1. In practice, the choice between BF and MF is not necessarily between two extremes, but between varying degrees of BF and MF respectively. The terms are used here and should be understood in this latter sense.

2. The analysis here builds upon that of Moorthy (1998), who critiques the Solow-Blinder and Sargent-Wallace advocacy of BF and also compares the steady state outcomes under BF and MF assuming stable velocity, i.e. a Quantity Theory approach. By contrast, this analysis derives values of relevant macro variables during the transition and allows the velocity of money to vary arbitrarily throughout.

3. The term potential output is alternatively called natural, sustainable, or the full-employment level of output. For convenience only the term potential will be used here.

4. Much macroeconomic analysis pays great attention to determining per se the outcomes for the current account deficit and nominal and real exchange rates. But the impact of these variables on macroeconomic welfare via their impact on inflation and output growth is seldom analyzed. Unless such analysis is carried out, the current account deficit and exchange rates are just accounting variables whose economic impact cannot be ascertained.

5. The amount of external borrowing to finance the fiscal deficit and the external public debt have been a small proportion of the fiscal deficit and domestic debt respectively during this decade, and can be ignored.

6. The total money stock equals the money multiplier times the stock of high-powered money. Since total money stock does not enter into the analysis here, for brevity and for convenience, high-powered money is referred to as money. However, the symbol H has been chosen to indicate that it is high-powered money (also called reserve money or the monetary base). Seigniorage here is only from high-powered money.

7. While all other variables are for period t, money and debt stocks are for period t -1, but can be approximated by period t values. This approximation is similar to using the approximation (1 + g)/(1 + R) = 1 + g – R that is used to derive the Domar condition as the solution of a first order difference equation. Alternatively equation (2) can be derived using a continuous time formulation.

8. Implicitly, all debt is one period in the basic Domar formula, or the same interest rate prevails for debt of all maturities. The complications due to varying interest rates will be discussed later. Capital gains and losses on outstanding bonds are ignored in calculating the impact of changing R on D/Y in the formula.

9. With external finance (EF) also, the formula becomes:
d* = (prdef – sr - ef)/[g_y – R], where ef = DEF/Y.

10. Different concepts of stability, sustainability, solvency are outlined or discussed in Spaventa (1987), Blanchard (1980), Buiter (1990).

11. The logic is as follows: in full equilibrium, the marginal product of capital equals the long run interest rate, ignoring taxes and depreciation. If the growth rate exceeds the marginal product of capital, society has sacrificed too much and over accumulated capital. In such a situation, the return on capital is an amount of future consumption that is less than the amount that can be had by just allowing for ongoing growth, and the current generation of consumers can gain (and no other generation of consumers can lose) by consuming some of the nation’s capital stock. This is explained in Scarth (1998).

12. "We assume in what follows that while the interest rate can be below the growth rate for extended periods of time, the Indian economy is not dynamically inefficient, and that there are no free lunches to be had by increasing the public debt." (Buiter and Patel, p. 108) Buiter and Patel also make an insightful distinction between solvency and strict solvency. Solvency by itself does not preclude the debt-ratio from rising explosively, which is unsustainable. Strict solvency would also require that the debt-ratio is stationary, or that it does not have a stochastic or deterministic trend.

13. Abel, Mankiw and Summers and Zeckhauser (1987) test for dynamic efficiency and claim that it holds since the value of profits exceeds the value of investment for many countries for many periods. Darby (1984) points out to evidence for the USA that the long run growth rate has averaged 3 per cent while the long run real interest rate has averaged 2 per cent. Therefore the stylized facts are in consonance with both dynamic efficiency and debt stability.

14. The monetarist paradox can be stated more precisely as: higher money growth, or an easy money policy, leads to higher (nominal) interest rates in the long run.

15. The term deficit here simply refers to the gap between government revenue and expenditure, whether or not that is financed by borrowing (issuing bonds) or printing money.

16. For India Rangarajan (1988) and Rangarajan and Arif (1990) use an econometric model to conclude that money demand is stable over five-year periods. This conclusion requires more careful scrutiny with 1990s data. For the USA, as Benjamin Friedman (1988) has pointed out, a well specified money demand function has been extremely unstable even over five-year periods.

17. The ADAS approach to inflation does not necessarily imply that the central bank bases its policy on an estimated natural rate of unemployment and/or potential GDP growth rate. While the central bank may have prior beliefs as to what the supply constraints in the economy are, and sometimes act preemptively based on these beliefs, it can also adjust its policy reactively in response to actual inflation data. If inflation tends to rise, this indicates that the Output Gap is positive and vice versa. However, a numerical exposition of debt dynamics using an ADAS approach entails specifying in advance the potential GDP growth rate. For a discussion of direct inflation targeting in the Indian context see Kannan (1999).

18. Another fruitful way to distinguish between these two views is to label (what has been defined as monetarism) the first three tenets as ‘the weak form of monetarism’ while the Quantity Theory can be called ‘the strong form of monetarism’.

19. This can be seen by expressing the seigniorage ratio as follows:
sr = DHt/Yt = (DHt/Ht)*Ht/Yt, which can be approximated by sr = g_H/Income Velocity. When velocity varies arbitrarily, the correspondence does not hold: a fall in sr need not necessarily correspond to lower money growth.

20. The central bank can alternatively choose some monetary aggregate as its target, a practice that has been abandoned due to its poor performance.

21. Strictly speaking, welfare should be related not to the Output ratio, but to the Output gap, which is zero when y = y*. For simplicity, the output ratio is chosen. There should be another term to capture the standard of living e.g., output per capita. Comparing two economies growing at trend (Output ratio = 100) and with the same inflation, the country with a higher per capita income should have a higher welfare. This term is also ignored here for analytical convenience.

22. In addition, inflation has shoe-leather costs, if the amount of real balances held falls with a rise in the inflation rate and thus the nominal interest rate. Even when money demand is interest-inelastic, or agents hold mostly interest-bearing inside-money deposits, inflation substantially reduces welfare due to transactions costs.

23. The initial values for inflation, GDP growth, primary deficit and other variables have been chosen to roughly correspond to current values. However, it must be stressed that this is only an illustrative, theoretical simulation. For acutal estimates of the Output Gap equation for India, see Vasudevan, Bhoi and Dhal (1999).

24. To compute velocity, the starting value of money stock needs to be specified.

Then from the values of the sr and nominal income, velocity for different periods can be computed.

25. For instance, if the primary deficit rose to 3 per cent of GDP and raised the real interest rate to 4.5 per cent, then if sr was unchanged at 1 per cent, given other parameter values, the debt would stabilize at 133.3 per cent.

26. For India, Charan Singh (1999) recently provides strong evidence against Ricardian equivalence.

27. A numerical example can elucidate this point. Suppose a 10 percentage point rise in the debt ratio raises the real rate by 2 basis points while a 1 percentage point drop in inflation lowers it by 5 basis points. Starting from the base case, under the tight money policy, debt goes up by 50 percentage points and inflation falls by 2.86 percentage points. Thus, D real rate = .2(50) + 5(-2.86) = -4.3 basis points.

28. Such agreement is not universal, though. From a Ricardian viewpoint, neither the deficit nor the debt matter. This analysis eschews the Ricardian view and concurs with the more general view that a lower deficit and debt are desirable, at any given level of primary spending.

29. Proponents of this view are Venkitaramanan (1995a,b, 2000), Chandrasekhar (2000), among others. In recent years, the Economic Survey and other official publications have repeatedly voiced concerns about the fiscal deficit and the growing burden of interest payments. However, no clear position is taken as to whether it would be desirable, at a given level of primary deficit, to increase monetization or instead tolerate a higher debt burden and higher interest payments. Typically, fiscal stringency is strongly advocated, while simultaneously the RBI’s role in helping the Government put through its borrowing program is lauded. (Cf. Annual Report 1998-99, Sec. 1.2, 1.9, 3.1) Such ambivalence damages the clear formulation and implementation of monetary policy in the face of a large deficit.

30. However, the interest burden (the ratio of interest payments to GDP) should be computed in real terms to remove that component of interest payments which is compensation for erosion of principal (Cf. Part I). Estimates of measures of the real interest burden for India are presented in Khundrapakam (1996).

31. For 1998-99, the breakdown of the holding of government dated securities is as follows : 63 per cent Commercial banks, 18.7 per cent LIC, 2.8 per cent RBI and 15.5 per cent others which includes retail investors. Out of the Rs. 223375 crore of Government Securities held by commercial banks, Rs. 178505 crore was held to meet SLR requirements and thus tax exempt (this amount is calculated as 25 per cent of NDTL for that year which was Rs. 714020 crore for that year). The taxable portion is thus about Rs. 45,000 crore. With an interest rate of 10 per cent and a tax rate of 25 per cent the tax paid on this interest income would have been Rs. 900 crore. Regarding bonds held by the public, due to both tax evasion and tax exemption upto Rs. 12,000 on interest income, the amount of tax paid on interest is also small.

32. The cumulative increase between 1990-91 to 1995-96 for the four income series in Table 2 from left to right are: 141.5%, 140.51%, 142% and 138.4%. The compound annual growth rates over this period for the old and new GDP series are respectively 15.87% and 15.56%, a difference that is small enough to ignore.

33. A well functioning financially deregulated economy does not refer here to external financial sector openness but to the absence of domestic financial repression that leads to preferential government access to credit and to the lack of an active secondary market for government debt that equalizes prices for similar new and old issues.

34. The implications of the difference between R(D) and R(ML) under conditions of both financial openness and financial repression respectively will be discussed later.

35. Rates were reduced effective January 1999 for most of the Small Saving schemes [for details, cf. Report on Currency & Finance, 1997-98, Pg. 228. However, the 1999 reductions were small, a maximum of 1 per cent, the same as the reduction for PPF rates in 2000. However, since R(SSPF) is the average rate and all SSPF deposits made between 1991-1998 pay over 12%, R(SSPF) will decline by much less than 1 per cent for 1999-2001.

36. An early recommendation in a 1997 conference along these lines was made by the former Finance Secretary "interest rate deregulation requires that interest rates on postal savings be made more flexible, perhaps by linking them to interest rates in the banking system in some way." [Ahluwalia (1999)]

37. The actual average interest rates R(D) and R(SSPF) Rajaraman and Mukhopadhayay (1999) have labelled implicit interest rates. They state that both R

(D) and R (SSPF) crossed over in 1997-98 but the data presented in Table 1 g_Y indicate that this occurred only for R(SSPF).

38. "Even without the formal forecasting exercise, it is clear that interest rates will not be forecast to fall, given their steady rise over time (p.69)"

39. It is also necessary to look at the spread between private borrowing rates and R(ML) in assessing the total economic consequences of the debt, but this comparison is dealt with later sections.

40. In this Section II.2, the Domar gap is defined with respect to R (ML) but it can be measured for any rate.

41. This is contrary to the situation under financial repression, under which a large spread between R (ML) and R (D) implies that the Domar gap understates the debt burden. Financial repression can be thought of as analogous to the easy money, Keynesian liquidity phase of a financially open economy.

42. The accounting categories of capital versus primary revenue expenditure may not correspond to their economic impact. Some of the expenditure on social services can be considered as investment in human capital. Conversely, some of the capital expenditure is wages and does not go to creating capital assets.

43. Financial liberalization often entails policies that change in the inflation rate and thus levels of nominal interest rates. But ceteris paribus liberalization should lead to a higher government rate and a lower private rate.

44. The difference between banks actual investment in approved government securities and the SLR, reported in the last two columns in Table 6, is one indicator of declining financial repression.

45. Along these lines, in the simulation model of Rangarajan and Mohanty (1997), monetization of capital expenditures augments capital stock and raises GDP growth in the long run, at the cost of higher inflation.

46. Khan and Reinhart (1990) have found that private investment has been more closely related to growth than public investment in developing countries. The cross-country study by Greene and Villaneuva (1991) finds that there is no obvious correlation between high rates of private and public investment. This finding should not be surprising. When public investment is financed by financial repression this reduces private investment which would tend to offset any complementarity between public and private investment that may otherwise exist.

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