Subsidy, Fiscal Deficit and Inflation in Developing Countries

Proponents of the New Economic Policy are of the view that, if subsidies are reduced and funds released therefrom are used to step up public investment to give a boost to aggregate investment, then fiscal deficit will stay unchanged and there will be no disturbance to the macroeconomic stability to the economy. This paper shows that the relationship between investment, fiscal deficit and macroeconomic stability is a complex one. More precisely, the paper uses a structuralist dual economy model to show that there exist conditions under which if subsidies are reduced and public investment is stepped up to keep unchanged or raise aggregate investment, then both fiscal deficit and inflation will rise. Moreover, the conditions under which this happens are precisely those, which have been presumed to be true by the proponents of the New Economic Policy.