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Intermediate Meeting of Working Group of the Joint Research, 2020

August 5–7, 2020.

Given that the 2019 Joint Research topic was ‘Fiscal Sustainability and Institutional Change’, a natural step in the research agenda is to explore ‘The Interdependence between Fiscal and Monetary Policies,’ in our economies. This topic is important on its own right and, in particular, at the present juncture for many economies.

The reasons why fiscal sustainability is important for economic stability have been studied in several contexts. The interaction between fiscal and monetary policies have been analyzed as well; in particular, the mechanisms through which fiscal policy can affect monetary policy (e.g., Sargent and Wallace, 1981). This should be a concern for many economies given that, on the one hand, both policies could complement each other and, on the other, a deficient fiscal policy might impair the transmission of monetary policy. In addition, this is relevant for the region considering its fiscal and monetary history (e.g., Esquivel et al., 2019).

There is some agreement on the theoretical models that are most suitable to analyze the interdependence of the fiscal and monetary policies. Nevertheless, there is less consensus on which is the most suitable empirical approach.

Sargent and Wallace (1981) argue that government nominal debt should be backed by future net fiscal resources or seigniorage. Hence, if there is the perception that fiscal resources are insufficient, then the need to obtain additional resources from seigniorage rises, which would put pressure on the general price level and, thus, distort monetary policy. Based on this argument, Catao and Terrones (2005) analyze the extent to which fiscal deficits affect inflation. The authors derive a relationship between inflation and fiscal deficits based on a macroeconomic model.

One could also assess the degree to which fiscal dominance is present. This can be addressed as in Aiyagari and Gertler (1985) and De Resende (2007). An assumption is that the government commits to collect the necessary net fiscal resources to back a fraction (δ) of the outstanding nominal debt. The fraction (1−δ) is obtained from seigniorage. We have that if δ is close to one, then there is evidence that monetary policy is being implemented independently of fiscal policy. If, however, δ is statistically significantly less than one, one would have evidence on monetary policy being accommodative to fiscal policy.

The general purpose of the Intermediate Meeting of the Joint Research Group is to review and discuss the research projects of the participants. The meeting provides them a forum to discuss the common research topic, present the approaches addressed, and show the progress on their research. Thus, this forum serves to encourage feedback among participants on a common research theme.

References

Aiyagari, S. R. and M. Gertler (1985). The backing of government bonds and monetarism. Journal of Monetary Economics, 16(1), pp. 19-44.
Catao, L. A. and M.E. Terrones (2005). Fiscal deficits and inflation. Journal of Monetary Economics, 52(3), pp. 529-554.
De Resende, C. (2007). Cross-country estimates of the degree of fiscal dominance and central bank independence (No. 2007, 36). Bank of Canada Working Paper.
Esquivel, C., T.J. Kehoe and J.P. Nicolini (2019). Lessons from the Monetary and Fiscal History of Latin America. University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2019-47
Sargent, T. and N. Wallace (1981). Some unpleasant monetarist arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review. 5(3), pp. 1–17.

In the Intermediate Meeting of the Joint Research Group 2020, eleven research projects were presented.¹A way to classify them, based on some of their main features, is the following one, although it is certainly not the only one. As part of this classification, brief descriptions of the themes of each project are included, as well as some of the discussion points that were made in this meeting. As a note, the majority of projects are work in progress.

Both, the case of Mexico (André et al. 2020) and that of Spain (Burriel et al. 2020) consider dynamic stochastic general equilibrium (DSGE) models for small economies, in the following sense. The project by Mexico (André et al. 2020) studies the possible policy fiscal responses and monetary, or a combination thereof, in a small economy that depends on exporting a commodity. This economy is subject to shocks that may affect it significantly. The authors consider how changes in the reference rate affect fiscal variables and how monetary policy reacts to changes in fiscal policy. Their model’s main channel is the risk premium. The authors assess shocks to the price of oil, to the risk premium and to economic activity. It was argued that it would be desirable to be more transparent about the estimation procedure, what would certainly provide a greater support to their results. A possible extension to this model is to consider that while Mexico exports oil, it imports gasoline. Additionally, the fact that the adjustment in the local price of gasoline does not always behave symmetrically to changes in its international price could be considered. More generally, a possible addition is to consider that the government and agents are affected differently by oil price shocks, and that the effects are a function of the oil price, an exogenous variable, and government decision, as the determination of the tax on the price of gasoline.

For its part, the work of Spain (Burriel et al. 2020) studies the effects of fiscal policy and fiscal space for countries in a monetary union, which have different levels of public debt. They develop a model of a monetary union of two countries, calibrating it to Spain and Germany, in which the sustainability of the debt is determined endogenously and affects the risk premium. They find that, usually, the costs of fiscal consolidation driven by government spending in the country with high debt (typically a country from the Euro zone’s periphery, in this case Spain) are greatly reduced when this consolidation improves their sustainability prospects endogenously. A central object in their model is a fiscal limit that depends on the maximum expected present value of the net tax revenue of the economy in question. In fact, the authors estimate the distribution of said object. The authors mentioned the possibility of extending its model with a distribution reflecting heavy tails. Related to this point, a participant suggested the possibility of modeling the fiscal limit with a robustness approach; i.e., recognizing that, given the prevailing conditions, a portion of the tax collection of the economy cannot be modeled as quantifiable risk, because it is uncertain in the sense of Knight, and thus a robustness approach could be desirable.

The projects by Colombia (Lozano and Arias, 2020), Costa Rica (Lankaster and Sandoval, 2020), and Dominican Republic (Ramirez and Lopez, 2020) use models with some structure, they could even be considered semi-structural models. The main objective of the project by Colombia (Lozano and Arias, 2020) is to analyze the interdependence between fiscal and monetary policies in Colombia, focusing on the risk channel. In particular, it aims to identify the potential episodes of fiscal dominance. The key transmission mechanism of their model is as follows. The fiscal health affects the country’s sovereign risk, which, in turn, affects the exchange rate. The exchange rate affects inflation expectations (pass-through) and the fiscal health of the economy, completing the circle. Marked changes in expected inflation would probably make the central bank react. Prominently, changes in the reference rate affect the fiscal health. In the model, the sensitivity of the country risk to the global risk is in terms of domestic fiscal health, which lead to a healthy discussion. The following points are worth mentioning. The first is that their model can, in essence, be based on a log linear approximation of a micro-founded model. As mentioned, the sensitivity of country risk to the global one is a function of domestic fiscal health in a non-linear way. Their functional specification is economically sound, but it is no longer consistent with the linearization of a base model. A possible exercise is to estimate a parallel reduced form model maintaining the sensitivity assumption and assuming that the associated coefficient depends on a regime-switching model.

The one by Costa Rica (Lankaster and Sandoval, 2020) assesses if from 1991 to 2019 there was fiscal dominance. This is done with the estimation of a reaction function of the Central Bank. They do this by considering fiscal variables, and estimating, for instance, whether there is an impact of the fiscal deficit on inflation. This issue has regained much relevance for Costa Rica, given the significant increase in the level of public debt in recent years and the projected levels in the coming years. They find evidence that indicates that the primary deficit positively affects the monetary policy rate.

The project by the Dominican Republic (Ramírez and López, 2020) studies the interaction between monetary and fiscal policy with a semi-structural model for a small open economy. The transmission mechanism they emphasize is the link between market interest rates and public spending. They are specially interested in the estimation of the parameters that characterize the sensitivity of market rates to fiscal shocks. The fact that the authors estimate the model for other economies of the region is worth highlighting. This enhances their analysis and, in tandem, sheds light upon other cases.

There are three research projects that share certain methodological similarities, but the monetary-fiscal histories of the respective countries differ. One of the works is from Uruguay (Bucacos, 2020), one from Guatemala (Castañeda-Fuentes and Toc Bac, 2020) and the other one from Belize (Soutar and Arana, 2020). All three examine the extent to which a situation of fiscal dominance has existed in each of the countries. They have used some of the methods proposed in the Joint Research Program 2020, in Resende (2007), and Catao and Terrones (2003). For the most part, such approaches are largely econometric. These studies estimate the fraction of the nominal government debt that is perceived are being backed by the expected net tax revenues. In some cases, they find some evidence that those economies had some periods with fiscal dominance.

There are two projects that do not allow for a direct classification: the second project by Uruguay (Ponce et al. 2020) and the project by CEMLA (Ramos-France et al. 2020). The project by Uruguay empirically explores the impact of fiscal policy on inflation expectations. Notably, such expectations are from a group of entrepreneurs, so the authors interpret them as inflation expectations determined by price-setters in Uruguay. Interestingly enough, they find evidence on an interdependence between fiscal and monetary policies using the aforementioned inflation expectations. In particular, they find evidence that different fiscal indicators affect the level of such expectations. They estimate their model with the GMM method in two steps. As is known, this approach allows for the incorporation of information that is not explicitly part of the equations. This GMM advantage could be exploited further, changing the instruments, thinking they are different information sets.

For our part (Ramos-France et al. 2020), CEMLA analyzes the relationship between three variables macroeconomic, inflation, inflation expectations and fiscal deficits financed by seigniorage for various economies in the region. A relative advantage is that the model they used has inflation as its only input, with which two parameters are estimated, among others, that affect the distribution of fiscal deficits, the mean and volatility, which are in turn distributed according to two Markov chains, which are independent. Following Sargent et al (2009), they interpret the changes in expected inflation from unstable to stable levels, and changes in regimes of the mean of the fiscal deficits’ distribution as cosmetic and fundamental reforms, respectively. In a CEMLA’s paper, we have explored extending this model considering a more general demand for money, among other modifications.

For his part, Urrutia (2020) proposes studying the role of informality in the fiscal and monetary policies. He underscored that, while there are several aspects that have improved in emerging market economies such as macroeconomic stability, fiscal discipline and, to an extent, the convergence of inflation, informality still represents challenges and is a key element in most emerging market economies. In effect, informality has an adverse impact on workers productivity and has implications for the potential tax collection and monetary policy. He underscored two outcomes from one of the models he cited: i) informality implies that an adverse shock to technology (productivity) affects inflation outcomes negatively, and ii) the sacrifice ratio is greater.

All of the researchers were encouraged to continue their important work, improving their research. While there were some notable improvements in the projects presented, in all cases they were significant opportunities. The best papers will be selected to be presented in the CEMLA Network of Researchers in the fall of 2020.

Projects

André, Marine C., Alberto Armijo, Sebastián Medina and Jamel Sandoval, “Fiscal-Monetary Policy Model for a Small Open Economy,” Banco de México.
Bucacos, Elizabeth, “Interdependence of Fiscal and Monetary Policy: The Case of Uruguay.”
Burriel, Pablo, Javier Andrés and Wenyi Shen, “Debt sustainability and fiscal space in a heterogeneous Monetary Union: normal times vs the zero-lower bound,” Banco de España.
Castañeda-Fuentes, Juan Carlos, and José Roany Toc Bac, “The Interdependence of Fiscal and Monetary Policies,” Banco Central de Guatemala.
Guirola, Luis, José Ramón Martinez-Resano and Javier J. Perez, “Debt sustainability analysis at times of fiscal stress: implications for monetary policy,” Bank of Spain.
Lankester, Valerie and Catalina Sandoval “Fiscal or Monetary Dominance: the case of Costa Rica,” Banco Central de Costa Rica.
Lozano, Ignacio and Fernando Arias “Fiscal and Monetary Policies in Colombia: The Role of Sovereign Risk” Banco de la República.
Ong A Kwie-Jurgens, Nancy “The Interdependence between Fiscal and Monetary Policies,” Centrale Bank van Suriname.
Pineda Zelaya, David Ricardo and Julio Landa, “Analysis on the Interdependence of Monetary and Fiscal Policy in Honduras,” Central Bank of Honduras.
Ponce, Jorge, Miguel Mello and Fernando Borraz, “Fiscal Policy and Inflation Expectations,” Banco Central del Uruguay.
Soutar, Candice and Rumile Arana “The Interaction of Monetary and Fiscal Policy: Evidence from Belize” Central Bank of Belize.
Ramírez, Francisco and Nabil López “Fiscal Deficit, Monetary Policy and the Control of Inflation in Central America and the Dominican Republic,” Banco Central de la República Dominicana.
Ramos Francia, Manuel, Santiago García Verdú and José Manuel Sánchez “Inflation Dynamics under Fiscal Deﬁcit Regime-Switching” CEMLA.
Urrutia, Carlos, “Informality and the Interdependence of Fiscal and Monetary Policies,” ITAM.

¹The authors of one of the projects by Bank of Spain (Pérez et al. 2020) notified us that, due to force majeure, they could not participate in the Meeting. Having said that, they underlined that they would keep on participating in the Joint Research Program 2020. On the other hand, there are two presentations pending on the progress of the project by the Central Bank of Honduras and the Central Bank of Surinam. The researchers from the Central Bank of Honduras, while present in the meeting, decided not to present. Unfortunately, the researchers from the Central Bank of Surinam could not participate in the meeting.

Wednesday, August 5

Opening Remarks
Santiago García-Verdú, CEMLA