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Abuse of or even poorly conceived government spending will not only discredit public policies generally, but also set back these economies, their prospects and people further back. Simply buying over existing privately held assets will not enhance economic capacities, capabilities and output. Similarly, pouring good money after bad money, including the corrupt or fraudulent investments of previous governments will not improve them. All rights reserved. Jomo Kwame Sundaram. Republish Print. The Week with IPS. Your contribution will make a huge difference.

Make a Difference. The time period considered for the study is from Q2 to Q1. This is the period when i fiscal dominance over monetary policy eased substantially with the elimination of automatic monetisation of fiscal deficit and prohibition on direct government borrowing from the Reserve Bank; and ii the operating procedure of monetary policy in India underwent a paradigm shift in the early with the introduction of liquidity adjustment facility and the interest rate channel becoming the main monetary policy signaling instrument. Before conducting the vector autoregression VAR analysis, the four variables viz.

Ng-Perron tests, not reported to conserve space, however, show that all the series are stationary at least at 10 per cent level. The lag length of the VAR was selected as one, since four out of the five tests select optimal lag length to be one Table 2. The variable least influenced by other variables was ordered first while the variable most influenced by other variables was placed at the last. An important point which emerges from the above Granger causality results is the unidirectional causality running from fiscal deficit to policy rate. This implies that, even after the elimination of automatic monetisation of fiscal deficit and prohibition on direct borrowing of government from the Reserve Bank, fiscal policy continues to impinge on the outcome of monetary policy.

The responses of different variables through impulse response functions IRF obtained from a shock of one standard deviation and the variance decomposition are as follows 2. Chart 1 shows the time path of the responses in different variables to shock in output gap. It is seen that any positive shock to output gap converges back to its long run path in about two years.

The positive shock to output gap leads to rise in inflation. Monetary policy reacts strongly in a counter-cyclical manner by raising the policy rate. Fiscal policy response, on the other hand, remains largely pro-cyclical, i. This pro-cyclical behaviour could follow as increase in revenue buoyancy of the government during the upswing of a business cycle makes government in developing countries to spend even more and remain downward inflexible during downswing of the business cycle Alesina and Tabellini, ; Ilzetzki and Vegh, There follows a strong counter-cyclical monetary policy, as reflected in the policy rate rising to a peak level by the fourth quarter after the shock.

As a result of this monetary policy action, decline in inflation overshoots by the fifth quarter before converging subsequently. Overall, responses of monetary and fiscal policies to output shocks are opposite to each other. The variance decomposition shows that shock to output gap accounts for about 25 per cent of the total changes in the policy rate, while it accounts for about 6.

Output gap accounts for about 4. The negative impact of inflation shock on output growth appears to last several quarters, though the statistical significance is weak initially. The response of inflation to its own shock is to converge back to its equilibrium level fairly rapidly in about three quarters. Interestingly, the correction in inflation overshoots by the third quarter before converging back around the eighth quarter.

This could be attributed to strong counter-cyclical monetary policy reaction of the authority to raise the policy rate to a peak by the third quarter before gradually converging back. The response of fiscal policy is again pro-cyclical as it increases by the second quarter before converging back by the fifth quarter Chart 2. This increase in fiscal deficit due to inflation could follow from price rise leading to increase in government expenditure more than that of revenue receipts.

A number of studies in the Indian context in the past have found that price elasticity of government expenditure is significantly higher than the price elasticity of government receipts for example, Khundrakpam, and The variance decomposition analysis shows that other than its own impact shock to inflation accounts for highest percentage of the total variation in policy rate 26 per cent. This also suggests strong monetary policy responses to rise in inflation.

Shock to inflation explains only about 3 per cent total variation in output gap and fiscal deficit Annex Tables 1 to 4. A positive shock to fiscal deficit takes about five to six quarters to converge back to its long run equilibrium path. On other hand, increase in fiscal deficit leads to rise in the level of output above the potential in the very first quarter.

However, the positive impact remains only till the second quarter, and by the third quarter the impact dies out completely and turns negative thereafter.


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In a supply constrained economy like India, this very short-term positive impact of fiscal expansion on output while having a negative impact in the medium to long-term could arise at least for the following two reasons. First, fiscal deficit, typically associated with government dis-savings may subsequently lower the overall savings, and therefore, investment in the economy, leading to lower level of output. Second, rising fiscal deficit could lead to hardening of the borrowing cost of more efficient private sector, and thus, crowd-out private sector investment and lower output growth RBI, and With the rise in output over the potential level following the shock in fiscal deficit, inflation rises from the first quarter and fall back to zero only by the fourth quarter.


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Monetary policy again reacts in a counter-cyclical manner but with a lag from the second quarter. Over the longer term, as fiscal expansion leads output to fall below the potential, both monetary policy and inflation is subsequently eased Chart 3. The variance decomposition analysis shows that shock to gross fiscal deficit explains about 3 per cent of the total variation in output gap and policy rate, while explaining around 12 per cent of the total variation in inflation Annex Tables 1 to 4.

Chart 4 shows the responses of various variables to a shock in policy rate.

What Is Fiscal Policy?

Increase in policy rate leads to decline in output below its potential level, reflecting negative impact on aggregate demand, with the decline peaking by the third quarter. This decline in the level of output below potential leads to decline in inflation, which also peaks by the third quarter, before converging back along with the convergence of output to its potential level. Increase in policy rate or monetary tightening leads to some fiscal expansion initially, which could follow from rise in borrowing cost of the Government and the fall in the level of output, before narrowing after the fourth quarter Chart 4.

The variance decomposition analysis shows that shock to policy rate accounts for about 20 per cent of the total variation in inflation by the fifth period, suggesting a significant impact of monetary policy on inflation. Policy rate accounts for around 4 per cent of the total variation in output gap Annex Tables 3 to 6.

This study analysed the behaviour of interaction between fiscal and monetary policies in India using quarterly data for Q2 to Q1. The choice of period of the study was influenced by the operating procedure of monetary policy in India which underwent a paradigm shift in the early with the introduction of liquidity adjustment facility and the interest rate channel becoming the main monetary policy signaling instrument.

The complete phasing out of automatic monetisation of fiscal deficit by april , the fiscal dominance over monetary policy had also eased substantially. Granger causality tests indicate that fiscal policy continues to unilaterally influence monetary policy even after the elimination of automatic monetisation of fiscal deficit and prohibition of RBI from buying government securities from the primary market. The impulse response functions from VAR analysis showed that monetary policy is highly sensitive to shocks in inflation and it responds swiftly in a counter-cyclical manner.

However, the response of fiscal policy shows a pro-cyclical tendency to both inflation and output shocks, which perhaps explains as to why monetary policy responds strongly than otherwise it would have. The study also suggests that expansionary fiscal policy is effective in raising the level of output over the potential level only in the short run.

In the medium to longer term, however, fiscal expansion leads to economic slowdown. It seems fiscal deficit leads to decline in savings and investment in the economy over the medium term, besides crowding-out more efficient private sector investment by government consumption. Janak Raj, J. Khundrakpam and Dr. We thank the participants in the above seminar for their valuable suggestions. These are strictly the personal views of the authors. Agha A.

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Aurbach, Alan J. Your Practice. Popular Courses. Login Newsletters. Monetary Policy vs. Fiscal Policy: An Overview Monetary policy and fiscal policy refer to the two most widely recognized tools used to influence a nation's economic activity. Key Takeaways Monetary policy addresses interest rates and the supply of money in circulation, and it generally is managed by a central bank. Fiscal policy addresses taxation and government spending, and it generally is determined by legislation.

Monetary policy and fiscal policy together have great influence over a nation's economy. Compare Investment Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. Related Articles. Federal Reserve Fiscal Policy vs. Monetary Policy Central Bank. Partner Links.

Monetary Policy vs. Fiscal Policy: What's the Difference?

Related Terms Expansionary Policy Definition Expansionary policy is a macroeconomic policy that seeks to boost aggregate demand to encourage economic growth. Tight Monetary Policy Definition A tight monetary policy is a course of action undertaken by a central bank—such as the Federal Reserve—to slow down overheated economic growth.

Monetary Theory Definition Monetary theory is a set of ideas about how changes in the money supply impact levels of economic activity. Contractionary Policy Combats Economic Distortion During Inflationary Times Contractionary policy is a macroeconomic tool used by a country's central bank or finance ministry to slow down an economy. Monetary Policy Definition Monetary policy: Actions of a central bank or other agencies that determine the size and rate of growth of the money supply, which will affect interest rates.

Quantitative Easing Definition Quantitative easing is a monetary policy in which a central bank purchases specified quantities of financial assets to increase the money supply and encourage lending and investment.