Deficit, money and price: the Indian experience

Fiscal Deficit (FD) is widely regarded as the kingpin of any stabilization package. FD is targeted for controlling inflation as it entails money financing. It is assumed, in monetarist approach, that money supply and inflation have high association due to the implicit assumption of neutrality of money. The concept of neutrality of money, which is an expression of the monetarist's version of the Quantity Theory of Money, refers to the hypothesis that changes in the quantity of money affect the nominal, but not the real variables in the macroeconomic system. The issue is examined for the case of a developing economy, India, by examining the relationship between money, output and price level. We find the presence of bi-directional causality between money and price level and furthermore that money is non-neutral. It is concluded that money is not exogenous in the Indian context in the long run and there is no systematic relationship between money, FD and/or high-powered money. (C) 2004 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.