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Determination of Interest Rate in India: Empirical Evidence on Fiscal Deficit-Interest Links and Financial Crowding Out

Controlling for the capital flows, using the high frequency macrodata of financially deregulated regime, the paper examined whether there is any evidence of fiscal deficit determining interest rate in the context of India. The period of analysis is FY 2006-07[04] to FY 2011[04]. Quite contrary to the debates in the policy circles, the results found that increase in fiscal deficit does not cause the rise in interest rates. Using the asymmetric vector autoregressive model, it is established that the rate of interest is affected by the reserve money changes, expected inflation and volatility in the capital flows, but not the fiscal deficit. This result has significant policy implications for interest rate determination in India. The long term and short term interest rates are analysed to determine the occurrence of financial crowding out, but fiscal deficit does not appear to be causing both shorts and longs.