Deficit Financing in LDCs: Evidence From South Asia

Fiscal policy triggers three distinct effects on the economy such as (1) interest rate effect (2) price effect and (3) exchange rate effect. A VAR system was developed to capture these effects in five South Asian countries. Empirical results suggest that budgetary action does not have any perceptible influence on the interest rate of the sampled countries. In terms of the price effect, fiscal action has opposite effects in Bangladesh and India. Fiscal action tends to increase aggregate price level in India but reduces the price level in Bangladesh, although the magnitude is very small. For Pakistan the price effect is positive but statistically insignificant while the price effect for Nepal and Sri Lanka is negative but statistically insignificant. Fiscal action is found to have no perceptible influence on the exchange rates of the sampled countries except Nepal where increased government expenditure tends to appreciate the Nepali currency. Overall, empirical findings suggest that expansionary fiscal action does not lead to crowding out behaviour in the sampled countries.