Do Macroeconomics Channels Matter for Examining Relationship Between Public Debt and Economic Growth in India?

Abstract

This paper investigates the impact of public debt on economic growth using key macroeconomic channels for the period 1970–2013 in the context of India. The analysis is undertaken in two different steps: first, it is examined whether public debt has any nonlinear impact on economic growth and second, determines the key channels through which public debt affects economic growth. The results derived from 2SLS model show that public debt positively affects economic growth in the short run, while it shows a negative impact in the long run. Further, by using Nonlinear ARDL approach, this paper supports the existence of a nonlinear impact of public debt on economic growth. The channels through which public debt significantly affects economic growth are households saving, public investment and total factor productivity growth. From policy perspective, we suggest that government should target the public investment and productivity channels for utilizing the public debt in India, and the government should opt for borrowings as long as it leads to capital formation of the country.

Appendix: Measuring Capital Stock

The physical capital stock data are not readily available for India. Thus, following Easterly and Levine (2002), we use a perpetual inventory method (PIM) to compute capital stocks. Specifically, let K(t) equal the real capital stock in period t. Let I(t) equal the real investment rate in period t. The real investment is defined in this paper as gross fixed capital formation at constant 2000 US$. Let d equal the depreciation rate, which we assume equals 0.07. Thus, the capital accumulation equations states as:

$\hbox {K}(\hbox {t}) = (1-\hbox {d}) \hbox {K}(\hbox {t}-1) + \hbox {I}(\hbox {t})$. To make an initial estimate of the capital stock, we make the assumption that the country is at its steady-state capital-output ratio. Thus, in terms of steady-state value, let k = K/Y, let g = the growth rate of real GDP, Y is the real GDP and let i = I/Y. Then, from the capital accumulation equation plus the assumption that the country is at its steady-state, we know that k = i/[g + d]. Thus, if we can obtain a reasonable estimate of the steady-state values of i, g and d, then we can compute a reasonable estimate of k. Then, using the calculated value of k, an initial estimate of capital stock (k) multiplied with initial GDP(Y) can be obtained. In order to work out the initial estimate of k, we assume the steady state capital output ratio (d) = 0.07. We construct the steady-state growth rate (g): a weighted averaged of the countries average growth rate during the first ten years for which we have output and investment data and the world growth rate. The world growth rate is computed as 0.0234. Based on Easterly et al. (1993), we give a weight of 0.75 to the world growth rate and 0.25 to the country growth rate in computing an estimate of the steady-state growth rate for each individual country. We then compute i as the average investment rate during the first ten years for which there are data. Thus, with values for d, g, and i for each country, we estimate k for each countries. To reduce the influence of business-cycles on estimates of Y, we use the average real GDP value between 1969 and 1971 as an estimate of initial output. Thus, the capital stock, for example, in 1970 is given as: Y*k.