Interest Rate Targeting-Critical Role of Fiscal Stance

This paper examines the relationship between budget deficits, money creation and debt financing which suggests that interest rate targeting and inflation control are both monetary and fiscal policy issues. It then formalises these links within an analytical framework which, by highlighting the concept of the 'high-interest trap'. suggests that, for any given deficit, there exists optimal levels of monetisation and market borrowings. The model is then applied to evaluate the implications of the Union Budget 1998-99 and the results indicate that unless government borrowings are reduced substantially, the inflation rate would be much higher than what the fundamentals require it to be.