattrss 1985). According to th Kynsian liquidity ffct, incom and prics ar slow to ract as th mony supply incrass, and thus th montary systm xprincs xcss liquidity at unchanging nominal incom lvls. Contmporanous with th liquidity ffct, thr runs th financial ffct. As pr th financial ffct, as th growth of mony incrass, banks find thmslvs saddld with xcss rsrvs, and ths xcss rsrvs hav to b tmporarily parkd in short-trm markt scuritis. This tmporary spurt in th dmand for short-trm marktabl scuritis lowrs short-trm intrst rats. Whn th mony supply incrass with th ris in incom, th dmand for mony riss. As a rsult, th ral balanc of th conomy dcrass, finally pushing up th nominal intrst rat. Pric xpctation ffct (Fishr Effct) shows that whn mony supply incrass, th xpctd inflation incrass and thrby th nominal intrst rat also incrass. All fiv ffcts will b prsnt in any givn situation, though thir duration, strngth, and timing ar largly an 9

12 mpirical mattr and will vary from situation to situation. Th rlationship btwn montary xpansion and intrst rat has bn obscur in th mpirical litratur. Whil Mishkin (1982) found that th intrst rat and mony growth surpriss hav a significant positiv corrlation, Makin (1983) found that it is ngativ and significant. Makin xplaind ths contradictory findings wr as a rsult of th diffrnt mthod usd to masur intrst rats. Makin implid that his priod-avrag short-trm intrst rat is rsponding to th initial liquidity ffct, whil Mishkin s nd-of-priod short-trm intrst rat masur is sampld aftr th Fishr ffct bgins to dominat. Grir (1986) also showd that laggd mony surpriss hav a significant positiv impact on rats. Fishrian thory prdicts that th nominal intrst rat will tnd to chang at th sam rat as changs in xpctd inflation. Thus, it manifsts a on-to-on rlationship btwn th xpctd inflation and th nominal intrst rat. According to Fishr s quation, a on-prcnt incras in th xpctd rat of inflation, in turn, causs a on-prcnt incras in th nominal intrst rat. Only a fw studis in th contxt of th US by Fldstin (1976) and Gibson (1970) found cofficints clos to unity. But Sargnt (1976), Shillr (1979), and Wood (1981) obsrvd that ths findings of cofficints clos to unity ar limitd to a particular priod of US history, until th arly 1970s. Furthrmor, vn a unit cofficint would contradict th suprnutrality hypothsis that an incras in inflation will not affct ral intrst rats in th long run. Robrt Lucas (1980) finds no mpirical support for th hypothsis, which h calls on of th cntral implications of th quantity thory of mony. Bginning with Irving Fishr (1930), most of th mpirical invstigations hav discovrd that fully anticipatd inflation has lss than a unit ffct on th nominal intrst rat, and thus rducs th ral intrst rat vn in th longst of runs. Fama (1975) concludd that on... cannot rjct th hypothsis that all variation through tim in on-to-six month nominal rats of intrst mirrors variation in corrctly assssd on-to-six month xpctd rats of purchasing powr. Fama s conclusion rsts on two assumptions: (1) thr is a constant xpctd ral intrst rat and (2) all rlvant information about futur inflation is fully incorporatd in th xpctd-inflation componnt of th markt intrst rat. Both assumptions ar contradictd by vidnc by Carlson (1977). Carlson pointd out that variations in short-trm intrst rats ar not good prdictors of variations in inflation rats. Furthrmor, both of th ky assumptions ar of dubious validity. Evidnc has bn prsntd that xpctd short-trm ral intrst rats do hav notabl variation. 10

13 Undr th scnario of larg capital flows in a flxibl xchang rat rgim, th nominal xchang rat apprciation lads to th dtrioration of intrnational comptitivnss. So to prvnt th ral apprciation of th xchang rat and to prsrv xtrnal comptitivnss, th cntral bank intrvns in th Forx markt to striliz th incrmntal liquidity thus gnratd, thrby kping th montary xpansion undr control. This procss has, howvr, quasi-fiscal costs associatd with it, as it imposs th dangr of incrasing th ral intrst rat, which can furthr induc th capital flows. Anothr xplanation is that an incras in th xchang rat of th prvious yar would mak th domstic currncy lss valud in th intrnational markt, and thrfor would attract th dmand for domstic financial assts from abroad. This may lad to incras in th intrst rat. Capital flows hav bn incorporatd in th macro modl; howvr, xchang rat is droppd in th conomtric modl for mpirical rasons of nonstationary sris as wll as multicollinarity btwn capital flows and xchang rat. 3. INTERPRETING DATA Data is organizd from th high frquncy sris of macro variabls from th data bank of RBI. Slction of th appropriat intrst rat from th availabl spctrum of intrst rats in India for an laborat analysis of th link btwn intrst rat and fiscal dficit is th crucial stp in data mining. Th major intrst rats ar call mony markt rat, bank rat, trasury bill rats (91 days, 364 days, and 182 days), bank rat, prim lnding rat of trm lnding institutions, and intrst rat on datd scuritis of th govrnmnt of India. Among ths intrst rats, call mony markt rat has xhibitd larg volatility and th bank rat has appard to b non-varying in natur, which intuitivly can b optd out in analyzing th link btwn fiscal dficit and intrst rat. Long-trm intrst rats ar also optd out as a rfrnc rat. Prim lnding rat is rlvant as it is a significant dtrminant of privat invstmnt bhavior, but optd out as it is a long-trm rat and has also shown a broad stickinss in th rats. Th rdmption yild on datd scuritis of India is idntifid on th grounds that a shift from signiorag financing to bond financing of fiscal dficit in India can hav som prssur on th intrst rat spcially th intrst rat on bonds or scuritis but optd out as it is long-trm. Trasury bill rat is idntifid as th rfrnc intrst rat. Thortically, a rfrnc rat is dfind as th pric of a short-trm low risk instrumnt in a fr liquid markt. Th wightd avrags of trasury bill rats of 91 days, 182 days, and 364 days ar usd as th intrst rat variabl in this papr. Howvr, th dtrmination of long-trm intrst rats, in particular, th govrnmnt scuritis rat, and th rol of fiscal dficit in dtrmining th longs is also analyzd outsid th purviw of 11

14 rfrnc rat analysis at th latr stag, as th intrst rat on govrnmnt scurity is also an important rat spcially whn govrnmnt scuritis constitut a major chunk of bond financing of dficit in India. Having slctd th rlvant intrst rats for th analysis, th nxt task is to transform ths intrst rats into x ant ral intrst rat. According to th Fishr hypothsis, nominal intrst rat ( n) is givn by n = r + whr r is th ral intrst rat and (6) is th xpctd rat of inflation. Th ral intrst rat in any priod, thus, is postulatd to volv as a dviation btwn nominal intrst rat and th xpctd inflation. Corria-Nuns and Stmitsiotis (1995) usd th low frquncy componnt of consumr pric changs as gnratd by th Hodrick-Prscott (HP) filtr to modl xpctd inflation. W us th HP filtr for computing xpctd inflation. 10 Using th HP filtr, how do w captur xpctd inflation from th obsrvd sris? 11 Lt us assum that obsrvd inflation contains both xpctd and unxpctd componnts u. = + u. (7) Th HP filtr dcomposs obsrvd inflation into a stationary cyclical componnt and a smooth trnd componnt ( and dnot th logarithms of obsrvd and xpctd inflation, rspctivly) by minimizing th varianc of th cyclical componnt subjct to a pnalty for th variation in th scond diffrnc of th trnd componnt. This rsults in th following constraind last squar problm. i T Min ( - ) 2 + [( t+1- t ) - ( t- T=1 t=2 t-1 )] 2 Th sam procdur through th HP filtr mthodology is also usd to driv th unanticipatd componnt in th rsrv mony, as wll as th mony supply, by dcomposing th sris into cyclical and structural componnts. 10 Apart from th HP filtr mthod, various othr conomtric mthods hav also bn mployd to construct appropriat proxis for th markt s xpctations of futur inflation. Tanzi (1985) usd survys of inflationary xpctations such as Livingston indx to gnrat a sris on xpctd inflation in th contxt of th US. Autorgrssiv modls hav also bn usd to gnrat a sris of xpctd inflation. 11 Th HP filtr has good mathmatical proprtis in ordr to xtract th unobsrvabl variabl of xpctd inflation out of th obsrvd sris. Th xpctd inflation sris computd using th HP filtr contains both forward- and backward-looking information on inflation rats, which maks it rlvant in a rational xpctations framwork. Past information is ncssary to adjust prics from a disquilibrium position, whil information rgarding futur trnds is also rquird bcaus rational conomic agnts look forward in tim to form xpctations about th futur inflation rat (Corria-Nuns and Stmitsiotis 1995). 12

15 4. ECONOMETRIC ESTIMATION OF THE INTEREST RATE MODEL AND RESULTS A significant dbat xists in th tim sris litratur on prforming th prtsts of intgration and co-intgration (Todo and Yamamoto 1995). A stationary tims sris ar intgratd of ordr zro, xt ~ I(0). Th tim sris conomtrics ncountrs problms: how to involv a mixtur of I(0) and non-stationary I(d) sris, whr th ordr of intgration d can b diffrnt for diffrnt sris and vn fractional, and whr th stationarity assumptions ar difficult to vrify. A fw attmpts to liminat ths problms of prtsts for vctor autorgrssions (VAR) can b found in conomtric litratur, th prominnt bing th mthodology by Todo and Yamamoto (1995) and Vinod (2006). Gtting to thortical basics of conomics, Samulson (1947) xplaind conomic quilibrium as dscribing a givn st of functional quations and initial conditions dscribing rlationships btwn variabls... for th purpos of dtrmining th volution of a st of conomic variabls through tim, and thrfor convrting conomic tim sris to stationarity via diffrncing transformation justifid by unit root tsting is problmatic for volutionary short sris (Vinod 2006). Th ntir dbat on unit roots has roots in th work of Nlson and Plossr (1982), which suggstd that most of th macroconomic variabls hav a unit root tim-sris structur. For instanc, thr is a considrabl amount of dbat about th stationary proprtis of prics. Whil Prron (1989), Lvin and Lin (1992), Culvr and Papll (1997) suggstd that inflation is a stationary sris, othr studis in th multivariat country contxts by Bailli, Chung, and Tislau (1996), Bailli (1989), Ball and Ccchtti (1990), and Johansn (1992) found vidnc in favor of unit roots in pric sris. This dbat poss a srious nd rvisit to th macroconomtrics, which assums inflation as a unit root macroconomic variabl. This dbat on th unit root proprtis can b xtndd to othr macro variabls: namly, dficits, intrst rat, xchang rat, capital flows, and mony supply, as wll. Against th backdrop of this dbat, th mthodology usd in this papr is not an attmpt to avoid th difficult infrnc problms associatd with unit root tsting, but rathr proposs a judicious slction of macro variabls to avoid th mixing of I(0) and I(d) variabls, and car is takn to protct th tim sris proprtis of th macro variabls by not succumbing to a dtrnding or diffrncing procss during th prtsts. Th unit roots ar initially prformd through th augmntd Dicky Fullr (ADF) mthodology. Howvr, as suggstd by Prron (1989), ADF has a tndncy not to rjct th null hypothsis of unit root 13

16 whn th sris has a structural brak. A tst for structural braks has bn attmptd by dciding apriori th units of brak, and th growth rat analysis of both substs of tim priods wr analyzd and no significant diffrnc btwn th cofficints was found. 12 Tabl 2 rports th unit roots prformd on th macro sris usd in th study. Tabl 2 Augmntd Dicky Fullr (ADF) infrnc on unit roots Macro Variabls T-stat McKinnon Critical Valus Lags Dcision rgfd I(0) with no c,t TB-rroi (at 5%) 2 I(0) with no c,t TB-roi (at 10%) 2 I(0) with no c,t wpi I(0) with no c,t uma I(0) with no c,t Kflows I(0) with no c,t Pfolio I(0) with no c,t uhpm I(0) with no c,t B-roi I(0) with c, no t Lrroi I(0) with no c,t Elroi I(0) with c,t Sourc: Rsrv Bank of India (2002), basic data 12 Th potntial xistnc and timing of structural braks in th sris could also b attmptd through Zivot and Andrws (1992) tst, which idntifis possibl priods of structural brak in th tim sris basd upon a sris of dummy variabl constructs. If th dummy variabls ar statistically significant, th prcis tim of th structural brak can b dtrmind basd on a max R 2 critria. 14

17 Tabl 3 Phillips Prron (PP) infrnc on unit roots Macro Variabls PP T-stat Lags Critical Valus Dcision rgfd I(0) with no c,t TB-rroi (at 10%) I(0) with no c,t TB-roi (at 10%) I(0) with no c,t (at 5%) I(0) with no c,t wpi I(0) with no c,t uma I(0) with no c,t Kflows I(0) with no c,t pfolio I(0) with no c,t uhpm I(0) with no c,t B-roi (at 10 %) I(0) with c, no t Lrroi (at 5 %) I(0) with no c,t Elroi (1%) I(0) with c,t Sourc: Rsrv Bank of India (2002), basic data Th ADF and PP tsts of unit roots rvald that th macro variabls for th study ar stationary at lvls with no drift and trnd. Thrfor, th logical nxt stp that follows is to analyz th causality. Toda and Yamamoto (1995) dvlopd an altrnativ causality tsting procdur basd on th tst quations of Grangr, but augmntd with xtra lags dpnding on th potntial ordr of intgration of th sris of intrst. If th sris ar assumd I(1), on xtra lag is addd to ach variabl in th tst quation. If both variabls ar assumd I(0), no xtra lag is addd in th quation, and th Toda Yamamoto tst is quivalnt to th Grangr Causality tst. A Wald Tst is carrid out to dtrmin th rlationship btwn th two variabls. Howvr, Hsiao (1981) is usd in this papr as it simultanously idntifis th optimal paramtrization of th modl and th causality dirctions. Th optimal paramtrization is attmptd in Hsiao (1981) through Final Prdiction Error (FPE). Vctor Auto Rgrssion modls can b writtn in gnral form as y t = + (L) y t + t (i) whr y t is vctor of modl variabls is vctor of constants 15

18 t is vctor of whit nois rror trms (L) is vctor of polynomials in th lag oprator, L whr ij k t 1 i j i i L whr L is th lag oprator t and t ar whit nois rror trms. To choos th ordr of lags in ii (L) and ij (L) by th minimum FPE is quivalnt to applying an approximat F tst with varying significanc lvls; for dtails, s Hsiao (1981). Akaiks dfinition of Final Prdiction Error critria is xprssd as 2 T m n 1 y( m, n) FPE y ( m, n) * T m n 1 T whr T is th numbr of obsrvations, m and n ar th ordr of lags of th variabls concrnd privat corporat invstmnt [y] and dtrminants [x s ], rspctivly, and 2 T t 1 ^ m ii n y( m, n) ( y ( L) y ( L) x a) t whr suprscripts m and n dnot th ordr of lags in 11 (L) and 12(L). And t ^ ij st ^ 2 m 11 (L), n 12 (L) x s t and ^ a ar th last squar stimats. Th causality can b dtctd as follows: If FPE y (m, n) < FPE y (m, 0) thn x (s)t Grangr causs y t, dnotd by x (s)t y t. In th multivariat autorgrssiv modling, th squnc in which variabls ntr th quation mattrs. W usd Spcific Gravity Critria suggstd by Cains, Kng, and Sthi (1981) for squncing th variabls. Cains, Kng, and Sthi (1981) suggstd th following procdur for multivariat autorgrssiv modling for stationary procsss: (1) For a pair of stationary procsss (X, Y), construct bivariat AR modls of diffrnt ordrs, thn compar th multivariat final prdiction rrors of ths modls and choos th modl of ordr k possssing minimum FPE to b th optimal modl for th pair of procsss (X, Y). (2) Construct bivariat AR (k) modls (both causal modls and non-causal indpndnt modls) for (X, Y) and apply th stag wis causality dtction procdur to dtrmin th ndognity, xognity, or indpndnt rlations btwn X and Y. (3) If a procss, say X, has n multipl causal variabls, y 1,y 2,., y n, w rank ths multipl causal variabls according to th dcrasing ordr of thir spcific gravitis. 16

19 (4) For ach causd (ndognous) procss, X, w first construct th optimal univariat AR modl using FPE critrion, thn w includ X s multipl causal variabls, on at a tim, according to thir causal ranks and us FPE critrion to dtrmin th optimal ordrs of th modl at ach stp. (5) Pool all th optimal univariat AR modls constructd in (4) and stimat th systm. Th final prdiction rror (FPE) of fitting on dimnsional autorgrssiv procss for fiscal dficit (DEF) and intrst rat (TB) ar computd with uppr bound of lag lngth (L * ) assumd qual to 15. First, w hav considrd ral intrst rat as a controlld variabl, and holding th ordr of its autorgrssiv oprator to on, w squntially addd th lags of th manipulatd variabls up to th L * of 15. In this tratmnt of ral intrst rat as th manipulatd variabl, w found that FPE DEF (m*,n*) > FPE DEF (m*,0), which implis fiscal dficit dos not Grangr-caus th intrst rat. Howvr, th changs in mony supply, xchang rat, and inflationary xpctations dtrmins th intrst rat. Tabl 4 Shorts Optimal paramtrization and causality dtction Controlld Variabl (i r - Manipulatd Variabls Optimum Lags of Manipulatd Variabl Final Prdiction Error t ) [1] Causality Infrnc (i r - t ) [1] (xpinf) t (xpinf)t (i r - t ) (i r - t ) [1] (xpinf) t hpm t hpm (i r - t ) (i r - (i r - t ) [1] (xpinf) t hpm t (Kflows) t (r) t (i r - t ) [1] (xpinf) t hpm t (Kflows) t df t df t (i r - t ) t ) (df)t [1] (df)t [1] (i r - t ) (i r - t ) (df) t (df)t [1] (i r - (df)t [1] (i r - (df)t [1] (i r - t ) (xpinf) t (xpinf) t (df) t t ) (xpinf) t hpm t hpm t (df) t t ) xpinf) t hpm t (Kflows) t Kflows) t (df) t Not: Figurs in th parnthss dnots th lag lngth of controlld variabl. Sourc: Rsrv Bank of India, basic data 17

20 Tabl 5 Longs Optimal paramtrization and causality dtction Controlld Variabl l(i r - Manipulatd Variabls Optimum Lags of Manipulatd Variabl Final Prdiction Error t ) [1] Causality Infrnc l(i r - t ) [1] (xpinf) t (xpinf)t l(i r - t) l(i r - t ) [1] (xpinf) t (Kflows) t Kflows l(i r - t ) l(i r - t ) [1] (xpinf) t (Kflows) t hpm t hpm t l(i r - t ) l(i r - t ) [1] (xpinf) t (Kflows) t hpm t df t df t (i r - t ) (df)t [1] (df)t [1] l(i r - t ) (i r - t ) (df) t (df)t [1] l(i r - (df)t [1] l(i r - (df)t [1] l(i r - t ) hpm t hpm t (df) t t ) hpm t (xpinf) t (xpinf) t (df) t t ) hpm t (xpinf) t (Kflows) t Kflows) t (df) t Not: Figurs in th parnthss dnots th lag lngth of controlld variabl. Sourc: Rsrv Bank of India, basic data To xamin whthr thr xists rvrs causality btwn fiscal dficit and ral intrst rat, w rpatd th xprimnt, kping fiscal dficit as th controlld variabl and squntially addd th lags of manipulatd variabls to th st. Tabls 4 and 5 prsnt th rsults of Hsiao autorgrssiv modling of causality dtction for th shorts and longs. Th rsults showd that in th contxt of rcnt financial libralisation and drgulation of intrst rats, dficit dos not induc a ris in intrst rat. Rathr, th dirction of causality runs from ral intrst rat to dficit. This rsult is in conformity of th rcnt trnd in Indian public financ whr th shar of non-intrst xpnditur in total xpnditur is on th dclin. This is du to th sharp incras in intrst paymnt obligations stmming from th rising cost of srvicing th intrnal dbt. Th rason bhind this can b attributd to intrst rat drgulation, whr th high intrst rat fuld th accumulation of mor dbt through incras in intrst paymnts and th consqunt dbt-dficit spiral. It is also found that in th drgulatd financial rgim, th intrst rat is primarily dtrmind by th inflationary xpctations in th conomy. Th rsult is tru for th intrst rat dtrmination of shorts and longs. 18

21 5. CONCLUSION This papr xamind whthr thr is any vidnc of financial crowding out in th rcnt yars of financially drgulatd intrst rat rgim. Using th high frquncy macrodata, w found quit contrary to th popular blif that incras in fiscal dficit inducs a ris in th intrst rat, that thr xists no significant rlationship btwn th two. Th conclusion drawn from th multivariat vctor autorgrssiv analysis for th priod from FY 2006[4] to FY 2011[4] rvald that th intrst rat is affctd by th unanticipatd componnts of high-powrd mony, xpctd inflation, and fluctuations in capital flows. As th causality is not stablishd from fiscal dficits to intrst rats, th plausibl vidnc for nil financial crowding out is rinforcd in th Indian contxt. A rvrs causality runs from ral intrst rat to dficit. This rsult is in conformity with th rcnt trnd in Indian public financ whr th shar of non-intrst xpnditur in total xpnditur is on th dclin bcaus of th sharp ris in intrst paymnt. On of th principal rasons for th sharp incras in intrst paymnt obligation is th rising cost of srvicing th intrnal dbt. Th rason bhind this can b attributd to intrst rat drgulation, whr th high intrst rat fuld th accumulation of mor dbt through incras in intrst paymnts and th consqunt dbt-dficit spiral. Th conomtric rsults rvald that nithr th long-trm nor short-trm intrst rat is dtrmind by fiscal dficit in India. This rsult has significant policy implications for intrst rat dtrmination in India, as th cntral bank has kpt th policy rats unchangd in all rcnt policy announcmnts, citing prim rasons bing th high fiscal dficits. Kping th intrst rats high or unchangd has ngativ implications for conomic growth. Whil th cntral banks, globally, rducd th intrst rats, only RBI of India dciding not to cut intrst rats, as fiscal dficit which dos not hav any mpirical vidnc for dtrmining both shorts and longs is high in India. 19

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