II
The Prime Minister's Economic Advisory Council (PMEAC)
in its recent report has put forward an argument which
is slightly different from the one presented above,
though belonging to the same genre. This argument
states: "The consequences of a high fiscal deficit
depend upon the way the deficit is financed." If the
deficit is financed by monetisation, and if this
monetisation is "excessive", then this leads to
domestic inflationary pressure, whose "impact is the
highest on the poor." On the other hand if the deficit
is financed by "borrowing in domestic financial
markets" then "the result is that real interest rates
become very high" which chokes off private investment.
The PMEAC's argument is different from the one
presented above because it does not assert that an
increase in real interest rates is the inevitable
consequence of a rise in the fiscal deficit; the
consequence according to it depends on how the deficit
is financed. But this proposition, namely that the
consequences of a fiscal deficit are determined by how
it is financed, flies in the face of elementary
economics, as can be seen from simple IS-LM analysis.
Consider the first case
mentioned by the PMEAC, the case of monetisation. Even
if the deficit is financed by monetisation which adds
to bank reserves, this need not cause an inflationary
squeeze on the poor as long as the real economy is
demand-constrained to start with, and the deficit is
not large enough to cause it to become
supply-constrained
[1]
. (Moreover when
bank reserves are being added to, it is not even clear
why the deficit should be "financed largely by
monetisation" as the PMEAC report assumes rather
arbitrarily). On the other hand suppose the entire
deficit is completely monetised. If the value of the
Keynesian multiplier (at unchanged interest rates) is
higher than the value of the money multiplier times
the income velocity of circulation of money (also at
unchanged interest rates), there would be an excess
demand for money that would push up the interest
rates, even though the fiscal deficit had been
entirely monetised! In other words the proposition
that when the fiscal deficit is monetised it affects
not the interest rates but only prices relative to
money wages is doubly wrong: there is no necessary
reason why it should at all affect prices, and there
is no necessary reason why it should not at all affect
the interest rates.
Now consider the second case, where there is no
monetisation. Even if the deficit is financed entirely
by "borrowing in the domestic financial market", it
need not raise the interest rate at all if banks had
excess reserves to start with. On the other hand if
the fiscal deficit so financed occurs in a real
economy which is supply-constrained to start with,
then it raises prices in terms of the wage-unit,
thereby imposing an inflationary squeeze on the poor.
Thus the PMEAC's second case which is supposed to show
that a fiscal deficit financed by market borrowing as
opposed to monetisation causes a rise in interest
rates rather than in prices in terms of the wage-unit
is also doubly wrong: there is no necessary reason why
it should at all affect the interest rates, and there
is no necessary reason why it should not at all affect
prices.
There are two quite distinct errors underlying the
argument of the PMEAC report. First, as simple IS-LM
analysis would show, it is not how the fiscal deficit
is financed that matters but the state of ex-ante
excess demand in the goods and the money markets with
which we start and how these are affected by the
fiscal deficit. Second, again as simple IS-LM analysis
would show, a rise in the fiscal deficit would raise
prices in wage units (whether or not it raises
interest rates) only if the economy is
supply-constrained to start with, and would raise
interest rates (whether or not it raises prices in
wage-units) only if bank credit is supply-constrained
to start with. This latter situation in turn cannot
arise if banks have excess reserves (for a given stock
of reserve money), or, alternatively, if the stock of
reserve money itself can adjust to the demand for it.
Thus the argument of the PMEAC report must necessarily
be assuming (though this is nowhere explicitly stated)
both that the real economy is supply-constrained and
that bank credit is supply-constrained. Both these
assumptions are palpably wrong in the context of the
Indian economy today. Let us see how.
[1]
Of course even in a demand-constrained system an
increase in aggregate demand, while generating larger
employment and output, might cause some increase in
the price in terms of the wage-unit, owing to
(possibly) increasing marginal costs. But this surely
is not what the PMEAC is referring to, for otherwise
even getting out of a slump would be dubbed
"anti-poor". Its notion of "inflation" clearly refers
to a state of affairs where it is only price
adjustments that occur.
