Impact of Deficit Financing and Trade Openness on Private Consumption in India

Abstract

The Ricardian equivalence hypothesis claims that private consumption is neutral to the fiscal deficit and its mode of financing (debt vs tax). The study reinvestigates the Ricardian equivalence hypothesis in India by taking private consumption as the dependent variable, whereas government expenditure, government debt, tax, domestic income, and trade are considered as independent variables. In the Indian context, the Ricardian view raises an interesting point. If the Ricardian equivalence holds in the Indian economy, households alter their spending patterns and consequently increase their savings, making the policy changes ineffective. The autoregressive distributed lag (ARDL) bound testing approach was applied to the annual time series data from 1988 to 2021. The estimates confirm a significant long-run and short-run relationship between the variables; the results reject the Ricardian Equivalence and propound the Keynesian approach that the mode of financing the fiscal deficit (debt vs tax) does matter to the private consumption expenditure. The estimates also assert the long-run relation between trade openness and private consumption spending. The positive and significant coefficient shows that an open economy leads to an increase in consumption, which indirectly supports the Compensation Hypothesis. Given that deficit financing and trade openness have a substantial influence on India’s consumer spending, it can be concluded that expansionary fiscal and liberal trade policies should be carefully devised and supported. This study contributes to the existing literature on the Ricardian equivalence and trade openness by presenting new evidence on designing sustainable fiscal policy by spending wisely without imperilling the country’s consumption expenditure and global presence.