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Asymmetric effects of fiscal balance on monetary variables: evidence from large emerging economies

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Abstract

This paper investigates the nonlinear impacts of fiscal balances on interest rates, exchange rates and inflation in large emerging economies. The paper applies asymmetric cointegration modelling in a nonlinear autoregression distributed lag framework to discriminate the effects of negative and positive changes in the fiscal balance on monetary variables in BRICs. This approach is advantageous to the analysis of dynamic asymmetric relationships in both the long and short run regardless of whether variables are a mix of I(0) and I(1). A distinctive feature of this study is that the main result indicates that monetary variables react differently to negative and positive changes in fiscal balances over the long run for Brazil and India, but not for the others. Since interest rates and inflation are more sensitive to worsening fiscal position, fiscal consolidation is an essential criterion for the effectiveness of monetary policy in the economies characterised with large fiscal imbalance and debt stocks, such as Brazil and India. The implementation of expansionary fiscal policy should be reconsidered carefully in economies with a better fiscal performance like China and Russia, since the persistently rising budget deficits eventually countered the effectiveness of monetary policy by keeping market interest rates and inflation at high levels. This paper provides evidence in favour of the dominant role of fiscal policy to stabilise monetary variables in large emerging economies. We also highlight the importance of long-term fiscal sustainability to improve the monetary policy effectiveness.

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Notes

  1. According to Sargent and Wallace (1981), persistent deficits result in high inflation in the long run, but not necessarily in the short run.

  2. Flandreau et al. (1998) claims that under the market discipline hypothesis, investors charge high interest rates to borrowers with high default risks.

  3. The level of global risk aversion is represented by the Chicago Board Options Exchange Volatility Index (VIX) which measures the market expectations towards short-term volatility in stock market.

  4. Monetary policy arithmetic proposed by Sargent and Wallace (1981) states that under a regime of fiscal dominance, the growth of the monetary base is directly determined by the fiscal authority’s deficits. In models with forward-looking behaviour, expected future budget deficits will be financed by seigniorage gained from money creation. The inflation, therefore, will rise even though the central bank conducts a current tightening of monetary policy.

  5. According to the IMF database, an increase in REER implies an appreciation of the domestic currency against the US dollar and vice versa.

  6. We are grateful to anonymous referee’s comments for the choice of real exchange rate and inflation variables.

  7. We thank the anonymous referee for suggesting this point.

  8. The number of lag lengths, p, can vary across independent variables.

  9. F statistics significantly reject the null hypothesis of no cointegration in the regression normalised on \(\pi _t\), but the t statistics does not (Table 6).

  10. According to the classification of exchange rate arrangements by IMF, Brazil and India have both followed a floating exchange rate system, while China and Russia have adopted a soft-peg regime.

  11. More specifically, the ratios of budget deficit to GDP for Brazil and India have remained high around 7–8%, while those for China and Russia have been much lower, around 3–4% (Fig. 3).

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Acknowledgements

I would like to thank George Tawadros and Bilgehan Karabay for helpful comments and suggestions.

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  1. School of Economics, Finance and Marketing, RMIT University, Melbourne, VIC, 3000, Australia

    Ngan Tran

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Tran, N. Asymmetric effects of fiscal balance on monetary variables: evidence from large emerging economies. Empir Econ 57, 1045–1076 (2019). https://doi.org/10.1007/s00181-018-1483-y

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