The purpose of this paper is to examine the deficit–inflation nexus in the two fastest growing economies, India and China, which happen to be crucial affiliates of the global growth generator countries apart from their association in Brazil, Russia, India, China, and South Africa.
The paper uses the prism of the vector auto regression framework, for the period 1985–1986 to 2016–2017 for both India and China. For this purpose, gross fiscal deficit, money supply, exchange rate, crude oil prices and output gap are examined as the key elements in the determination of inflation. The econometric framework used chiefly comprises of cointegration analysis, vector error correction model, Granger causality and impulse response functions.
The findings of this paper support the hypothesis that fiscal deficits are inflationary only in the Indian context and that the Ricardian equivalence cannot be negated for China at least in the short run. The results presented in the paper are a little agnostic about whether New Keynesian Phillips Curve (NKPC) explains the inflation dynamics in India, given that both inflation inertia and output gap are not robust. However, for the Chinese economy, NKPC along with structural theory is instrumental in describing trends pertaining to inflation during the period of the study.
The paper warrants broader policy framework to aim at addressing structural bottlenecks to ensure non-inflationary growth keeping in mind the structural views on inflation. Furthermore, the paper fosters greater synthesis between monetary and fiscal policies, especially considering the global economic disruptions the world economy is subject to.
Considering there are only a limited number of studies on fiscal deficit of China, the present paper is of paramount significance in terms of growing concern over the sustainability of the growth process in China. Additionally, the paper is first-of-its-kind attempt to account the effectiveness of a healthy monetary–fiscal interface in achieving macroeconomic stability in India and China.
The episode of global financial crisis (GFC) and economic disruptions like Covid-19 flag the issue of containing inflation and fiscal deficit as a prerequisite for reviving growth in emerging market economies (EMEs). Fiscal policy which is permanently expansionary is not only highly unsustainable but also often blamed for high and persistent inflation. Much of the prevailing literature is full of the unfriendly results of inflation irregularities but has not explored its major sources and deficit–inflation nexus in the two fastest growing economies, India and China, who happen to be crucial affiliates of the global growth generator countries  apart from their association in Brazil, Russia, India, China, and South Africa.
Concluding remarks and policy implications
5. Concluding remarks and policy implications China’s boom since the late 1970s has been a major success story in economic circles. Nevertheless, less phenomenal, but still significant growth pickup of India since 1980s intrigues one to carry out a detailed macroeconomic analysis of both the economies. In this light, the present paper is an attempt to examine the comparative trends in fiscal deficit and inflationary developments in India and China. There is enough support for the hypothesis that fiscal deficits are inflationary only in the Indian context; and that the Ricardian equivalence cannot be negated for China at least in the short run. Our results also suggest that in the short run, monetary policy needs to respond decisively to tackle China’s deflation problem considering the indirect role of monetary policy as per the Granger causality results. Besides, in the short run, the supply and demand-driven factors are more important than fiscal policy in managing inflation in China. Concomitantly, almost all the factors, namely, fiscal deficit, money supply, exchange rate and oil prices, are relevant in tackling inflation in India in the near term.