A government plans to borrow Rs. 10 lakh crore to fund infrastructure projects. If the fiscal deficit for the year is Rs. 12 lakh crore and interest payments on past debt are Rs. 2 lakh crore, calculate the primary deficit. Further, explain how this borrowing could affect the domestic interest rate and the rupee exchange rate in the short run.
Answer
Primary deficit is Rs. 10 lakh crore. Borrowing increases demand for loanable funds, raising domestic interest rates and can depreciate the rupee in the short run.
Step-by-step solution
- Primary deficit is calculated as Fiscal deficit minus Interest payments.
- Subtract the interest payments (Rs. 2 lakh crore) from the fiscal deficit (Rs. 12 lakh crore).
- 12 lakh crore – 2 lakh crore = 10 lakh crore.
- Thus the primary deficit is Rs. 10 lakh crore.
- Borrowing Rs. 10 lakh crore creates additional demand for funds in the loanable funds market.
- Higher demand for funds pushes up the equilibrium interest rate (crowding‑out effect).
- Higher domestic rates attract foreign capital seeking better returns.
- If capital inflows are large, the rupee may appreciate; if the market expects higher inflation from fiscal expansion, investors may sell rupee, leading to depreciation.
- In the short run, the net effect depends on expectations, but borrowing typically raises domestic rates and can put downward pressure on the rupee.
Common mistake: Assuming borrowing lowers interest rates or ignoring crowding‑out.
Concept tested: Impact of borrowing on interest rates and exchange rate
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