1. Fiscal Deficit-Economic Growth Nexus in India: A Cointegration analysis
Ranjan Kumar Mohanty1
Abstract
The basic aim of the study is to examine both the short run and long run relationship between
fiscal deficit and economic growth in India by covering the time period from 1970-71 to 201112. Johansen Cointegration test, Granger Causality test, And Vector Error correction Model
(VECM) technique are adopted in order to examine the objectives of this study. The Johansen
methodology confirms the existence of long run relationship between GDP and the selected
variables. The findings of the paper indicate that there is negative and significant relationship
between fiscal deficit and economic growth in the long run. One percent increase in Fiscal deficit
is likely to significantly decrease gross domestic product by 0.216537. But the Vector Error
Correction model and Granger Causality test discards the short run relationship between fiscal
deficit and economic growth. The findings of study also reveal that the negative impact of postreform fiscal deficit on economic growth is more than the impact of pre-reform’s fiscal deficit.
This is contrary to Keynesian theory, but in conformity with Neo-classical theory, which holds
that fiscal deficits lead to a fall in the Gross Domestic Product. The study suggests the reduction
of subsidies and invests this money in health, education, infrastructure sectors such as power and
roads etc., so that it will enhance the productivity of both human capital and physical capital,
which will go a long way in increasing the percapita income of the people.
Key Words: - Fiscal deficit, Economic Growth, Johansen Cointegration, Granger Causality,
Vector Error Correction.
JEL Codes: H62, O40, C32.
I. Introduction
The impact of fiscal deficit on economic growth is one of the highly debated issues in all world
economies. The target of achieving sustained growth and maintaining macroeconomic stability is
the dream among many developed, developing and underdeveloped economies. The economic
growth and stability of developing countries in recent times has brought the issues of fiscal
deficit into sharp focus. Continuing high levels of fiscal deficit, even if adoption of fiscal
Responsibility and Budget Management Act (FRBM), pose a serious danger to macroeconomic
stability in India. The excessive fiscal deficits seem to be the major concern of academicians and
policy makers in India. The annual growth rate of GDP is 6.5 percent in 2011-12, whereas gross
fiscal deficit is 5.8 percentage of GDP in same period in India. Now, the question of interest is
whether this persistent fiscal deficit hampers economic growth in India? How has increase in
fiscal deficits impacted India’s economic growth over the last four decades?
In India, gross fiscal deficit is defined as the excess of the sum total of revenue expenditure,
capital outlay and net lending over revenue receipts and non-debt capital receipts including the
proceeds from disinvestment. The government has to incur deficits to finance its revenue and
1
Mohanty is a Ph.D scholar at the Centre for Economic Studies & Planning, School of Social Sciences, Jawaharlal
Nehru University, New Delhi-110067, India. Mail- ranjanmohanty85@gmail.com, phone- +91 9013673174

2. expenditure mismatches and also to finance investments. The problem arises when the deficit
level becomes too high and chronic. The ill-effects of high deficits are linked to the way they are
financed and how it is used. The fiscal deficits can be financed through domestic borrowing,
foreign borrowing or by printing money. Excess use of any particular mode of financing of the
fiscal deficit has adverse macroeconomic consequences, viz, seigniorage financing of fiscal
deficit can create inflationary pressures in the economy, bond financing of fiscal deficit can lead
to rise in interest rates and in turn can crowd out private investment and the external financing of
fiscal deficit can spill over to balance of payment crisis and appreciation of exchange rates and in
turn debt spiraling.
Sometime large fiscal deficit can affect the country’s economic growth adversely. A higher fiscal
deficit implies high government borrowing and high debt servicing which forces the government
to cut back in spending on relevant sectors like health, education and infrastructure. This reduces
growth in human and physical capital, both of which have a long-term impact on economic
growth. Large public borrowing can also lead to crowding out of private investment, inflation
and exchange rate fluctuations. However, if productive public investments increase and if public
and private investments are complementary, then the negative impact of high public borrowings
on private investments and economic growth may be offset. Fiscal deficit used for creating
infrastructure and human capital will have a different impact than if it is used for financing illtargeted subsidies and wasteful recurrent expenditure. Therefore the fear about high fiscal deficit
is justified if the government incur deficit to finance its current expenditure rather than capital
expenditure.
In this context, it is important to understand the consequences of rising fiscal deficit on the
economic growth of Indian economy. There have been concerns about the high fiscal deficit. The
literature, in particular the empirical part, on the relationship between fiscal deficit and economic
growth is scarce. Recent empirical studies investigate the impact of budget deficit on growth in
advanced and emerging countries by using cross country data and only few of them; attention is
devoted to the country specific. This study has examined the empirical relationship between
fiscal deficit and economic growth in India by using time series data from 1970-71 to 2011-12.
This study has also estimated the relationship by using two sub periods such as one for 19701991, and another for 1992-2011 for more clarification. Both short run and long run relationship
testing is being carried out in this study through Granger Causality test, Johansen Cointegration
and Vector Error Correction Model (VECM).
I.1 Trends in Deficit of Central Government in India
The following figure-1 traces the trends in deficits of central government over the past four
decades. The gross fiscal deficit as a percent of Gross Domestic Product (GDP) increased from
3.04 percent of GDP in 1970-71 to the peak of 8.37 percent in 1986-87 and then declined to 4.84
percent in 1996-97. It was around 7 percent of GDP during 1987-88 to 1990-91. During the
1990s the average fiscal deficit as a percent of GDP was 5.67 percent. However, after 2003-04
central governments contained the fiscal deficit from 4.48 percent of GDP to its all time
minimum of 2.54 percent in the year 2007-08. Then it increased to 6.48 percent in 2009-10 and
declined to 5.89 percent. Similarly primary deficit, which is fiscal deficit excluding interest
payment has increased from 1.74 percent in 1970-71 to a peak of 5.43 percent in 1986-87 and
declined to 0.53 percent of GDP in 1996-97. Primary deficit was dissolved from the year 200304 to the year 2007-08 except the year 2005-06. It was 2.78 percent during the year 2011-12.

3. After 1991-92, primary deficit has declined much due to the rising interest payment and to some
extent a decline in fiscal deficit. Revenue deficit was incurred in the period 1971-72 and 197273. It was 0.57 percent in 1979-80, after that it increased to 3.26 percent in 1990-91. It reached
maximum of 5.25 percent of GDP in 2009-10. The average of revenue deficit as a percentage of
GDP in 1980s, 1990s and 2000s has been 1.72 percent, 3.02 percent and 3.40 percent
respectively. It was 4.46 percent of GDP during the period 2011-12.
Figure-1
I.2 Gross Fiscal Deficit and Growth Rate of Gross Domestic product:As it is clear from the figure-2, India’s economic growth rate has been plotted against this GFD
to GDP ratio for the period 1970-71 to 2011-12. It is seen that the rate of growth is lower when
the GFD-GDP ratio of the Central government is high. This implies higher fiscal deficit may be
detrimental for the Indian economy. This simple trend analysis is not sufficient for any valid
inference. Therefore the study has used the advanced econometric technique.
Figure-2
In this paper, Section I is the introduction, while Section II discusses the theoretical issues and
empirical literature on fiscal deficit and economic growth. Section III presents the research
questions, objectives, data source and the methodology used in this study. Section IV analyses
the empirical results and interpretations and Section V concludes with a summary of the study
and recommendations.
II. Review of literature:
II.1 Theoretical Perspectives

4. There is no agreement among economists either on analytical grounds or on the basis of
empirical results whether financing government expenditure by incurring a fiscal deficit is good,
bad, or neutral in terms of its real effects, particularly on investment and growth. Generally
speaking, there are three schools of thought concerning the economic effects of budget deficits:
Neoclassical, Keynesian and Ricardian. Among the mainstream analytical perspectives, the neoclassical view considers fiscal deficits detrimental to investment and growth, while in the
Keynesian paradigm, it constitutes a key policy prescription. Theorists persuaded by Ricardian
equivalence assert that fiscal deficits do not really matter except for smoothening the adjustment
to expenditure or revenue shocks. While the neo-classical and Ricardian schools focus on the
long run, the Keynesian view emphasizes the short run effects.
II.1.1The Neo-Classical View
The component of revenue deficit in fiscal deficits implies a reduction in government saving or
an increase in government dis-saving. In the neoclassical perspective, this will have a detrimental
effect on growth if the reduction in government saving is not fully offset by a rise in private
saving, thereby resulting in a fall in the overall saving rate. This, apart from putting pressure on
the interest rate, will adversely affect growth. The neo-classical economists assume that markets
clear so that full employment of resources is attained. In this paradigm, fiscal deficits raise
lifetime consumption by shifting taxes to the future generations. If economic resources are fully
employed, increased consumption necessarily implies decreased savings in a closed economy. In
an open economy, real interest rates and investment may remain unaffected, but the fall in
national saving is financed by higher external borrowing accompanied by an appreciation of the
domestic currency and fall in exports. In both cases, net national saving falls and consumption
rises accompanied by some combination of fall in investment and exports. The neo-classical
paradigm assumes that the consumption of each individual is determined as the solution to an
intertemporal optimisation problem where both borrowing and lending are permitted at the
market rate of interest. It also assumes that individuals have finite life spans where each
consumer belongs to a specific generation and the life spans of successive generations overlap.
II.1.2 Keynesian View of Fiscal Deficits
The Keynesian view in the context of the existence of some unemployed resources, envisages
that an increase in autonomous government expenditure, whether investment or consumption,
financed by borrowing would cause output to expand through a multiplier process. The
traditional Keynesian framework does not distinguish between alternative uses of the fiscal
deficit as between government consumption or investment expenditure, nor does it distinguish
between alternative sources of financing the fiscal deficit through monetisation or external or
internal borrowing. In fact, there is no explicit budget constraint in the analysis. Subsequent
elaborations of the Keynesian paradigm envisage that the multiplier-based expansion of output
leads to a rise in the demand for money, and if money supply is fixed and deficit is bond
financed, interest rates would rise partially offsetting the multiplier effect. However, the
Keynesians argue that increased aggregate demand enhances the profitability of private
investment and leads to higher investment at any given rate of interest. The effect of a rise in
interest rate may thus be more than neutralised by the increased profitability of investment.
Keynesians argue that deficits may stimulate savings and investment even if interest rate rises,
primarily because of the employment of hitherto unutilised resources. However, at full
employment, deficits would lead to crowding out even in the Keynesian paradigm. In the
standard Keynesian analysis, if everyone thinks that a budget deficit makes them wealthier, it
would raise the output and employment, and thereby actually make people wealthier. Unlike the

5. loanable funds theory, the Keynesian paradigm rules out any direct effect on interest rate of
borrowing by the government.
II.1.3 Ricardian Equivalence Perspective
In the perspective of Ricardian, fiscal deficits are viewed as neutral in terms of their impact on
growth. The financing of budgets by deficits amounts only to postponement of taxes. The deficit
in any current period is exactly equal to the present value of future taxation that is required to
pay off the increment to debt resulting from the deficit. In other words, government spending
must be paid for, whether now or later, and the present value of spending must be equal to the
present value of tax and non-tax revenues. Fiscal deficits are a useful device for smoothening the
impact of revenue shocks or for meeting the requirements of lumpy expenditures, the financing
of which through taxes may be spread over a period of time. However, such fiscal deficits do not
have an impact on aggregate demand if household spending decisions are based on the present
value of their incomes that takes into account the present value of their future tax liabilities.
Alternatively, a decrease in current government saving that is implied by the fiscal deficit may be
accompanied by an offsetting increase in private saving, leaving the national saving and,
therefore, investment unchanged. Then, there is no impact on the real interest rate. Ricardian
equivalence requires the assumption that individuals in the economy are foresighted, they have
discount rates that are equal to governments’ discount rates on spending and they have extremely
long time horizons for evaluating the present value of future taxes. In particular, such a time
horizon may well extend beyond their own lives in which case they save with a view to making
altruistic transfers to take care of the tax liabilities of their future generations2.
II.2 Empirical Studies:
The study has reviewed some important empirical studies on fiscal deficit and economic growth.
Christopher S. Adam and David L. Bevan (2002) examined the relation between fiscal deficits
and growth for a panel of 45 developing countries and found a possible non-linearity in the
relation between growth and the fiscal deficit for a sample of developing countries. Yaya Keho
(2010) examined the causal relationship between budget deficits and economic growth for seven
West African countries over the period 1980-2005. The empirical evidence showed mixed
results. In three countries, it did not find any causality between budget deficit and growth. In the
remaining four countries, deficits had adverse effects on economic growth. Nelson and Singh
(1994) used data on a cross section of 70 developing countries during two time periods, 19701979 and 1980-1989, to investigate the effect of budget deficits on GDP growth rates. This study
concludes that the budget deficit had little or no significant effect on the economic growth of
these nations in the 1970s and 1980s.
Jorge C. Avila (2011) analyzed the relationship between fiscal deficit, macroeconomic
uncertainty and growth of Argentina for the period 1915-2006, and concluded that the deficit
hampered on per-capita income growth in Argentina through the volatility in relative prices.
Lance Taylor et al. (2012) examined the interactions between the ‘primary’ fiscal deficit,
economic growth and debt for the period 1961-20 of USA. It found a strong positive effect on
growth of a higher primary deficit, even when possible increases in the interest rate are taken
into account. Osinubi et al. (2006) synthesized a relationship between budget deficits and
external debt in Nigeria between 1970 and 2003. The results of the econometric analysis
confirmed the existence of the debt Laffer curve and the nonlinear effects of external debt on
growth in Nigeria.
2
C. Rangarajan, and Srivastava, D ,(2005), “Fiscal deficits and government debt in India: implications for growth
and stabilization”, National Institute of Public Finance and Policy (NIPFP),Working Paper no 35.

6. Goher Fatima et al. (2011) aimed at verifying the impact of government fiscal deficit on
investment and economic growth using time series of thirty years stretching between 1980 and
2009 and believed that fiscal profligacy has seriously undermined the growth objectives thereby
adversely impacting physical and social infrastructure in the country. Niloy Bose, M Emranul
Haque, and Denise R Osborn (2003) examined the growth effects of government expenditure for
a panel of thirty developing countries over the decades of the 1970s and 1980s and found that the
share of government capital expenditure in GDP is positively and significantly correlated with
economic growth, but current expenditure is insignificant.
Alfredo Schclarek (2004) empirically explored the relationship between debt and growth for a
number of developing and industrial economies. For developing countries, the study found that
lower total public external debt levels associated with higher growth rates and for industrial
countries, it did not find any significant relationship between gross government debt and
economic growth. Gadong T. Dalyop (2010) examined the effectiveness of fiscal deficits on the
growth rate of the Real Gross Domestic Product and found that fiscal deficit in the Nigerian
economy is Ricardian. Fiscal deficits therefore had little effect on the level of economic activity.
Khalifa H. Ghali (1997) built an endogenous growth model to untangle the nature of the
relationship between government expenditure and economic growth in Saudi Arabia by
examining the intertemporal interactions among the growth rate in per capita real GDP and the
share of government spending in GDP. The empirical analysis found no consistent evidence that
government spending can increase Saudi Arabia’s per capita output growth.
Nur Hayati Abd Rahman (2012) investigated the relationship between budget deficit and
economic growth from Malaysia’s perspective by using quarterly data from 2000 to 2011. It was
found that there is no long-run relationship between budget deficit and economic growth of
Malaysia, consistent with the Ricardian equivalence hypothesis. L.A.V. Catao and M. E.
Terrones (2005) showed a strong positive association between deficits and inflation among highinflation and developing country groups, but not among low-inflation advanced economies by
using the data from 107 countries over 1960–2001. Sanjeev Gupta et al. (2005) assessed the
effects of fiscal consolidation and expenditure composition on economic growth in a sample of
39 low-income countries during the 1990s. The paper found that strong budgetary positions are
generally associated with higher economic growth in both the short and long terms.
Richard J. Cebula (1995) examined the impact on per capita real economic growth in the United
States of federal budget deficits with quarterly data over the 1955-1992 periods. The empirical
findings indicated that federal budget deficits, over time, reduce the rate of economic growth.
Brender and Drazen(2008) found that high budget deficit recorded by a country will give
negative signals to the citizens that the government authorities did not perform well in managing
the funds of a country . As a result, there is a probability of re-election process to be conducted
in order to replace the authorities. Indirectly, the authorities who did not perform well may not be
able to bring the country to the upper level. Hence, it will not contribute to high economic
growth due to lack of confidence among citizens, investors and other neighboring countries.
Tan (2006) examined both the long and short run relationship between fiscal deficit, inflation
and economic growth in Malaysian economy during 1966-2003. They found the absence of long
run relationship among these variables and also found that fiscal deficits appeared to have neither
long nor short run links with income. Eisner and Pieper (1987) reported a positive impact of
cyclically and inflation-adjusted budget deficits on economic growth in the United States and
other Organization for Economic Cooperation and development (OECD) countries. The negative
impact of fiscal deficits on long-run growth has been empirically documented in several studies,

7. such as Fischer (1993), Easterly and Rebelo (1993), Easterly, Rodriguez, and Schmidt-Hebbel
(1994), Bleaney, Gemmell, and Kneller (2001). Fisher (1993) found that larger budget surpluses
were strongly associated with more rapid growth through greater capital accumulation and
greater productivity. Easterly and Rebelo (1992) also found a consistent negative relation.
III. Research Questions
Does fiscal deficit affect gross domestic product (GDP) of the Indian economy?
Does it significantly affect the growth of Indian economy in the long run?
Is there any short run relationship between fiscal deficit and GDP in India?
III.1 Objectives
To investigate the long run relationship between fiscal deficit and economic growth in
Indian economy
To examine the short run relationship between fiscal deficit and economic growth in
Indian economy
III.2 Data Source and Methodology
The study is entirely based on secondary data. The objectives of the study are examined by using
time series data covering period from 1970-71 to 2011-12. Relevant data for the study are
obtained from Data Base on Indian Economy from Reserve Bank of India. All variables are in
2004-05 bases and measured in real terms by using GDP deflator. All variables are converted to
natural log. This study has examined the empirical relationship between fiscal deficit and
economic growth in India by using three periods i.e. 1970-71 to 2011-12, 1970-1991 and 19922011 for more clarification.
The objectives of the study are being examined by using Unit root test (ADF and PP test),
Johansen Cointegration Test, Granger Causality test, And Vector Error correction Model
technique.
III.3 Econometric Specification
The study has used the following specifications in order to evaluate the effects of fiscal deficit on
economic growth. The following mathematical models are used for analysis.
GDP = ƒ (FISDEF, GDCF, EMPLM) -------------------------------------------------- eqn -1
The estimated Long run model is of the following form
∆LGDP = β1 + β2 LFISDEFt + β3 LGDCFt + β4 LEMPLMt + µ1 …………………..eqn-2
The estimated Vector Error Correction Model (VECM) is of the following form
∆LGDPt = α1 + α2 ∆LFISDEFt-1+ α3 ∆LGDCFt-1 + α4 ∆ LEMPLMt-1 + ECMt-1+ εt ..eqn-3
Where,
LGDP = Log of gross domestic product at factor cost proxy for economic growth
LFISDEF = Log of fiscal deficit held by the central government
LGDCF= Log of gross domestic capital formation
LEMPLM= Log of employment in the public and organized private sectors
µ and ε = Error term
∆= the first difference operator
α1, and β1 are intercepts, α2, α3, α4, β2, β3 and β4 are coefficients and µ and ε are error terms of
the estimated equations.

8. IV. Empirical Analysis:
IV.1 Testing for Unit Roots (ADF and PP)
In order to investigate the order of integration among the variables such as LGDP, LFISDEF,
LGDCF and LEMPLM, the study has used the Augmented Dickey Fuller (ADF) and Phillips
Perron (PP) tests. As per the above methodology, the tools of unit root tests ADF and PP tests are
tested for all the variables by taking null hypothesis as ‘presence of unit root’ (i.e. presence of
non-sationarity) against the alternative hypothesis ‘series is stationary’. If the absolute computed
value exceeds the absolute critical value, then we reject the null hypothesis and conclude that
series is stationary and vice-versa. It is clear from Table-1 and Table-2 that the null hypothesis of
no unit roots for all the time series are rejected at their first differences since the ADF and PP test
statistic values are less than the critical values at one percent levels of significances. Thus, these
variables are stationary and integrated of same order, i.e., I (1). Thus it is cleared that all the
variables have unit root in their level form but at first difference the variables became stationary.
Table -1 (ADF Test)
Level
First Difference
Variables
Constant
Constant&
Constant
Constant&
trend
trend
3.6527
-1.3720
-5.8904
-8.0161
LGDP
(1.0000)
(0.8549)
(0.0000)
(0.0000)
-0.9248
-2.8393
-6.7666
(0.7702)
(0.1926)
(0.0000)
1.1169
-1.7428
-7.4584
LGDCF
(0.9970)
(0.7137)
(0.0000)
-2.7165
-2.2685
-4.4364
LEMPLM
(0.0801)
(0.4401)
(0.0010)
Note- Brackets show MacKinnon (1996) one-sided p- values.
LFISDEF
-6.6726
(0.0000)
-7.9657
(0.0000)
-4.9184
(0.0015)
Table - 2 (PP Test)
Level
Constant
First Difference
Variables
Constant&
Constant
Constant&
trend
trend
4.8045
-1.3720
-5.9294
-10.5432
LGDP
(1.0000)
(0.8544)
(0.0000)
(0.0000)
-0.7090
-2.7293
-7.5895
-7.4585
LFISDEF
(0.8332)
(0.2309)
(0.0000)
(0.0000)
-3.2241
-1.4849
-7.4549
-11.5130
LGDCF
(1.0000)
(0.8187)
(0.0000)
(0.0000)
-4.0767
-2.4745
-4.5275
-5.0583
LEMPLM
(0.0028)
(0.3384)
(0.0008)
(0.0010)
Note- Brackets show MacKinnon (1996) one-sided p- values.
IV.2 Johansen Cointegration Test

9. In case of non stationary data it is quite possible that there is a linear combination of integrated
variables that is stationary; such variables are said to be cointegrated. To understand the
cointegrating relationship across these variables the study uses Johansen (1991) Cointegration
Test. The Akaike information criterion (AIC), Schwarz information criterion (SBC), Final
prediction error (FPE), Hannan-Quinn information criterion (HQ) and the likelihood ratio (LR)
test collectively suggest an optimal lag length of one and the cointegration results are provided in
Table-3.
Table - 3 (Cointegration tests based on Johansen’s Maximum Likelihood Method)
LGDP = f(LFISDEF LGDCF LEMPLM )
No. of
CE(s)
Eigen
value
0.05
Max-Eigen 0.05
Trace
Critical
Statistics
Critical
statistics
Value
value
None*
0.562798
61.27835
47.85613
33.09440
27.58434
At most 1
0.357844
28.18395
29.79707
17.71699
21.13162
At most 2
0.181469
10.46696
15.49471
8.009774
14.26460
At most 3
0.059581
2.457187
3.841466
2.457187
3.841466
Trace test and Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
Both the trace statistics and max- eigen statistics rejected the null hypothesis of no cointegration
at the 0.05 level (61.27835 > 47.85613 and 33.09440 > 27.58434). But the null hypothesis of one
cointegration among the variables is not rejected at the 0.05 level (28.18395 < 29.79707 and
17.71699 < 21.13162) by both the trace statistics and max- eigen statistics respectievely. Hence,
the johansen methodology concludes there exist one cointegrating relationship among lGDP,
lfisdef, lgfcf and lemplm. So, estimation of VECM model is required in this context.
IV.3 Estimated long run relationship
The presence of cointegration between variables suggests a long run relationship among the
variables under consideration. The long run relationship between GDP, FISDEF, GDCF and
EMPLM for one cointegrating vector for the India in the period 1970-71 to 2011-12 is shown in
the Table no-4. For better understanding the relationship between GDP and FISDEF the study
has estimated the VEC model for the period of 1970-2011, 1970-1991 and 1992- 2011
separately. The justification for this is to examine whether pre-reform period fiscal deficit or
post- reform period fiscal deficit has more impact on GDP. When the variables are in logarithms
and one cointegrating vector is estimated, the coefficients can be interpreted as long run
elasticities. The Table no-4 shows all the coefficients are highly significant at 1% level for whole
period and sub-period (1992-2011).

10. Table -4 Result for the Estimated Long Run Coefficient
Dependent Variable Whole Period
Sub Period (1970- Sub Period (1992LGDP
(1970-2011)
1991)
2011)
Regressor
Coefficient
Coefficient
Coefficient
-0.216537*
-0.014488
-0.415029*
LFISDEF
(0.08299)
(0.15620)
(0.05101)
[-2.60922]
[-0.09275]
[-8.13650]
-0.565562*
-0.862909*
-0.424624*
LGDCF
(0.04042)
(0.20960)
(0.03356)
[-13.9934]
[-4.11694]
[-12.6530]
1.098850*
0.724290
1.464168*
LEMPLM
(0.36084)
(0.77714)
(0.41613)
[ 3.04527]
[ 0.93199]
[ 3.51850]
0.569570
0.290997
1.918147
C
Note : Standard errors in ( ) & t-statistics in [ ], * indicates 1% level of significance
During the long run period (1970-2011), one percent increase in Fiscal deficit is likely to
decrease gross domestic product by 0.216537 percent and this estimate is significant at 1% level.
Thus, it shows there is negative and significant relationship between fiscal deficit and gross
domestic product. In india, high fiscal deficit is detrimental for the growth of the economy.
Similarly, there is positive and significant relationship exist between employment in the public
and organsied private sector and GDP (1.098%) and gross domestic capital formation has
negative and significant effect on GDP.
Between periods 1970-1991 there is negative relationship between fiscal deficit and GDP but it
is insignificant. But GDCF is highly significant and negatively affect GDP. In case of
employment the impact is insignificant. But one interesting result has come out, when the study
examined the periods of 1992-2011 particularly after reform of the economy. At that time the
negative impact of fiscal deficit is more on GDP than the previous period. It reflects one percent
increase in Fiscal deficit is likely to decrease gross domestic product by 0.415209 percent and is
highly significant. For 1% increase in employment in the public and organsied private sector,
GDP is increased by 1.46416% and for 1% increase in gross domestic capital formation; it
reduces GDP by 0.4246%. These coefficients are significant at 1% level. So the cointegartion
result shows there is long run relationship among these variables and fiscal deficit has negative
impact on economic growth of the economy.
IV.4 Estimated Short run Co-efficient Results Based on Error Correction Model
The estimates of the error correction model based on the associated long-run estimates are shown
in Table-5.

11. Table-5 Error Correction Representation
Dependent Variable LGDP Whole Period Sub Period
(1970-2011)
(1970-1991)
Regressor
Coefficient
Coefficient
0.066486
0.072648
C
(0.0000)
(0.0001)
-0.161164
-0.265224
D(LGDP)
(0.4764)
(0.3505)
-0.001185
-0.060987
D(LFISDEF)
(0.9551)
(0.2097)
0.022668
-0.000272
D(LGDCF)
(0.6691)
(0.9976)
-0.433276
-0.722577
D(LEMPLM)
(0.2633)
(0.2230)
0.076875
0.135976
ECM t-1
(0.1189)
(0.2053)
Normality Test:
3.106209
1.278019
(0.211590)
(0.527815)
Serial Correlation LM Test:
Heteroskedasticity Test:
Note : p values in ( )
0.788124
(0.6743)
12.65802
(0.1242)
5.282286
(0.0713)
10.57262
(0.2271)
Sub Period
(1992-2011)
Coefficient
0.055206
(0.0047)
0.041720
(0.8916)
0.010631
(0.5169)
0.076441
(0.1408)
0.509278
(0.1293)
-0.029381
(0.6613)
0.737010
(0.691768)
0.220909
(0.6383)
4.822454
(0.7764)
All the variables are statistically insignificant. Apart from that, the coefficient of the error
correction term is insignificant. So it does not respond to the previous period disequilibrium in
the model. However, the result of this error correction model is reliable since it passes all
diagnostic tests. Statistically, the model itself is highly significant based on the probability of the
F-statistic. Only for the period 1992-2011 the coefficient of the error correction term has correct
sign, but it is insignificant. This implies the absence of short run relationship among the
variables.
IV.5 Granger Causality Tests:
It is evident from the Table no-6 that fiscal deficit doesn’t granger cause GDP and also GDP
doesnot granger cause fiscal deficit because it cannot reject null hypothesis in both the context.
So it shows the absence of any short run relationship between these two variables.

12. Table-6 Granger Causality Tests result
Null Hypothesis
DLGDP does not Granger Cause DLEMPLM
DLEMPLM does not Granger Cause DLGDP
DLFISDEF does not Granger Cause DLEMPLM
DLEMPLM does not Granger Cause DLFISDEF
DLGDCF does not Granger Cause DLEMPLM
DLEMPLM does not Granger Cause DLGDCF
DLFISDEF does not Granger Cause DLGDP
DLGDP does not Granger Cause DLFISDEF
DLGDCF does not Granger Cause DLGDP
DLGDP does not Granger Cause DLGDCF
DLGDCF does not Granger Cause DLFISDEF
DLFISDEF does not Granger Cause DLGDCF
F-Stat
0.23879
10.2165
0.77192
0.73799
0.02745
2.70721
0.60361
0.73920
0.00042
1.58784
0.06277
0.00530
Prob. conclusion
0.6280
Do not reject
Reject
0.0028
0.3853
Do not reject
Do not reject
0.3958
0.8693
Do not reject
Do not reject
0.1084
0.4421
Do not reject
Do not reject
0.3955
0.9837
Do not reject
Do not reject
0.2155
0.8036
Do not reject
0.9423
Do not reject
5. Conclusion and Policy Implications
The Johansen methodology concludes there exist one cointegrating relationship among LGDP,
LFISDEF, LGDCF and LEMPLM. Hence, it reflects there is long run relationship between GDP
and the selected variables. The finding of the paper indicates that there is negative and significant
relationship between fiscal deficit and economic growth in the long run. One percent increase in
Fiscal deficit is likely to decrease gross domestic product by 0.216537 percent and this estimate
is significant at 1% level. But the Vector Error Correction model and Granger Causality test
discards the short run relationship between fiscal deficit and economic growth. The findings of
study also reveal that the negative impact of post- reform fiscal deficit on economic growth is
more than the impact of pre-reform’s fiscal deficit. One percent increase in Fiscal deficit is likely
to decrease gross domestic product by 0.415209 percent and is highly significant in period 19922011, whereas during 1970-1991 it is likely to reduce 0.014488, but it is insignificant. In India,
high fiscal deficit is detrimental for the growth of the economy. This is contrary to Keynesian
theory, but in conformity with Neo-classical theory, which holds that fiscal deficits lead to a fall
in the Gross Domestic Product.
The resources so acquired should be invested in self-liquidating and profitable ventures. The
study suggests the reduction of subsidies and invests this money in health, education,
infrastructure sectors such as power and roads etc., so that it will enhance the productivity of
both human capital and physical capital, which will go a long way in increasing the percapita
income of the people.
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15. Appendix
Table 7 VEC model estimates (1970-2011) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM)
Error Correction:
D(LGDP) D(LFISDEF) D(LGDCF) D(LEMPLM)
CointEq1
0.076875
(0.04806)
[ 1.59961]
0.345915
(0.39690)
[ 0.87155]
0.107785
(0.17187)
[ 0.62712]
-0.068481
(0.02219)
[-3.08633]
D(LGDP(-1))
-0.161164
(0.22383)
[-0.72004]
0.252735
(1.84848)
[ 0.13673]
0.390752
(0.80047)
[ 0.48816]
0.178710
(0.10334)
[ 1.72934]
D(LFISDEF(-1))
-0.001185
(0.02091)
[-0.05669]
-0.213133
(0.17271)
[-1.23408]
0.019091
(0.07479)
[ 0.25527]
-0.010300
(0.00966)
[-1.06683]
D(LGDCF(-1))
0.022668
(0.05259)
[ 0.43108]
-0.191571
(0.43428)
[-0.44112]
-0.246715
(0.18806)
[-1.31189]
-0.015943
(0.02428)
[-0.65666]
D(LEMPLM(-1))
-0.433276
(0.38091)
[-1.13748]
3.801064
(3.14575)
[ 1.20832]
-1.087861
(1.36223)
[-0.79859]
0.057397
(0.17586)
[ 0.32637]
C
0.066486
(0.00999)
[ 6.65684]
0.035407
(0.08248)
[ 0.42926]
0.079967
(0.03572)
[ 2.23881]
0.002967
(0.00461)
[ 0.64332]
Standard errors in ( ) & t-statistics in [ ]

16. Table-8 VEC model estimates (1970-1991) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM)
Error Correction:
D(LGDP) D(LFISDEF) D(LGDCF) D(LEMPLM)
CointEq1
0.135976
(0.10235)
[ 1.32848]
0.237359
(0.68217)
[ 0.34795]
0.797706
(0.34489)
[ 2.31291]
-0.035007
(0.04950)
[-0.70719]
D(LGDP(-1))
-0.265224
(0.27460)
[-0.96587]
1.104059
(1.83011)
[ 0.60327]
-0.774053
(0.92527)
[-0.83657]
0.095728
(0.13280)
[ 0.72083]
D(LFISDEF(-1))
-0.060987
(0.04638)
[-1.31492]
-0.426067
(0.30911)
[-1.37835]
-0.187227
(0.15628)
[-1.19799]
-0.023505
(0.02243)
[-1.04787]
D(LGDCF(-1))
-0.000272
(0.08700)
[-0.00313]
-0.576292
(0.57982)
[-0.99391]
-0.144962
(0.29315)
[-0.49450]
-0.046036
(0.04207)
[-1.09415]
D(LEMPLM(-1))
-0.722577
(0.56662)
[-1.27524]
2.120709
(3.77637)
[ 0.56157]
1.320524
(1.90927)
[ 0.69164]
-0.018593
(0.27403)
[-0.06785]
C
0.072648
(0.01286)
[ 5.64975]
0.049779
(0.08570)
[ 0.58086]
0.077459
(0.04333)
[ 1.78773]
0.019838
(0.00622)
[ 3.18999]
Standard errors in ( ) & t-statistics in [ ]

17. Table-9 VEC model estimates (1992-2011) LGDP = ƒ (LFISDEF, LGDCF, LEMPLM)
Error Correction:
D(LGDP)
D(LFISDEF)
D(LGDCF)
D(LEMPLM)
CointEq1
-0.029381
(0.06564)
[-0.44760]
3.602680
(0.76507)
[ 4.70898]
-0.471595
(0.36808)
[-1.28123]
-0.003013
(0.03973)
[-0.07584]
D(LGDP(-1))
0.041720
(0.30050)
[ 0.13883]
-9.113820
(3.50245)
[-2.60213]
2.465831
(1.68506)
[ 1.46335]
0.048531
(0.18188)
[ 0.26683]
D(LFISDEF(-1))
0.010631
(0.01599)
[ 0.66495]
0.319830
(0.18634)
[ 1.71638]
-0.008592
(0.08965)
[-0.09584]
-0.000499
(0.00968)
[-0.05159]
D(LGDCF(-1))
0.076441
(0.04896)
[ 1.56127]
0.986645
(0.57065)
[ 1.72897]
-0.397739
(0.27455)
[-1.44872]
0.049365
(0.02963)
[ 1.66584]
D(LEMPLM(-1))
0.509278
(0.31592)
[ 1.61203]
4.515538
(3.68219)
[ 1.22632]
-1.954957
(1.77153)
[-1.10354]
0.664023
(0.19121)
[ 3.47270]
C
0.055206
(0.01646)
[ 3.35458]
0.543301
(0.19181)
[ 2.83249]
-0.022039
(0.09228)
[-0.23883]
-0.005960
(0.00996)
[-0.59837]
Standard errors in ( ) & t-statistics in [ ]