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Is Fiscal Policy Contracyclical in India?

An Empirical Analysis

November 20, 2007

By Pinaki Chakraborty and Lekha S. Chakraborty

ABSTRACT: The paper empirically examines the validity of Keynesian philosophy of contracyclical variation in fiscal policy to the macroeconomic activity in India. The macroeconomic activity is proxied by ‘output gap’ a concept defined to estimate the index of economic activity. Applying Johansen’s Full Information Maximum Likelihood test of cointegration, it was found that there exists a long run, stable relationship between fiscal policy stance and macroeconomic activity. Further, the causality detection in asymmetric vector autoregression model revealed that there exists feedback mechanism between fiscal policy stance and output gap, which reinforces the Keynesian theory that fiscal stance is contracyclical in nature. The policy implication of these results points to the fallacy of rule-based fiscal policy to contain fiscal deficit, based on the neo-classical assumption that fiscal deficit has detrimental effects through financial crowding out. The results reinforced the role of fiscal deficit not as an evil but as an instrument of short run demand management and also the significance of pump priming.

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