Debt, deficits, and inflation: An application to the public finances of India

Abstract

The paper studies the solvency of the Indian public sector and the eventual monetization and inflation that would be implied by stabilization of the debt-GNP ratio in the absence of changes in the primary deficit. The nonstationarity of the discounted public debt suggests that indefinite continuation of the pattern of behavior reflected in the historical time-series process is inconsistent with the maintenance of solvency. This message is reinforced by the recent behavior of the debt-GNP ratio and of the ratio to GNP of the sum of the primary budget surplus and seigniorage. Our estimates of the base money demand function suggests that even maximal use of the inflation tax would not be sufficient to restore solvency. Measures to reduce the primary deficit are therefore unavoidable.