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India’s historical fiscal performance has featured elevated deficit levels. Driven by the imperative need for fiscal stimulus measures in response to the crisis, efforts toward fiscal consolidation from 2003 to 2008 were reversed in 2008–2009 due to the financial crisis. These stimulus actions are believed to have wielded a notable influence on inflation dynamics. Presumably, a high inflation rate hinders growth and inflicts severe welfare costs. Accordingly, the principal objective of this paper is to scrutinise the threshold effects of fiscal deficit on inflation within the context of the Indian economy.

We employed the Smooth Transition Autoregressive (STAR) Model, a robust tool for capturing non-linear relationships, to discern the specific threshold level of fiscal deficit. Our analysis encompasses annual data spanning from 1971 to 2020. Additionally, we have leveraged the Toda-Yamamoto causality test to establish the existence and direction of a causal connection between fiscal deficit and inflation in the Indian economy.

Our analysis pinpointed a critical threshold level of 3.40% for fiscal deficit, a value beyond which inflation dynamics in India undergo a marked transition, signifying the presence of significant non-linear effects. Moreover, the results derived from the Toda-Yamamoto causality test offer substantiating evidence of a causal relationship originating from the fiscal deficit and leading to inflation within the Indian economic framework.

The findings of our study carry significant implications, particularly for the formulation and execution of both fiscal and monetary policies. Understanding the threshold effects of fiscal deficit on inflation in India provides policymakers with valuable insights into achieving a harmonious balance between these two critical economic variables.

To the best of our knowledge, this study is the first of its kind to empirically investigate threshold effects of fiscal deficit on inflation in India from a non-linear perspective using the Smooth Transition Autoregression (STAR) model.

This paper aims to revisit the theme of fiscal-monetary coordination in a general equilibrium setup that allows for unconventional monetary policy, monetary policy transmission and developing country characteristics.

This paper uses a calibrated new Keynesian dynamic stochastic general equilibrium (DSGE) model to study fiscal-monetary interaction.

Debt sits at the center of monetary-fiscal interaction. Under high-debt conditions, the inflation-output trade-off rises with an increase in the strictness with which monetary policy targets inflation, undermining the standard prescription of strict inflation targeting. At the same time, the transmission of monetary policy is also impeded, due to which unconventional monetary policy becomes more appropriate. The need for coordination among the policies gets enhanced in the presence of borrowing cost channel. While the presence of borrowing cost channel increases the need for policy coordination regardless of the debt situation, features like higher share of non-Ricardian households and weaker monetary policy transmission affect monetary-fiscal interaction to a greater extent under high-debt environment.

First, this paper uses inflation-output trade-off as a metric, to analyze fiscal-monetary interaction. Second, this paper considers the impact of developing country characteristics (such as a higher share of non-Ricardian households, impeded monetary policy transmission and supply constraints/borrowing cost channel) on fiscal-monetary interaction. Third, the DSGE model developed in this paper incorporates open market operations that could shed light on the role of unconventional monetary policy in the presence of high fiscal deficit and debt, which is particularly relevant in the current context of the COVID-19 pandemic. Fourth, the model also permits an investigation into monetary policy transmission under different debt regimes.