Public Finance: Chapter test

Statements 1 and 2 are correct. Entry 35 of List I reads 'Public debt of the Union' and Entry 43 of List II reads 'Public debt of the State', so each level of government legislates on its own debt. Statement 3 is wrong: 'Foreign loans' is Entry 37 of List I (Union List), which is why borrowing from abroad is a Union subject and States cannot raise loans outside India on their own.

Statements 1 and 2 are correct; both are the definitions printed in Budget at a Glance 2026-27. The fiscal deficit reflects the total borrowing requirement, and the primary deficit removes interest on past debt to show the current fiscal stance. Statement 3 is wrong: the revenue deficit is revenue expenditure minus revenue receipts. Fiscal deficit minus capital expenditure does not give it, because non-debt capital receipts (loan recoveries, disinvestment) also enter the fiscal deficit.

Jan Tinbergen (1952) showed that to hit, say, both full employment and external balance, a policy-maker needs at least two independent instruments. Mundell (1962) added the assignment principle: each instrument should be assigned to the target on which it has the greatest relative effect, for example fiscal policy to internal balance and monetary policy to external balance under fixed rates. Together they underpin the logic of a policy mix.

With floating rates, a fiscal expansion pushes up the interest rate, draws in capital and appreciates the currency; falling net exports offset the stimulus, so fiscal policy is weak while monetary policy is strong. With a fixed rate, the central bank must buy foreign currency to stop appreciation, expanding money supply, so fiscal policy is powerful and monetary policy is weak. Statement 3 reverses the floating-rate result.

The budget shows external debt at historical exchange rates, i.e. at book value: each loan is recorded at the rupee value it had when it was received. The Status Paper on Government Debt and the FRBM statements also report external debt at current exchange rates, which gives a larger figure after rupee depreciation. In the Budget 2026-27 statements, external sources made up only about 3.3 per cent of the Centre's total liabilities at book value.

PMGKAY free grain (March 2020) was paid for from the Union budget, and the ECLGS (May 2020) carried a 100% Government guarantee through NCGTC, a contingent fiscal liability. TLTRO and the loan moratorium were announced by the RBI on 27 March 2020 as monetary and regulatory measures. So two are fiscal.

Sargent and Wallace (1981) showed that when fiscal policy moves first and debt cannot grow faster than the economy forever, the central bank will eventually have to create money to finance the deficit. Tight money today only adds to interest-bearing debt, so the later money creation is bigger and future inflation higher. This is the classic case of fiscal dominance, named 'some unpleasant monetarist arithmetic'.

Crowding out happens because higher government spending raises income, which raises the demand for money and pushes up the interest rate, cutting private investment. In a liquidity trap the LM curve is flat: extra money demand is met at the same low interest rate, so the rate does not rise and the full multiplier effect on income comes through. A vertical LM curve, interest-sensitive investment or full employment all make crowding out larger.