2020 Joint Research Program
XXV Meeting of the Central Bank Researchers Network

The Interdependence of Fiscal and Monetary Policies

Santiago García-Verdú
Jorge Ponce


The Center for Latin American Monetary Studies’ (CEMLA) Board of Governors created the Joint Research Program with the dual aim of promoting the exchange of knowledge among researchers from Latin American and Caribbean central banks and of providing insights on topics that are of common interest to the region. Annually, the Central Bank Researchers Network chooses a subject to study among its members. The collection of papers in the Joint Research Program contains research by researchers from CEMLA’s associates and collaborating members. It is published as a working paper series to encourage debate among the central bank and academic community. The views expressed in the Joint Research Program are those of the author(s) and do not necessarily represent the views of their central banks, CEMLA’s Board of Governors, or CEMLA’s Staff. Previous volumes are available at https://www.cemla.org/jointresearch.html.

Following the 2019 Joint Research Program on ‘Fiscal Policy: Fiscal Sustainability and Proposals for Institutional Change’ a natural step in our research agenda for 2020 was to explore ‘The Interdependence between Fiscal and Monetary Policies’. This topic is relevant on its own and from an everyday perspective for some jurisdictions. Moreover, the COVID-19 pandemic is calling for heightened levels of public intervention worldwide. Policy options may be constrained and policy choices during the pandemic may shape the economy for long time. Hence, it is worth to provide research with the aim of informing policymakers about the interdependence between fiscal and monetary policies, as well as about its potential implications in the aftermath of the pandemic.

In mid of exceptional circumstances during 2020, nine projects transited from scratch to publishable versions. In the way we counted on the invaluable advice by Carlos Urrutia from ITAM, the fruitful comments by anonymous peer-reviewers, and the support by CEMLA staff. The outcome is compiled in a collection of papers with new empirical results and insights for the participating jurisdictions. They should help decision making processes and also serve as a platform for further research on the topic.

Santiago García-Verdú and Jorge Ponce

The Interdependence of Fiscal and Monetary Policies in Uruguay
Elizabeth Bucacos


The global COVID-19 pandemic has called for heightened levels of policy intervention stressing government accounts and amplifying their impact on the macroeconomy through an already nonexistent fiscal space. Policymakers’ choices during this disruption may shape the economy for decades to come. The main objective of this investigation is to evaluate the degree of fiscal dominance in Uruguay in 1999-2019 in order to improve the understanding of economic policy not only for theoretical reasons but for applied needs related to good practices and accountability. Two strategies are followed: one, to quantify the fraction of fiscal expenditures that is financed by monetary liabilities and, the other one, to analyze the effects of fiscal deficit on the price level and inflation because inflationary financing may prevent the central bank from reaching its inflation target. Both situations may subordinate the monetary policy to the fiscal policy signaling fiscal dominance. In addition, through the analysis performed to assess the degree of fiscal dominance, it was possible to detect the main determining factors of the Uruguayan price level (inflation) formation during the last two decades. So far, preliminary results suggest that inflation is not exclusively a monetary phenomenon and point to some inflationary financing with a mild degree of fiscal dominance.

Interdependence between Fiscal and Monetary Policy: The Case for Costa Rica
Valerie Lankester-Campos and Catalina Sandoval


We study whether fiscal policy affects monetary policy in Costa Rica during the period 1991-2019. We use three different methodological approaches. First, we test for fiscal dominance by evaluating the relationship between the primary balance and public liabilities using a Vector Autoregression model. Second, we estimate the reaction function of the Central Bank to evaluate whether the primary deficit and public debt have a significant effect on the monetary policy interest rate. This is carried out using an autoregressive distributed lag (ARDL) model with error correction. We find that the Central Bank does not accommodate its actions to fiscal policy. Third, in order to evaluate the long-run relationship between inflation and the fiscal deficit, we also use an ARDL model with error correction. There is evidence that in the long run the fiscal deficit affects inflation, mainly in the 90s.

Interdependence of Fiscal and Monetary Policy in Guatemala
José Roany Toc Bac


This paper analyzes the interdependence of monetary and fiscal policy in Guatemala using the intertemporal budget constraint of the government. The estimation of the fraction that backs the outstanding debt and the estimations of the deficit-inflation relationship for Guatemala by using DOLS and ARDL regressions respectively, indicate the existence of fiscal dominance in 1980s and 1990s with a statistically significant deficit-inflation relationship. Then it changed to a monetary dominance between 1999-2008 with no statistically significance deficit-inflation relationship. In the more recent period, 2008-2019, the results suggest evidence of fiscal dominance again, but with a wider confidence interval and a fiscal-deficit relationship not statistically significant, which may be related to insufficient data observations for this period.

The Interaction of Monetary and Fiscal Policy: Evidence from Belize
Candice Soutar and Rumile Arana


This study investigates the extent to which monetary and fiscal policies affect each other in the Belizean economy through the government’s consolidated budget constraint. The analysis hinges on the cointegration between macroeconomic variables, including central government’s debt stock, foreign reserves, and private consumption using a quarterly data set from 1997Q1 to 2020Q1. Applying a Dynamic Ordinary Least Squares (DOLS) methodology, we find evidence of fiscal dominance in Belize over the review period, while a break-point evaluation shows stronger evidence of this from 2006Q1 to 2014Q3 with a higher percentage of Central Government’s debt financed by the Central Bank. Furthermore, an Autoregressive Distributive Lag (ARDL) investigation on the impact of fiscal activities on foreign reserves highlighted a negative relationship between the two which becomes stronger with the degree of fiscal dominance. The results are indicative of the potentially de-stabilizing effects that this phenomenon can have in a fixed exchange rate regime.

The Decoupling between Public Debt Fundamentals and Bond Spreads after the European Sovereign Debt Crisis
Luis Guirola and Javier J. Pérez


This paper provides empirical evidence for the weakened relationship between public debt fundamentals and sovereign bond spreads in Spain, France, and Italy (versus Germany) after the 2010–2012 episode of sovereign debt markets’ significant fragmentation. We build on the literature that combines the Value at Risk approach with the estimation of the correlation pattern of public debt dynamics’ macroeconomic determinants via Vector Auto Regressions (VARs). Our measure of fiscal sustainability is based on a large number of Monte-Carlo debt trajectory simulations on the basis of such VAR models. This method allows to estimate the distribution of debt trajectories that the variables at each point in time imply, and takes into account their mutual dependence. Using this measure, we establish that the relationship between fundamentals and sovereign spreads: (i) differs across countries, and (ii) varies over time, and in particular, became weaker after the European sovereign debt crisis. We hypothesize this change might be related to bold actions that euro area policy makers took. First, governments acted to deepen the European Monetary Union, in particular in the fields of banking and capital markets’ integration, and further supra-national oversight of fiscal policies. Second, the European Central Bank (ECB) acted strongly to restore the adequate functioning of the transmission mechanism of monetary policy in the euro area.

Fiscal Policy and Inflation Expectations
Miguel Mello and Jorge Ponce


We find empirical evidence of a positive correlation between the budget deficit to GDP and inflation expectations of price setters. This implies an interdependence between fiscal and monetary policies: monetary policy faces more challenges to maintain inflation expectation anchored when the fiscal outcomes worsen. The limits imposed by fiscal policy to the achievement of monetary policy objectives are larger when the fiscal deficit is larger. The result is robust to considering other fiscal variables and to controlling for macroeconomic covariates.

The Relationship between Fiscal and Monetary Policies in Colombia: An Empirical Exploration of the Credit Risk Channel
Ignacio Lozano-Espitia and Fernando Arias-Rodríguez


This paper aims to provide evidence on the relationship between fiscal and monetary policy in Colombia through an empirical exploration of the credit risk channel. Under this approach, fiscal policy plays an important explanatory role in the sovereign risk premium, which, in turn, could affect the exchange rate and inflation expectations. The Central Bank reacts to inflation expectations using the policy interest rate; consequently, such reaction could be indirectly influenced by fiscal behavior. Using monthly data from January 2003 to December 2019, we estimate both jointly and independently the reduced-form core equations of a system that describes the credit risk channel in a small open economy. Our findings are in line with the model predictions. Fiscal policy affected the country’s sovereign risk during this period, but only slightly. Hence, there is insufficient evidence to sustain the idea that monetary policy has been significantly influenced by government fiscal management.

The Interaction between Monetary and Fiscal Policy through the Lens of a Semi-Structural Model: The Case for Central America and the Dominican Republic
Nabil López and Francisco A. Ramírez


The interaction between fiscal and monetary policy has been widely studied, primarily focusing on a framework where there is fiscal dominance and government deficits are financed by the central bank, thus imposing a constraint in the effectiveness of monetary policy. However, even without fiscal dominance, government spending could affect market interest rates even when the central bank keeps its rate unchanged, affecting the transmission mechanism of monetary policy and altering the effect of fiscal expansions on the economy.  Considering this effect, we study the interaction between fiscal and monetary policies in the Dominican Republic, Costa Rica and Guatemala after their transition to inflation targeting regimes, estimating the impact of fiscal shocks on market interest rate spreads. Using a semi-structural model for policy analysis, we find evidence suggesting that the effectiveness of monetary and fiscal policy is affected by the role of fiscal policy in determining market interest rates.

Policy Mix in a Small Open Emerging Economy with Commodity Prices
Marine C. André, Alberto Armijo, Sebastián Medina, and Jamel Sandoval


The article analyzes the interaction between monetary and fiscal policy in Mexico. A semi-structural model for a small open economy, based on Aguilar and Ramírez-Bulos (2018), is calibrated for Mexico using quarterly data from 2001 to 2020. The fiscal policy block models the fiscal deficit depending on output, an endogenous sovereign risk premium, a state-owned oil company and public debt dynamics with domestic and foreign components. A fiscal rule is assumed whereby the deficit has an upper bound. The monetary policy follows a Taylor rule. We study the effects of different shocks on the economy such as a worsen in commodity prices, an expansion of public spending, an increase in the risk premium, a hike in the interest rate and a real exchange rate depreciation. We show that, remarkably, the risk premium channel transmits threats on the fiscal block to the monetary block, calling for the central bank to stabilize inflation. Whereas, starting at the economy’s steady state, an exogenous monetary policy shock affects the fiscal block mainly through the interest rate influencing the debt service, leading to a fiscal response to stabilize deficit.

Debt Sustainability and Fiscal Space in a Heterogeneous Monetary Union: Normal Times vs The Zero-Lower Bound
Javier Andrés, Pablo Burriel, and Wenyi Shen


In this paper we study fiscal policy effects and fiscal space for countries in a monetary union with different levels of public debt. We develop a dynamic stochastic general equilibrium (DSGE) model of a two-country monetary union, calibrated to match characteristics of Spain and Germany, in which debt sustainability is endogenously determined a la Bi (2012) to shape the responses of the risk premium on public debt. Policy shocks change the market’s expectation about future primary surplus, producing a direct effect on the sovereign risk premium and macroeconomic responses of the economy. In normal times, the costs of a government spending driven fiscal consolidation in the high-debt country are greatly diminished when the consolidation improves its debt sustainability prospects. Fiscal consolidations in both members of the monetary union decrease real interest rates and amplify the reduction in risk premium in the highly-indebted country, improving union-wide output in the long run, at the cost of lower output in the low-debt country in the short run. On the contrary, when monetary policy is constrained at the zero-lower bound, the risk premium channel arising from the endogenous determination of debt sustainability becomes muted.