Fiscal Deficits, Interest Rates and Inflation

The relationship between budget deficits, money creation and debt financing suggests that interest rate targeting and inflation control are both monetary and fiscal policy issues. The paper formalises these links within two analytical frameworks, static as well as dynamic, which by highlighting the concepts of the 'high interest trap' and the 'tight money paradox', respectively, 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 2000-01 and the results indicate that unless government borrowings are reduced substantially, and about 40 per cent of the deficit is monetised, the inflation rate as well as the interest rate could be much higher than what they fundamentally ought to be.