Fiscal expansion stretched longer could harm economy: RBI study

Expansionary fiscal policies are effective in raising the level of output over the potential level only in the short run. In the medium-to-longer term, however, fiscal expansion only leads to economic slowdown, according to a working paper presented by the Reserve Bank of India (RBI).

The paper, prepared by Janak Raj, JK Khundrakpam and Dipika Das, noted that the reactions of the two policies to shocks in inflation and output are mostly in the opposite directions. While monetary policy reacts in a counter-cyclical manner, fiscal policy reaction is primarily pro-cyclical in nature.

"The positive impact of expansionary fiscal policy on output is highly short-lived, but there is a significant negative impact in the medium to long-term," the paper said.

Government's fiscal deficit and subsequent borrowing from the market could lead to a decline in overall savings and investment in the economy over the medium term, besides crowding out a more efficient private sector, the study noted.

According to the study, fiscal policy continues to unilaterally influence monetary policy in India even after the elimination of automatic monetisation of fiscal deficit and prohibition of RBI from buying government securities from the primary market.

The RBI is prohibited from buying government securities in the primary market under the FRBM Act, 2003, beginning April 2006.

Also, the operating procedure of RBI's monetary policy had undergone a paradigm shift in the early 2000 with the introduction of liquidity adjustment facility and the interest rate channel becoming the main monetary policy-signaling instrument.

Empirical evidence using quarterly data between Q1-2000 and Q2-2010, available with the RBI, showed that fiscal policy continues to substantially influence the conduct of monetary policy in the country.