Effect of Fiscal Deficit

on Real Interest Rates

This paper examines the proposition that an increase in the fiscal deficit, financed
by government borrowing, necessarily raises the real rate of interest and thus ‘crowds out’
private investment. It finds that theoretical positions that affirm this point of view
assume that the economy is in full employment, a condition that is not fulfilled
in most developing countries. The existence of a definitive positive relationship between
real rates of interest and the fiscal deficit-GDP ratio is tested empirically for India and for a
number of other countries in the world. The finding is that interest rates do not
necessarily depend on the fiscal deficit and that policies based on this
understanding are erroneous.
SURAJIT DAS

I Let us now discuss different versions of the theory, which say

Introduction that the fiscal deficit will necessarily raise the rates of interest
and as a result cause crowding out.

I
n mainstream economics literature it is a widely believed
theory that the fiscal deficit necessarily raises the real (do-
mestic) rate of interest. IMF-World Bank policy directives
say that a fiscal deficit (above a certain ratio of the GDP) is
necessarily bad for the health of the economy (no matter what
the actual state of aggregate demand be) because it necessarily
raises the rate of interest and hence, either lowers the level of
private investment via the so-called ‘crowding out’ effect, or
increases the country’s net external indebtedness. The same
understanding is being echoed in the official position of the
government of India and in top policy-making bodies in the
country. Therefore, the fiscal deficit-GDP ratio has to be kept
below a certain level under all circumstances. But as we know,
expansionary fiscal policy is a key instrument of the Keynesian
demand management theory. Now, if an increase in the fiscal
deficit necessarily causes crowding out (ignoring for the time
being its effect on net external indebtedness1 and on inflation2)
then surely the whole idea of raising demand by larger govern-
ment expenditure or by deficit financing is questionable. In fact,
if ‘crowding out’ occurs then expansionary fiscal policy cannot
have the effect of reducing unemployment and maintaining a high
level of activity, contrary to what has historically been the case.
In our present paper we want to investigate whether there is any
reason to believe that a higher fiscal deficit-GDP ratio necessarily
increases the real rate of interest and hence causes a crowding
out of private investment.
The next section concentrates on different theoretical
arguments or various versions of the theory that claims the fiscal
deficit must cause interest rates to go up. The third section
deals with the empirical evidences available for the Indian
economy and the fourth section discusses the empirical
evidences of thirty-six different countries, it takes into consider-
ation different kinds of interest rates like government bond
yields, treasury bill rates, prime lending rates, deposit rates
and money market rates of interest. This paper ends with a
concluding section.
II
Theoretical Overview
Let us consider the ‘treasury views’3 or the fixed pool of savings
view. Throughout we assume that the price level is constant so
that the nominal and real rates of interest are same, if not specified
otherwise. In pre-Keynesian literature the rate of interest was
believed to be determined by the savings-investment equality.
First, we consider the simple case where savings do not depend
upon the rate of interest. If investment demand increases due
to increased government investment expenditure (say by deficit
financing) then the rate of interest has to be adjusted in such
a way that full crowding out takes place and the ex post savings-
investment identity is maintained. In other words, savings cannot
increase with an increase in investment demand but increased
investment demand has to be curtailed by increasing the rate of
interest to maintain the ex post identity.
In Figure 1, the initial rate of interest ro is determined by the
equality (at point Eo) between savings (SoS*) and investment
(IoIo). Now if the government investment increases by deficit
financing the negatively sloped investment curve shifts rightward
(from I0I0 to I1I1) and the new intersection point (E1) of the
investment and savings schedules occurs at a higher level of rate
of interest (r1).
The dependence of savings on income was never recognised
by the treasury view. If we restate the treasury view taking into
account the dependence of the level of savings on the level of
income, it would be as follows: for any given level of real income
(y) there would be an amount of real savings (s = private savings
+ government savings), for any given distribution of income and
rate of taxation. If government investment increases, private
investment is bound to fall by the real rate of interest adjustment
to maintain the ex post savings-investment identity, because
savings out of the given income cannot increase any more. Let
the given level of output be y* and the private savings and

Economic and Political Weekly March 20, 2004 1299

government savings (i e, tax net of government consumption)
generated from that level of income be sp* and sg* respectively.
Now if private investment is denoted by IP and government
investment by Ig then in a simple closed economy framework
the ex post identity sp* + sg* ≡ Ip + Ig (sg <0 in case of deficit)
must hold. Since the left hand side of the equation is constant,
given the implicit assumptions of the treasury view, on the right
hand side if Ig component rises then Ip has to be lower by an
exactly equal amount, because the sum of these two has to remain
constant. From the above argument it follows that if the fiscal
deficit for financing government investment rises, the rate of
interest in the economy would necessarily rise to crowd out
private investment (exactly the same conclusion would follow
if the fiscal deficit rises for financing government consumption
as well, with private savings remaining unchanged).
But why is the theory propounded as if the level of income
is given? This is because there is an underlying assumption that
the economy is at full employment, which determines the fixed
pool of savings (since full employment output cannot be in-
creased, the level of full employment savings (S*), which is a
function of output cannot be raised too). That is precisely why
the savings schedule is vertical and rise in investment demand
does not lead to output adjustment or increased ex post investment
(which has to be identically equal to savings), but as an obvious
consequence, raises the rate of interest (from ro to r1). Therefore,
according to the treasury view, there can be only one level of
investment at full employment, which is not compatible with an
autonomous investment function.
In today’s world, the existence of large-scale involuntary un-
employment is an undeniable fact. Therefore it is inappropriate
to use theories assuming full employment (directly or indirectly)
to draw policy conclusions. We have in the Keynes-Kahn multiplier
analysis an alternative suited to a demand constrained economy.
Moreover, even if there is full employment there would also be
price adjustment and, instead of interest adjustment ex post
savings-investment identity can be reached through forced sav-
ings. There is in fact no reason to believe that if the government
raises demand by deficit financing there would not be any output
adjustment. With the rise in demand, both income and savings
increase through various rounds of the multiplier. In fact in a
demand-constrained economy, which is operating well below full
employment, if aggregate demand rises, aggregate supply would
also increase until the two (measured in ‘wage units’) are exactly
equal. To put it differently, the process of increase in income
and employment due to an increase in demand, would continue
until an amount of savings, which is exactly equal to the increase
in home and foreign investment is generated. That means, in fact
‘investment determines savings’, which is diametrically opposite
to the pre-Keynesian position of ‘savings determines investment’.
Hence, a fiscal deficit finances itself in the sense that it generates
an equal amount of ‘excess private savings’, i e, savings in private
hands in excess of private investment, at any given level of the
interest rate. Even if we assume that output adjustment is not
possible anymore, there would still be forced savings, via, price
adjustment, to equalise ex post savings with investment. There-
fore, there is no valid reason to believe that increased government
investment financed by borrowing would necessarily increase the
real rate of interest and cause crowding out of private investors,
to maintain ex post savings-investment identity.
In Figure 2, if the initial investment function is IoIo and after
an increase in investment financed by a fiscal deficit the curve
1300
Figure 1 Figure 2
R I1 S0 S1
r I0 I1 S0
I0
r1 E1
r* E0 E1
r0 E0
I1
I1
I0 I0
O S* I,S O S0 S1 I,S
shifts upward right to say I1I1, then at any given nominal interest
rate, the savings curve would also shift rightward from its initial
position (i e, from SoSo to S1S1) through income adjustment. If
the income adjustment takes the form exclusively of output
adjustment, with no change in price in terms of the ‘wage unit’
(as would happen, for instance, in a world of oligopoly with mark-
up pricing and horizontal prime cost curves), then the real interest
rate (at r* in the diagram) need not be affected at all. Again,
if the price level changes, then too savings would increase to
match the investment demand through redistribution of income,
i e, forced savings. The equilibrium point, i e, the intersection
of investment and savings curves can shift from Eo to E1 and
both ex post investment and savings can come to equality at a
higher level as compared to the initial situation.
Another, a bit more sophisticated, version of the treasury view
states that investment and savings are both functions of the real
rate of interest (where, dI(r)/dr<0 and dS(r)/dr>0) (Figure 3). Now
if aggregate investment demand increases, due to say an increase
in government investment through deficit financing, the rate of
interest would increase but there would not be full crowding out
because aggregate savings would also increase, due to the rise
in interest (since, dS(r)/dr>0). As a result of this, the rate of
interest would not increase to such a level that full crowding
out takes place. Both ex post investment and savings, however,
would be higher and the rate of interest also would increase. This
is called the theory of partial crowding out due to an increase
in government investment financed by a fiscal deficit (via higher
real rate of interest).
Graphically if the rate of interest is ro determined by the
intersection of negatively sloped investment (IoIo) and positively
sloped savings (SS) curves (at Eo), then due to the increase in
government investment financed by a fiscal deficit the IoIo curve
shifts upward-right say to I1I1. The new interest rate (at E1) would
be r1, which is higher than ro but lower than r*, (i e, the rate
of interest corresponding to full crowding out). This version of
the treasury view also says that if government investment in-
creases, the rate of interest would necessarily rise and in turn
cause crowding out (though partial).
While this view allows savings to depend on the interest rate
it is still pre-Keynesian in the sense that it takes the level of income
as given. However, once again in the context of a demand
constrained economy, there is no valid reason to believe that
increased government investment financed by borrowing would
necessarily increase the real rate of interest and cause crowding
out of private investors to maintain ex post savings-investment
identity. Even if we believe that the rate of interest affects, ‘ceteris
paribus’, the level of savings then too it is obvious that aggregate
savings can rise with a rise in aggregate investment demand
through an increase in output, even if the interest rate is kept
Economic and Political Weekly March 20, 2004
 Figure 3 Figure 4
r r I1
I0 I1 X S I0
r* E2
r1 E1
r* E0 GD
r0
E0
S I1 S0 S1
I0
O X0 X1
O X0 X1 I,S
unchanged. As savings are a positive function of income,
if exclusive output adjustment takes place with an increase
in aggregate demand (leaving prices in terms of the wage unit
unchanged), which is perfectly possible in an economy operating
well below full employment, savings will increase and ex post
savings-investment identity can be attained at any particular real
rate of interest in the economy. In fact, even in the case of full
employment, instead of output adjustment price adjustment takes
place; an increase in the level of aggregate investment demand
reduces the real income of wage earners and increases the real
profit share. Since a larger proportion is saved out of profit as
compared to wages, aggregate savings rises, called ‘forced savings’
in the literature of economics. Finally in this case, ex post
aggregate savings can become equal to aggregate investment
demand without increasing the real rate of interest. Therefore
it is clear that increased investment demand can always generate
an equal volume of aggregate savings, at any given level of the
interest rate, so that attributing a rise in the interest rate to the
higher investment demand is plain wrong.
In Figure 4, it is perfectly possible that the savings curve can
shift rightward (from S0S0 to S1S1) with the increase in gov-
ernment investment (i e, shift of investment curve from I0I0 to
I1I1) and leave the real rate of interest (r*) unaltered (the assump-
tion being that there is no price adjustment).
The initial savings-investment equality is at point Eo and the
after adjustment equality can be at point E1 which implies that
the increased aggregate investment demand results in both the
ex post investment and savings increasing from X0 to X1 at an
unchanged rate of interest (r*).
Pre-Keynesian economists regarded the rate of interest as the
factor, that brings the demand for investment and the willingness
to save into equilibrium with one another. But according to
Keynes the rate of interest is not the ‘price’ that brings into
equilibrium the demand for resources to invest and the readiness
to abstain from present consumption (i e, savings), It (the rate
of interest) is the price which equilibrates the desire to hold wealth
in the form of cash with the available quantity of cash”4 (i e,
nothing but demand for and supply of money equilibrium) [Keynes
1936:167]. This difference has serious consequences for macro-
economic policy decisions. In Keynes’s own words “a decreased
readiness to spend will be looked on in quite a different light
if, instead of being regarded as a factor which will, cetris paribus,
increase investment, it is seen as a factor which will, cetris
paribus, diminish employment” [Keynes 1936:185].
Let us now consider Dennis Robertson’s loanable funds theory
[Kahn 1945]. In any given period the supply of loanable funds
equals the sum of cash dishoarded and savings while the demand
of loanable funds equals the sum of investment and hoarding.
Economic and Political Weekly March 20, 2004
Figure 5
S0 S1 r SLF
r1 E1
E1 E0
r0
I1 DLF1
I0 DLF0
O DLF,SLF
I,S
Now both the demand and supply of the loanable funds are
taken to be functions of only the rate of interest and, therefore,
equality of demand and supply of loanable funds determines
the rate of interest in any given period. Now if the demand
for loanable funds increases due to say deficit financing then
the rate of interest increases.
In Figure 5, if fiscal deficit increases, the demand for loanable
funds would also increase and the DLF curve would shift right-
ward (from DLF0 to DLF1) and, as a result, the rate of interest
will increase (from ro to r1) since the SLF curve is positively
sloped (a positive function of rate of interest).
Any theory that draws the supply of a loanable fund (or supply
of savings) curve as a function of interest rate only is implicitly
assuming a given level of income. If it is not explicit, then it
is only because of intellectual failure. For every level of income,
there must be a different supply of loanable fund curve. One can
think of a single ‘supply of loanable fund’ curve only by assuming
income to be given, and the level of income as a full employment
one. This assumption is crucial for the loanable funds theory;
as once we recognise that the supply of loanable funds depends
on the level of output as well, we can have a new equilibrium
with a higher fiscal deficit, higher income and an unchanged real
rate of interest.
Thus in Figure 6, starting with the initial equilibrium E0, as
the demand for loanable funds goes up (shift of DLF curve
upward-right from DLFo to DLF1) its supply can also rise (shift
of SLF curve rightward from SLFo to SLF1) due to a rise in
income, and interest rates can be unaffected (at r*) at the new
equilibrium E1.
Thus the loanable funds theory shares with the treasury view
the counterfactual assumption of a given level of income and
fails to be relevant to the real world. Yet, in one sense it is an
improvement over the latter, since by explicitly taking into
account the hoarding and dishoarding of cash it recognises the
income velocity of money as an endogenous variable, depending
on the interest rate. However, this advance is not enough since
without an independent theory of interest rate determination, the
loanable funds theory is still dependent on a full employment
assumption for its logical consistency.
There exists another version of the theory of crowding out due
to financing larger government investment through borrowing.
According to this theory banks can create only a certain amount
of credit in any period.4 If the government takes more, out of
that banks would substitute government bonds for private bonds
or in other words, private investors would be rationed out because
the government is more attractive as a borrower. This theoretical
understanding is an improvement on the fixed pool of savings
or the loanable fund arguments in the sense that it does not assume
1301
 Figure 6
r
r DLF1
D
DLF0
r* E0 E1
E1
r1 S’ GovtDebt
r0
SLF0 SLF1
S D
O X0 X1 DLF,SLF O K1
that increased investment demand, via, deficit financing cannot
increase the savings or the supply of loanable funds. In the fixed
pool of bank credit theory, it is said that banks can create only
a certain amount of credit in any period. For this to be at all
true, it must be the case that the banks have no unutilised capacity
to create credit. But in most demand constrained developing
countries it is seen that the commercial banks always have excess
capacity to create fresh credit. For example they are seen to hold
more government securities, including low yield securities, than
the minimum requirement under the statutory liquidity ratio due
to lack of adequate demand for credit.
Let r and r’ be the rates of interest on government securities
and on credit, then banks would get rid of excess holding of
securities if 1/c times r’ exceeds r, where c is the cash reserve
ratio or, in other words, banks would never hold excess gov-
ernment securities over and above the SLR requirements, as long
as r’/c > r (we assume that commercial banks expand credit in
a coordinated manner, so that they take into account the multiplier
effects of a credit expansion). Therefore if there is sufficient credit
demand banks will not resort to excess holding of government
securities. In a situation like this, it is erroneous to believe that
if in a particular period the credit creating ability of commercial
banks is limited, and demand for credit increases due to an
increased fiscal deficit the rate of interest would necessarily go
up. Even if for the sake of argument we accept that banks cannot
create extra credit given the existing stock of reserve money, if
they can get additional reserve money when they need, credit
cannot be seen as a constraining factor. Monetary policy in other
words is the crucial factor here.
According to Samuelson and Nordhaus (1989) “the most serious
consequence of a public debt is that it displaces capital from the
nation’s stock of wealth” and “private capital is displaced by
government debt” (p 403). As an explanation of this it is argued
that as the supply of government bonds increases, peoples’
holding of other assets (except government bonds) must be
reduced since total desired wealth holdings are fixed for a given
real rate of interest. The authors have assumed that both demand
and supply of capital are functions of the real rate of interest
(where, dKd(r)/dr<0 and dKs(r)/dr>0) i e, as interest rates rise,
firms demand less capital, while individuals may want to supply
more.
Now an increase in government debt shifts the household’s
supply-of-capital schedule upward-left (from SS to S’S’ in the
Figure 7) because this schedule represents the amount of capital
that people willingly hold at each rate of interest. The capital
holdings are equal to the total wealth holdings minus the holdings
of government debt. The market equilibrium moves north-west
(from Eo to E1) along the demand for capital curve, interest rates
1302
Figure 7 Figure 8
r I0 I1 M
S’
r1 E1
S1
S
r0 E0
E0
L S0
O Y0 Y1 Y
K0 K
rise, and crowding out of private investors takes place. As
an obvious consequence of this, “in the long-run equilibrium,
the capital stock falls”.
Samuelson and Nordhaus are essentially comparing steady
states for an exogenously given ‘natural’ rate of growth. There-
fore, firstly, their argument is dependent on a full-employment
(or, at least, a constant rate of unemployment) assumption.
Secondly, even if we grant such an assumption, the only con-
clusion that we may logically reach is that there will be a fall
in private per capita holding of productive capital. What happens
to the aggregate per capita capital stock depends on what we
assume about the composition of government expenditure. If the
entire government debt is used to finance accumulation then the
per capita steady state capital stock will in fact remain unchanged.
Thus ultimately Samuelson and Nordhaus’ argument amounts
to a dynamic version of the treasury view.
According to the Keynesian tradition the rate of interest is
determined in the money market by the supply and demand for
money. In the IS-LM framework [Branson 1989] (whether in its
original closed economy version or for its extensions to an open
economy) the supply of money is taken to be exogenously given
(along with the assumptions of given prices and money wages)
while the demand for money – taken as the aggregate of trans-
action and asset demand – is believed to be a function of aggregate
output and the rate of interest (where, Md = f[Y, r]: dMd/dY>0
and dMd/dr<0). Now if the fiscal deficit financed by borrowing
increases demand (consumption and/or investment) and, as a
result, aggregate output of the economy increases, the demand
for money will also increase. Since the supply of money is
exogenously given the increased demand for money will cause
the rate of interest to rise. This in turn would cause private
investment demand to come down and the level of employment
and output to fall (though in magnitude it will have to be less
than the initial increase in output otherwise the very reason for
the increase in interest rate would have ceased to exist). Accord-
ing to these models if the fiscal deficit increases (in fact if
employment and output increase for a given stock of money) the
rate of interest increases, too. In the r-y plane, the slope of the
LM curve would be positive. If the IS curve (commodity market
equilibrium condition) shifts rightward due to, say increased
government demand, then the rate of interest increases and partial
crowding out takes place. Ultimately, we get a new equilibrium
point at a higher level of output and definitely at a higher rate
of interest.
In Figure 8, if y increases due to say increased government
expenditure then the commodity market equilibrium curve, i e,
IS curve shifts upward right (from I0S0 to I1S1), the rate of interest
increases from r0 to r1. In the money market as y increases the
Economic and Political Weekly March 20, 2004
 Figure 9
r M 1d
r I0
0
M d
M0s M1 s
r1 E1
r* E0 E2 r* L E0
M0s M 1s
M0d M 1d
O M 0s M 1s Md,Ms
O Y0
transaction (and precautionary) demand for money increases.
Since the money supply is exogenously given, the rate of interest
rises which in turn causes speculative demand for money to fall.
Ultimately the money market comes to equilibrium at a rate of
interest that higher than the initial level. The new equilibrium
point E1, i e, the intersection point of I1S1 and LM is situated
upward right as compared to the initial equilibrium point E0.
As the theory evolved (particularly after the Keynesian revo-
lution), economists accepted the fact that the level of output is
not given and hence the dependence of savings on income became
important. Simultaneously theories of the interest rate depending
on the investment-savings equality were replaced by theories,
which saw interest rates as being determined in the asset market.
Following exactly this line of thinking models like the IS-LM
came into the literature of economics. But in the IS-LM frame-
work (closed or open economy) the money supply (Ms or Ms/P)
is taken as exogenously given. Given this assumption any increase
in the demand for money would, cetris paribus, cause the rate
of interest to rise. The proponents of endogenous money argued
that money supply is not something, which is exogenously given,
but it is determined endogenously.
Figure 9 shows that if the demand for money increases due
to any expansionary measure on the fiscal front, the Md curve
shifts upward right (from Mod Mod to M1d M1d). Now the new
demand for money curve cuts the old money supply curve at E1
and the corresponding rate of interest becomes r1 which is higher
than r*. But an appropriate expansionary monetary policy can
increase the money supply and the Ms curve can also shift
rightward from Mos to M1s. The interest rate can remain the same
(r*) in the new equilibrium E2 as in the initial situation (Eo).
Even if we consider that money supply is a positive function
of r, then too the results not change. The dotted money supply
curve implies that money supply is interest responsive.
Now if money supply happens to be endogenous then it implies
that the rate of interest is set exogenously by policy-makers. Even
if money supply is not endogenous, interest rate still is a matter
of monetary policy. Therefore, the rate of interest is a policy
variable and is fixed at a particular level, though it can vary from
period to period according to the monetary policy. Therefore for
any period, the LM curve would be horizontal in the IS-LM
framework since money supply would be adjusted according to
the demand for money leaving the rate of interest unchanged.
Then if government investment financed by a fiscal deficit
increases, the IS curve can shift upward right. Hence the level
of employment and output may rise but the rate of interest would
be unaffected because of the horizontal LM curve.
In Figure 10, the LM curve in the interest rate-income plane
is shown to be horizontal, i e, in money market equilibrium
Economic and Political Weekly March 20, 2004
Figure 10 Figure 11
I1 P D0 D1 S0 S1
E1 M P* E0 E2
P’ E1
S0 S1
S0 S1 D0 D1
O X0 X1 D,S
Y1 Y
(equality of demand for and supply of money) can occur at
any given rate of interest (say at r*). Now if the IS curve shifts
rightward (from IoSo to I1S1) equilibrium shifts (from Eo to E1),
and as a result, the income level increases (from Yo to Y1) leaving
the interest rate unaffected (at r*).
In an economy where there is a lack of demand both in the
commodity and credit markets, and unutilised excess capacity
of credit creation with commercial banks, increased government
expenditure, by borrowing from the market, increases output in
the commodity market and raises the demand for money in the
money market: However the supply of money also increases and
the rate of interest does not rise.
Another very widely believed argument is that if the govern-
ment has to borrow from the market to finance the budget deficit
then the supply of government securities has to be increased and,
as a result, the price of government securities must fall in general.
Then the rate of interest would rise, which will in turn cause
crowding out of private investors. For example, the Reserve Bank
of India in its Report on Currency and Finance for the year
2002-03 expressed the fear that the demand for government
securities has reached saturation. Any further increase in gov-
ernment borrowing, would cause unwanted pressure on the interest
rates preventing commercial banks from meeting the demand for
credit if it rises in the future. In other words, any further gov-
ernment borrowing would cause rates of interest to rise and,
necessarily, cause crowding out.
The belief that the increased supply of government securities
must lower security price in general is based on an assumption
that the total demand for securities is given (or more generally,
the demand curve for securities as a function of the interest rate,
even if not vertical, is given). But a fiscal deficit not only increases
the supply of securities but also their demand, i e, it shifts both
the demand and supply curves outwards. The demand for secu-
rities increases precisely because the fiscal deficit increases the
level of private savings, which in turn have to be placed in various
financial assets. The identities (S – I) ≡ (G – T) and (S – I) +
(M – X) ≡ (G – T) hold for closed and open economies respec-
tively. A fiscal deficit always generates in a closed economy an
amount of private excess savings over private investment (in case
of open economy an excess of S+M over I+X), equal to itself,
at any given level of interest. In case of a demand constrained
economy, it happens through output adjustment and, in the case
of a supply constrained economy, it happens through price ad-
justment via income redistribution and forced savings. Hence,
there is no reason that an increase in the supply of government
securities would necessarily decrease the price of securities and
in turn increase the rate of interest in the economy in general.
In Figure 11, if the supply of the government securities in-
1303
creases, the supply curve shifts from SoSo to S1S1. If the
demand for it does not increase then the equilibrium point
is E1 and the corresponding price of the securities is P’ which
is lower than P* (initial price). But if an the increase in supply
increases the demand for government securities, as it must,
the demand curve shifts rightward from DoDo and the price
of securities rises. In figure DoDo shifts to D1D1, the new
intersection point becomes E2 and the corresponding price
is P* which is the initial price level corresponding to initial
equilibrium Eo. This is a special case of security prices
returning to their initial level, either if additional private
savings are fully held in the form of government securities,
or if the money supply is endogenous. Thus the monetary
system stands by to convert government securities to money,
to the extent required, in order to maintain a constant interest
rate.
From the above arguments it is seen that there is absolutely
no reason to believe that the fiscal deficit, financed through
market borrowing by issuing government securities necessarily
raises the real rate of interest and causes crowding out. In a world
where widespread unemployment and large-scale unutilised
capacity persists, i e, where the level of actual output is much
less than the potential level of output, aggregate output is likely
to increase with an increase in government demand, rather than
price adjustment or inflation. Again as the rate of interest is
determined by the money market equilibrium condition, i e, by
the demand for money-supply of money equality, if money supply
is endogenously determined and adjusted according to its demand
through appropriate monetary policies, rates of interest become
mere policy variables. According to the monetary policy of the
government it may be high or low irrespective of the level of
fiscal deficit or government borrowings. The question however
is: how empirically valid is this theory? In the next two sections
of this present work, the empirical evidences in India as well
as in other countries are examined.
III
Indian Case
Now we shall look at the available empirical evidence on the
Indian economy during the period 1990-91 to 2000-01, i e, the
so called deregulated regime of interest rates to find out whether
interest rates in India are in any way dependent on the fiscal
deficit-GDP ratio or not. The preceding years (i e, before 1990s)
were characterised by the regime of regulated interest rates, and
may not throw much light on the issue being considered. In this
Table 1: Results of Unit Root Test, Order of Co-Integration and Regression
of Different Interest Rates on Fiscal Deficit-GDP Ratio for India (1990s)
Category Order Obs P>F
section, the data on fiscal deficit GDP ratio and interest rates
deflated by WPI have been considered for the sake of analysis.
All the data used in this chapter are taken either from the
government of India or from the Reserve Bank of India (RBI).
In the case of lending and deposit rates, we have taken into
account only the upper limits (provided by RBI) of the respective
rates for different years. If crowding out is caused by high interest
rates then the upper limits of rates of interest deserve much more
attention. In the case of 91-days treasury bill rates, the annual
averages are calculated as the simple arithmetic mean of 52 weeks
and, in the case of 364-days treasury bill rates, the annual data
are simple averages of the fortnightly rates.
To check whether any definite positive linear relationship exists
between real rates of interest and the fiscal deficit-GDP ratio
on the basis of above data, we have used some
elementary econometric tools. First, we have tested every series
for the ‘unit roots’ or for the existence of ‘random walk’ by using
the McKinnon p-value as well as Dickey Fuller test statistic. Any
series is considered to be stationary if either the McKinnon p-
value (through Monte Carlo simulations) is less than 5 per cent
(i e, Z(t)<0.05) or the absolute value of the Dickey Fuller test
statistic is greater than its critical values (either -3.750 for 1per
cent or -3.000 for 5 per cent or -2.630 for 10 per cent level).
That is, the null hypothesis [Yt = @ Yt-1 + ut , null hypothesis
is @ = 1] that the series is non-stationary or unit roots exist must
be nullified (accordingly with 99 per cent or 95 per cent or 90
per cent level of confidence respectively). Then we have made
the time series stationary by taking appropriate differences (in
all the cases here either the series are stationary or they are
stationary at the first difference level) for all the variables under
consideration. The first differences are calculated simply by
subtracting the previous year’s values from the current year’s
values of each variable, for different years between the time
period 1990-1991 and 2000-2001. Then (y=AX+B, where A,B
are constants was regressed. The generalised form of the regres-
sion coefficient is given by b=(X’X)–1X’y), taking every station-
ary series of different rates of interest into account and the fiscal
deficit-GDP ratio as the explanatory variable. R2 or the coef-
ficient of determination (R2 = b2 Φxx/Φyy, where y is the de-
pendent variable and x is the explanatory variable, Φxx = Γi(xi–
Γixi/n)2 and Φyy = Γi(yi–Γiyi/n)2 is a measure of how well the
regression line fits the data. The adjusted R2 is used sometimes
depending on the degrees of freedom.
A function of sample observations whose computed value
determines the final decision regarding acceptance or rejection
of the null hypothesis is called a test statistic. Here we have
R2 AdjR2 Coeff P>|t|

GBY (central government) 2 10 0.3126 0.1268 0.0176 1.347053 0.313

GBY (state government) 2 10 0.2600 0.1552 0.0496 1.502225 0.260
GBY (mt) 2 10 0.4387 0.0767 -0.0388 0.9643648 0.439
GBY (lr) 2 10 0.2120 0.1870 0.0853 1.496926 0.212
DR (sr) 2 10 0.5850 0.0389 -0.0812 0.5796948 0.585
DR (mt) 2 10 0.6462 0.0276 -0.0939 0.5190213 0.646
DR (lr) 2 10 0.6462 0.0276 -0.0939 0.5190213 0.646
LR (SBI) 1 11 0.9064 0.0016 -0.1093 0.1450044 0.906
LR (min rate) 2 10 0.9923 0.0000 -0.1250 0.0103754 0.992
91 days TBR 2 7 0.8694 0.0060 -0.1929 0.4261541 0.869
364 days TBR 2 8 0.6405 0.0387 -0.1215 0.8689711 0.641
Call MMR 1 11 0.4564 0.0630 -0.0411 -1.112384 0.456

Source: Reserve Bank of India.

1304 Economic and Political Weekly March 20, 2004

used F (in general F[K–1, n–K] = [{R2/(K–1)}/{(1–R2)/(n–
K)}], [K–1, n–K] is the degrees of freedom) or t (here these
two are equivalent because our regression model has only
one explanatory variable) as the test statistic. Here our null
hypothesis is that the regression coefficient will be zero and
hence the alternative hypothesis is that the regression
coefficient is non-zero. That is, if the null hypothesis cannot
be rejected (with 90 per cent level of confidence) we cannot
say that the alternative hypothesis will be necessarily true,
i e, the rates of interest necessarily depends positively on
the fiscal deficit-GDP ratio.
In the first column of Table 1 we have mentioned the kind
of rates of interest taken into consideration. The numbers in the
second column denote the level at which both the series of interest
rate and fiscal deficit-GDP ratio are stationary, i e, 1 denotes that
both the series are stationary at their current values, 2 denotes
that both the series are stationary at their first difference level
and 3 means they are stationary at their second difference levels.
Other columns carry the usual meanings of their respective
column headings. The meanings of abbreviations used in Table 1
are as follows, Order ⇒ Order of co-integration where both the
series are stationary, Obs ⇒ Number of observations, Coeff ⇒
(Linear) Regression coefficient, P>F/|t| ⇒ Probability of
null hypothesis that regression coefficient is zero to be true,
R2/AdjR2 ⇒ their usual meanings.
As far as real government bond yields are concerned we see
from Table 1 that the yield from the central government security
series is stationary at its first difference level. However, neither
correlation nor the regression coefficients, at the first difference
level with respect to fiscal deficit-GDP ratio,5 is significant. It
is evident that the real government bond yield series is stationary
at its first difference level but here too neither correlation
nor regression coefficients are significant. Both in case of real
medium- and long-term government bond yields it is evident that
the series are stationary at their first difference level but none
of the correlation and regression coefficients are significant. In
other words the null hypotheses cannot be rejected even at 90
per cent level of confidence. Therefore, from our above men-
tioned results, it will be erroneous to argue that government bond
yields are necessarily affected by the fiscal deficit-GDP ratio or
a higher fiscal deficit-GDP ratio will necessarily cause govern-
ment bond yields to increase.
Now let us consider the deposit rates. The real short-term
deposit rate series in our country is stationary at its first difference
level but neither the correlation nor the regression coefficients
are significant. If the medium- or long-term real deposit rates
are taken into consideration, the result still does not alter in the
sense that the series become stationary at the first difference level
However, the correlation and the regression coefficients are
insignificant when we take fiscal deficit-GDP ratio as the ex-
planatory variable. Therefore the change in real deposit rates in
India does not necessarily depend upon the change in the fiscal
deficit-GDP ratio during the last decade.
Now we will consider lending rates and their relation with the
fiscal deficit-GDP ratio in India during the time period 1990-
1991 to 2000-2001. It is evident that both the current SBI lending
rate series and its first difference are stationary but their corre-
lation coefficients with the fiscal deficit-GDP ratio or the change
of fiscal deficit-GDP ratio are insignificant. The regression co-
efficients of real SBI lending rate on the fiscal deficit-GDP ratio
or of the change of real SBI lending rate on the change in fiscal
Economic and Political Weekly March 20, 2004
deficit-GDP ratio are insignificant. The real average lending rate
of all major lending institutions series in India is stationary at
its first difference level but both correlation coefficient of change
in real lending rate and change in fiscal deficit-GDP ratio and
regression coefficient of change in real lending rate on change
in fiscal deficit-GDP ratio are highly insignificant. Therefore,
in the case of lending rate also, according to our observations
there is no definite relation between real lending rate and fiscal
deficit-GDP ratio. In other words it will be erroneous to argue
that high fiscal deficit-GDP ratio raises the lending rates and in
turn, necessarily causes crowding out of private investment.
As far as the short or long term real treasury bill rates are
concerned we see that both the series are stationary at their first
difference level. In case of real 91-days (short-term) treasury bills
the correlation as well as the regression coefficients between the
change in treasury bill rate and change in fiscal deficit-GDP ratio
are highly insignificant. In case of real 364-days (long-term)
treasury bills, we get the same insignificant correlation and
regression coefficients. Therefore in general we can tell that it
will not be justified to claim any necessary relation between fiscal
deficit-GDP ratio and real treasury bill rates in India during the
period under consideration.
The results of correlation between real call money rate and
fiscal deficit-GDP ratio and between the first differences of both
the variables and the results of unit root tests are also given. From
Table 1, it is observable that the real call money rate series
becomes stationary at its first difference level but both correlation
and regression coefficients are highly insignificant. Therefore in
India it cannot be said that the real money market rate of interest
essentially depends on the fiscal deficit-GDP ratio, particularly
in the period under consideration.
In this section, we have tried to examine whether any necessary
relationship exists between rates of interest and fiscal deficit-
GDP ratio in the Indian context considering various real rates
of interest such as the government bond yield, deposit rate,
lending rate, 91 and 364 days treasury bill rates, call money rate
during the time span 1990-1991 to 2000-2001. On the basis of
available empirical evidence we can conclude by saying that there
is absolutely no reason to believe that the rates of interest would
necessarily rise if the fiscal deficit, as a proportion of GDP, is
raised under the so-called deregulated regime of interest rates,
in the context of Indian economy.
IV
International Evidence
In this section we want to see the empirical evidence on the
relationship between the fiscal deficit and the level of interest
rates for countries other than India. Here we wish to test whether
the statement that ‘the fiscal deficit-gross domestic product ratio
necessarily affects the real rates of interest’ is valid for different
countries all over the world. Moreover on the basis of the
available information, we want to examine whether a fiscal deficit
is necessarily bad for the health of the economy, in the sense
that it necessarily raises interest rates and causes a crowding out
of private investment.
We have used International Financial Statistics (IFS) data
available in the ‘Yearbook of International Financial Statistics
2000’ provided by International Monetary Fund (IMF). We have
taken the data of 17 years (1983-1999) into consideration. We
have calculated the real rates of interest for five kinds of interest
1305
Table 2: Results of Unit Root Test, Order of Co-Integration and Regression of Different Interest Rates on Fiscal Deficit-GDP Ratio
No Category Order Country Obs P>F R2 Adj R2 Coefficient P>|t|

1 GBY 1 Austria 12 0.1874 0.1669 0.0835 122.467 0.187

2 GBY 1 Sri Lanka 10 0.8067 0.0079 -0.1161 53.1277 0.807
3 GBY 1 Venezuela 15 0.8566 0.0026 -0.0741 40.99107 0.857
4 GBY 2 Belgium 14 0.9216 0.0008 -0.0824 -15.18239 0.922
5 GBY 2 Ireland 15 0.0479 0.2685 0.2122 129.3144 0.048
6 GBY 2 Pakistan 16 0.3919 0.0528 -0.0148 61.3544 0.392
7 GBY 2 Sweden 11 0.2176 0.1634 0.0704 -36.87868 0.218
8 GBY 3 Norway 9 0.4842 0.0455 -0.0413 -42.48041 0.484
9 GBY 3 Denmark 15 0.0038 0.4866 0.4472 -220.1706 0.004
10 GBY 3 Thailand 12 0.5032 0.0460 -0.0494 -141.6749 0.503
1 TBR 1 Bulgaria 8 0.4921 0.0819 -0.0711 1818.653 0.492
2 TBR 1 Israel 15 0.0006 0.6100 0.5799 -820.1708 0.001
3 TBR 1 Poland 6 0.2035 0.3657 0.2071 -525.5587 0.203
4 TBR 1 Sri Lanka 16 0.7732 0.0061 -0.0649 -47.5655 0.773
5 TBR 2 Hungary 10 0.2530 0.1594 0.0544 492.7953 0.253
6 TBR 2 Malaysia 13 0.0494 0.3070 0.2440 102.7307 0.049
7 TBR 3 Zimbabwe 7 0.3656 0.1652 -0.0018 -158.3041 0.366
1 LR 1 Bulgaria 9 0.4493 0.0840 -0.0468 1840.43 0.449
2 LR 1 El Salvador 17 0.1546 0.1303 0.0723 238.6198 0.155
3 LR 1 Venezuela, Rep Bol 15 0.9217 0.0008 -0.0761 24.94039 0.922
4 LR 2 Colombia 13 0.4312 0.0572 -0.0285 -54.82819 0.431
5 LR 2 Czech Republic 6 0.4731 0.1353 -0.0809 -131.8965 0.473
6 LR 2 Egypt 13 0.2592 0.1140 0.0335 -72.39933 0.259
7 LR 2 Hungary 9 0.1958 0.2261 0.1155 563.024 0.196
8 LR 2 Peru 12 0.0583 0.3136 0.2449 -14049.61 0.058
9 LR 2 Poland 9 0.3248 0.1381 0.0150 -494.4919 0.325
10 LR 3 Belarus 5 0.1252 0.5978 0.4637 59769.05 0.125
11 LR 3 Chile 15 0.2231 0.1118 0.0435 502.6915 0.223
12 LR 3 Denmark 15 0.0101 0.4105 0.3651 -216.9105 0.010
13 LR 3 Ecuador 10 0.4911 0.0611 -0.0562 196.2485 0.491
14 LR 3 Thailand 12 0.4118 0.0683 -0.0248 -149.3268 0.412
1 DR 1 Argentina 12 0.6473 0.0218 -0.0761 -77615.32 0.647
2 DR 1 Austria 12 0.1231 0.2209 0.1430 151.1763 0.123
3 DR 1 Bulgaria 9 0.4799 0.0737 -0.0587 1739.613 0.480
4 DR 1 El Salvador 17 0.1508 0.1326 0.0748 222.9907 0.151
5 DR 1 Israel 17 0.4367 0.0408 -0.0231 73.90268 0.437
6 DR 1 Venezuela Rep Bol 15 0.8881 0.0016 -0.0752 -34.7868 0.888
7 DR 2 Belgium 14 0.8619 0.0026 -0.0805 29.33359 0.862
8 DR 2 Colombia 13 0.3692 0.0738 -0.0104 -62.90698 0.369
9 DR 2 Czech Rep 6 0.3670 0.2052 0.0065 -172.3902 0.367
10 DR 2 Hungary 15 0.2193 0.1136 0.0454 330.1716 0.219
11 DR 2 Jordan 7 0.8642 0.0064 -0.1923 -11.62897 0.864
12 DR 2 Poland 5 0.4513 0.1992 -0.0678 -785.2854 0.451
13 DR 2 Slovenia 5 0.9287 0.0031 -0.3291 -7.927066 0.929
14 DR 3 Belarus 5 0.1333 0.5825 0.4434 59174.54 0.133
15 DR 3 Chile 15 0.1819 0.1327 0.0660 547.1868 0.182
16 DR 3 Denmark 15 0.0028 0.5101 0.4724 -222.3814 0.003
17 DR 3 Norway 13 0.5646 0.0311 -0.0570 -35.54968 0.565
18 DR 3 Thailand 12 0.3177 0.0996 0.0095 -175.0124 0.318
1 MMR 1 Argentina 9 0.0244 0.5388 0.4729 4042.467 0.024
2 MMR 1 Bulgaria 9 0.5002 0.0673 -0.0659 1640.381 0.500
3 MMR 1 Indonesia 15 0.1322 0.1656 0.1014 -326.5479 0.132
4 MMR 1 Sri Lanka 17 0.6458 0.0145 -0.0512 -64.90381 0.646
5 MMR 2 Austria 11 0.5475 0.0416 -0.0649 68.28616 0.548
6 MMR 2 Belgium 14 0.6992 0.0129 -0.0694 65.51469 0.699
7 MMR 2 Ireland 16 0.0172 0.3427 0.2957 182.9615 0.017
8 MMR 2 Kuwait 11 0.3666 0.0912 -0.0097 7.059883 0.367
9 MMR 2 Malaysia 13 0.0875 0.2423 0.1734 82.79058 0.087
10 MMR 2 Morocco 6 0.0571 0.6367 0.5459 -253.3792 0.057
11 MMR 2 Pakistan 16 0.3306 0.0676 0.0010 79.14081 0.331
12 MMR 2 Singapore 14 0.0271 0.3454 0.2909 -86.56216 0.027
13 MMR 2 Slovenia 5 0.8553 0.0130 -0.3160 -22.00739 0.855
14 MMR 2 Tunisia 16 0.4669 0.0384 -0.0303 22.84936 0.467
15 MMR 2 Turkey 12 0.3434 0.0900 -0.0010 259.4499 0.343
16 MMR 2 Uruguay 5 0.4910 0.1695 -0.1073 194.3757 0.491
17 MMR 3 Norway 13 0.9937 0.0000 -0.0909 0.5710075 0.994
18 MMR 3 Poland 4 0.9603 0.0016 -0.4976 -55.32075 0.960
19 MMR 3 Thailand 12 0.2513 0.1291 0.0421 -215.2747 0.251
20 MMR 3 Denmark 15 0.0072 0.4379 0.3947 -245.0373 0.007
21 MMR 3 Finland 14 0.9796 0.0001 -0.0833 -1.561747 0.980
22 MMR 3 Korea 15 0.6174 0.0197 -0.0557 -58.46089 0.617

Source: Calculated from IFS CD-ROM – 2001, IMF.

1306 Economic and Political Weekly March 20, 2004

rates, viz, government bond tield (GBY), treasury bill rate
(TBR), money market rate (MMR), lending rate (LR) and
deposit rate (DR) with respect to wholesale prices of the
respective years for each country for which data are available.
If the nominal rate of interest is R per cent and the inflation
rate is û = (dP/P)X100, then the real rate of interest is
calculated as r = R- û. We have calculated the fiscal deficit-
GDP ratio simply by dividing fiscal deficit in the national
currency for each country by GDP in the national currency
for the respective years. Exclusion of countries is dictated
entirely by the non-availability of data. For those countries
where the so-called regulated regime of rate of interest was
previously in operation, we have excluded them or the years
during which interest rates were regulated. In this section also,
we used the same technique and same econometric tools as in
the preceding section.
In the second column of Table 2, we have mentioned the kind
of rates of interest taken into consideration. The numbers in the
third column denote the level at which both the series of interest
rate and fiscal deficit-GDP ratio are stationary, i e, 1 denotes that
both the series are stationary at their current values, 2 denotes
that both the series are stationary at their first difference level
and 3 means they are stationary at their second difference levels.
Other columns carry the usual meanings of their respective
column headings. We did not take industrially developed coun-
tries called the G7 countries into consideration and exclusion
of some other countries are strictly because of unavailability of
data. All the calculations are done in STATA – 7 package and
all the data are collected from International Financial Statistics
CD-ROM – 2001 (provided by IMF). The meanings of abbre-
viations used in Table 2 are as follows: Order ⇒ Order of co-
integration where both the series are stationary, Obs ⇒ Number
of observations, Coeff ⇒ (Linear) Regression coefficient, P>F/
|t| ⇒ Probability of null hypothesis that regression coefficient
is zero to be true, R2 /AdjR2 ⇒ their usual meanings.
Let us first consider the government bond yield (GBY) and
see its relationship with the fiscal deficit-GDP ratio. For Australia,
Venezuela and Sri Lanka both the series, viz, fiscal deficit – GDP
ratio and the real government bond yield are stationary; for
countries like Belgium, Ireland, Pakistan and Sweden both the
series are stationary at their first difference level and for Norway,
Denmark and Thailand both the series are stationary at their
second difference level. Out of a total of 10 countries only for
two countries, namely, Ireland and Denmark, are the regression
coefficients significant at 90 per cent level of confidence. But
for Ireland the sign of the regression coefficient is positive, and
in the case of Denmark it is negative. As far as the government
bond yield is concerned, we can conclude that it does not nec-
essarily depend on the fiscal deficit-GDP ratio, except in the case
of Ireland. Only in case of Ireland are the regression coefficients
positive and significant. Otherwise our results show that the
regression coefficients are either insignificant or negative.
Therefore it is not true that if the fiscal deficit-GDP ratio in-
creases, the real government bond yield will necessarily rise.
In case of treasury bill rate (TBR) we see that for countries
Bulgaria, Israel, Poland and Sri Lanka both real interest rate and
fiscal deficit – GDP ratio series are stationary; for Hungary and
Malaysia at their first difference level and for Zimbabwe at their
second difference levels both the series are free of unit roots.
Among seven countries, only for Israel and Malaysia, is the
probability of the null hypothesis, that the regression coefficient
Economic and Political Weekly March 20, 2004
will be zero, less than 10 per cent. For Malaysia, the sign of
the correlation coefficient is positive but it is negative for
Israel. Hence it will not be justified to conclude that the fiscal
deficit-GDP ratio necessarily affects the rate of interest
positively, particularly when the short-term treasury bill is
concerned. From the above results, in fact, there is no reason
to believe that a higher fiscal deficit-GDP ratio will necessarily
raise the real treasury bill rates.
For Bulgaria, El Salvador and Venezuela both fiscal deficit-
GDP ratio and real lending rate (LR) series are stationary; they
are stationary at their first difference level for countries Colom-
bia, Czech Republic, Egypt, Hungary, Peru and Poland and at
their second difference level for Belarus, Chile, Denmark, Ecuador
and Thailand. Among the total of 14 countries, only for Peru
and Denmark is the probability of null hypothesis, that the
regression coefficient will be zero, less than 10 per cent. More-
over, both the significant coefficients are negative, i e, if fiscal
deficit-GDP ratio increases the lending rate decreases and vice
versa. As far as the real prime lending rate is concerned we see
that there is not even a single country under consideration where
the regression coefficient of real lending rate on fiscal deficit-
GDP ratio or of change in real lending rate on change in fiscal
deficit-GDP ratio significant as well as positive. Therefore, this
case as well, there is no reason to believe that the fiscal deficit-
GDP ratio necessarily affects the real lending rate or an increase
in the fiscal deficit, as a percentage of GDP, will necessarily cause
the prime lending rate to go up.
The real deposit rate (DR) and the fiscal deficit-GDP ratio
become free of unit roots for Argentina, Austria, Bulgaria, El
Salvador, Israel and Venezuela; for Belgium, Colombia, Hun-
gary, Czech Republic, Jordan, Poland and Slovenia at their first
difference level and for Belarus, Chile, Denmark, Norway and
Thailand at their second difference level. Out of a total of 18
countries only in the case of Denmark do we get a significant
regression coefficient but that coefficient also has a negative sign.
Therefore, from here also, it will not be prudent to argue that
a higher fiscal deficit, as a proportion of GDP, necessarily leads
to a higher real deposit rate in the economy.
If we take into account the real money market interest rate or
MMR we see that both interest rate and the FD-GDP ratio series
become stationary for the countries Argentina, Bulgaria, Indo-
nesia and Sri Lanka; both the series become stationary at their
first difference level for countries Austria, Belgium, Ireland,
Kuwait, Malaysia, Morocco, Pakistan, Singapore, Slovenia,
Tunisia, Turkey and Uruguay. Both the series become unit root
free at their second difference level for Norway, Poland, Thai-
land, Denmark, Finland and Korea. Out of a total of 22 countries,
only in the case of Argentina, Ireland, Malaysia, Morocco,
Singapore and Denmark are the regression coefficients signifi-
cant, i e, we can reject the null hypothesis with at least 90 per
cent level of confidence. Among them, for Argentina, Ireland
and Malaysia the coefficients are positive but for Morocco,
Singapore and Denmark the coefficients are negative. Therefore
this empirical evidence also does not support the widely believed
proposition that a higher fiscal deficit or higher fiscal deficit-
GDP ratio necessarily raises the real rate of interest (in this case
the real money market rate of interest) in the economy.
In this section we have considered five kinds of rates of interest,
viz, real government bond yield, short-term treasury bill rate,
prime lending rate, deposit rate and money market rate of interest.
In fact there are only a few countries where the correlation
1307
between the real rate of interest and fiscal deficit-GDP ratios,
or the change in the real rate of interest and change in fiscal deficit-
GDP ratio are significant and positive, i e, move in the same
direction. The regression results of the rates of interest on the
fiscal deficit-GDP ratio show that, for very few countries, the
regression coefficients are significant as well as positive. That
is, for very few countries it can be said that the fiscal deficit,
as a proportion of GDP, rises, as a result of which the rates of
interest rise. Again, when we regress the change in real interest
rates on change in fiscal deficit-GDP ratio, we get similar results
as before, in the sense that, for very few countries, it gives
significant positive results. It means that for very few countries
it is true that changes in the fiscal deficit-GDP ratio cause rates
of interest to change in the same direction. Therefore, we can
conclude from this section that it is not justified to say – at least
as far as empirical evidence of different countries (obviously
those countries which we have considered in our present work)
is concerned – that the fiscal deficit, as a proportion of GDP
necessarily raises the rates of interest in the economy and, hence,
in turn necessarily causes crowding out.
V
Conclusion
In the second section of this paper, different theoretical argu-
ments which say that a fiscal deficit financed by borrowing from
the domestic market necessarily raises the real rates of interest
in the economy, were discussed along with their counter argu-
ments. The pre-Keynesian positions were discussed and it was
shown how full employment is the underlying assumption of
these theoretical prescriptions. This assumption is necessary for
the logical tenability of the argument, irrespective of whether
the savings curve (as a function of the interest rate) is vertical
or upward sloping. The loanable fund theory of Dennis Robertson
was also discussed along with its counter arguments. The fixed
pool of bank credit view and its limitations were discussed
together with the ‘displacement of private capital by government
debt’ argument of Samuelson and Nordhaus. Having discussed
the above mentioned versions of the theory that ‘the fiscal deficit
necessarily causes real interest rates to rise,’ we have reached
the conclusion that the theory is untenable in its various versions.
There is absolutely no reason to believe that real rates of interest
would necessarily rise due to the fiscal deficit or due to deficit
financing of the government in any economy.
In the third section of paper, data on the Indian economy was
analysed. Here, with the help of some elementary econometric
tools like correlation, unit root tests and regression, it was tested
whether any definite positive relationship between real rates of
interest and the fiscal deficit-GDP ratio exists. We considered
different kinds of interest rates, viz, government bond yields,
deposit rates, lending rates, 91-day and 364-day treasury bill rates
and the call money rate of the Indian economy, during the time
period 1990-1991 and 2000-2001 or the period of deregulated
rates of interest. Finally, we came to the conclusion that it would
be erroneous to argue that a higher fiscal deficit-GDP ratio would
necessarily raise the real rates of interest in the Indian economy.
The fourth section of our present work concentrates on the
empirical evidence available for different countries all over the
world during the last two decades (1980s and 1990s). In this
section also, the data of different real rates of interest, viz, real
government bond yields, short-term treasury bill rates, prime
1308
lending rates, deposit rates and money market rates of interest
and their relation with the fiscal deficit-GDP ratio were analysed.
This section concluded that, as far as the empirical evidence from
different countries all over the world is concerned, it would not
be justified to argue that the fiscal deficit, as a proportion of
GDP, necessarily raises real rates of interest in the economy and
hence affects growth by crowding out private investors.
This paper ends with the conclusion that interest rates do not
necessarily depend on the fiscal deficit -29and that policies based
on this understanding are also erroneous. The argument that ‘the
interest rates are high because of government borrowing’ has
neither any theoretical nor any empirical basis, neither in India
nor in other countries around world.
Address for correspondence:
dsurajit_jnu@yahoo.com
Notes
[For this paper, I am very much indebted to Prabhat Patnaik, Prasenjit Bose
and Jyotirmoy Bhattacharya. Without their academic help and moral support
this work would not have been completed.]
1 From the ex post identity (S-I) + (M-X) º (G-T) we get that a fiscal deficit
always generates an amount of (S+M) over (I+X) equal to itself. Therefore
the current account crisis is not necessary.
2 In the presence of huge involuntary unemployment and unutilised capacity
there is absolutely no reason to believe that there will be only price
adjustment instead of output adjustment. In fact there will be output
adjustment through Keynes-Kahn multiplier and that adjustment will
continue until supply matches the increased demand in the long run
(provided the economy does not reach full employment before that).
3 See Kahn 1972,
4 See Patnaik 2001.
5 Fiscal deficit-GDP ratio is stationary and its first difference is also
stationary.
References
Branson, W H (1989): Macroeconomic Theory and Policy, Harper and Row
Publishers, third edition, New York.
Kahn, R (1954): ‘Some Notes on Liquidity Preference’, Manchester School
of Economics and Social Studies, September, pp 229-57.
– (1972): ‘Selected Essays in Employment and Growth’, Cambridge University
Press, Cambridge.
Keynes, J M (1936): The General Theory of Employment, Interest and
Money, Harcourt, Bruce and Company, New York.
Patnaik, P (2001): ‘On Fiscal Deficits and Real Interest Rates’, Economic
and Political Weekly, April 14.
Samuelson, P A and W D Nordhaus (1989): Economics, Mcgraw-Hill Book
Company.
Economic and Political Weekly March 20, 2004