Fiscal and Monetary Policy Interactions in Pakistan Using a Dynamic Stochastic General Equilibrium Framework

Shahid, Muhammad and Qayyum, Abdul and Shahid, Waseem (2016): Fiscal and Monetary Policy Interactions in Pakistan Using a Dynamic Stochastic General Equilibrium Framework.

Abstract

Currently Pakistan’s economy is under stress and registered a sluggish growth for many years in a row. The performance of major economic indicators is not satisfactory. Low investment, double digit inflation, fiscal imbalances and low external capital inflows indicates the severity of the grave economic situation. This paper investigates fiscal and monetary policy interaction in Pakistan using dynamic stochastic general equilibrium model. Finding of the paper reveals that fiscal and monetary policy interacts with each other and with other macroeconomic variables. Inflation responds to fiscal policy shocks in the form of government spending, revenue and borrowing shocks. Monetary authority’s decisions are also affecting fiscal policy variables. It is also evident that fiscal discipline is critical for the effective formulation and execution of monetary policy.

• Item Type: MPRA Paper
• Language: English
• Keywords: Monetary Policy, Fiscal Dominance, DSGE, Pakistan
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents

References

Ahmad, S., Ahmed, W., Pasha, F., Khan, S., and Rehman, M., (2012). Pakistan Economy DSGE Model with informality. SBP Working Paper No. 47, State Bank of Pakistan.

Ahmed, W., Haider, A., and Iqbal, J., (2012). Estimation of Discount Factor  and Coefficient of Relative Risk Aversion  in selected countries. SBP Working Paper No. 53, State Bank of Pakistan.

Adolfson, M., Laséen, S., Linde, J., and Villani, M., (2008). Evaluating an estimated new Keynesian small open economy model. Journal of Economic Dynamics and Control, 32: 2690 – 2721

Arby, M. F., and Hanif, M. N., (2010). Monetary and Fiscal Policy Coordination: Pakistan’s Experience, SBP Research Bulletin, 6: 3 – 13. An, S., and Schorfheide, F., (2007). Bayesian analysis of DSGE models, Econometric Reviews, 30: 889 - 920.

Beetsma, R. and Jensen, H., (2004). Mark-up Fluctations and Fiscal Policy Stabilisation in a Monetary Union. Journal of Macroeconomics, 26(2): 357-376.

Bernanke, B., M. Gertler and S. Gilchrist (1999). The financial accelerator in a quantitative business cycle framework, Handbook of Macroeconomics Volume, Amsterdam: Elsevier Science, North-Holland.

Calvo, G. A., (1983). Staggered Prices in a Utility Maximizing Framework. Journal of Monetary Economics, 12: 383 - 398.

Cebi, C., (2012). The interaction between monetary and fiscal policies in Turkey: An estimated New Keynesian DSGE Model. Economic Modelling, 29: 1258 - 1267.

Cespedes, L, R. Chang and A. Velasco (2004). Balance sheets and exchange rate policy. The American Economic Review, 94: 4.

Chari, V.V., L. J. Christiano and P. Kehoe (1991), Optimal monetary and fiscal policy, Some recent results, Journal of Money, credit and banking, 23: 519- 539.

Charles, W., (1999). Economic policy coordination in EMU, Strategies and Institutions, mimeo

Choudhri, E. U., and Malik, H. A., (2012). Monetary Policy in Pakistan: A Dynamic Stochastic General Equilibrium Analysis. IGC Working Paper 12/0389, International Growth Center (IGC), London School of Economics and Political Science, UK.

Christiano, L., M. Eichembaum, and C. Evans, (2005). Nominal rigidities and the dynamic effects to a shock of monetary policy, Journal of Political Economy, 113: 1 - 45.

Christiano, L., R. Motto and M Rostagno (2007). Financial factors in business cycles, Mimeo, European Central Bank.

Choi, W. G., and D. Cook, (2004). Liability Dollarization and the Bank Balance Sheet Channel. Journal of International Economics, 64: 247 – 282.

Clarida, R., Gali, J., and Gertler, M., (1999). The science of monetary policy: A new Keynesian perspective, Journal of Economic Literature, 37: 1661 – 1707

Coenen, G., and Straub, R., (2005). Does government spending crowd in private consumption? Theory and empirical evidence from the euro area. International Finance, 8(3): 435 – 470.

Devereux, M. B., and M. Saito, (2005). A Portfolio Theory of International Capital Flows. manuscript, University of British Columbia.

Devereux, M. B., and A. Sutherland, (2006). Solving for country portfolios in an open economy macro model. Manuscript, University of British Columbia.

Engel, C., and A. Matsumto, (2005). Portfolio choice in a monetary open-economy DSGE model. University of Wisconsin and International Monetary Fund.

Favero, C. A., and Monacelli, T., (2005). Fiscal Policy Rules and Regime (In)Stability: Evidence from the US. IGIER Working Paper 282.

Fabio, C., and L. Sala, (2006). Back to square one: identification issues in DSGE models, Computing in Economics and Finance, Vol. 196.

Fialho, M. M., and Portugal, M. S., (2005). Monetary and Fiscal Policy Interactions in Brazil: An Application of the Fiscal Theory of the Price Level. Estudos Econômicos, 35:657-685.

Forni, L., L. Monteforte, and L. Sessa (2009). The general equilibrium effects of fiscal policy: Estimates for the Euro area. Journal of Public Economics, 93: 559 – 585.

Fragetta, M., and Kirsanova, T., (2010). Strategic Monetary and Fiscal Policy Interactions: An Empirical Investigation, European Economic Review, 54(7): 855 – 879.

Galí, J., (2003). New Perspectives on Monetary Policy, Inflation, and the Business Cycle. In Advances in Economic Theory, Applied Macroeconometrics, Oxford University press, 3: 151 – 197.

Galí, J. and Gertler, M., (1999). Inflation Dynamics: A Structural Econometric Analysis, Journal of Monetary Economics, 44: 195 – 222.

Galí, J., and Monacelli, T., (2005). Monetary Policy and Exchange Rate Volatility in a Small Open Economy, Review of Economic Studies, 72(3): 707-734.

Hagen, J. V., and Mundschenk, S., (2001). The political economy of policy coordination in the EMU, Swedish Economic Policy Review, 8: 107 – 137.

Haider, A. and Khan, S. U. (2008a). Does Volatility in Government Borrowing Lead to Higher Inflation? Evidence from Pakistan. Journal of Applied Economic Sciences, 4: 187 - 202.

Haider, A. and Khan, S. U., (2008b). A Small Open Economy DSGE Model for Pakistan. Pakistan Development Review, 47(4): 963 – 1008.

Ireland, P., (2004). Technology Shocks in the New Keynesian Model. The Review of Economics and Statistics, MIT Press, 86: 923-936.

Jacques, M. (1997). Some Cross-Country Evidence about Debt, Deficits, and the Behavior of Monetary and Fiscal Authorities. CEPR Discussion, Paper No.1653.

Javid, M., and Munir, K., (2010). The Price Puzzle and Monetary Policy Transmission Mechanism in Pakistan: Structural Vector Autoregressive Approach. The Pakistan Development Review, Pakistan Institute of Development Economics, 49(4): 449 – 460.

Kirsanova, T., Satchi, M., Vines, D., and Wren-Lewis, S., (2007). Optimal fiscal policy rules in a monetary union. Journal of Money, Credit, and Banking, 39 (7): 1759–1784.

Kydland, F. E., and Prescott, E., (1982). Time to Build and Aggregate Fluctuations. Econometrica, 50: 1345 - 1370.

Kumhof, M and D Laxton (2007). A party without a hangover? On the effects of US government deficits, mimeo IMF.

Kumhof, M., R. Nunes, and I. Yakadina, (2008). Simple Monetary Rules under Fiscal Dominance. Board of Governors of the Federal Reserve System, International Finance Discussion Papers No. 937

Leeper, E. M. (1991). Equilibria under Active and Passive Monetary and Fiscal Policies. Journal of Monetary Economics, 27(1): 129-147.

Lubik, T. A., and Schorfheide, F., (2005). A Bayesian look at new open economy macroeconomics. National Bureau of Economic Research 20: 313 - 366.

Lubik, T. A., and Schorfheide, F., (2007). Do central bank responds to exchange rate movements? A structural investigation. Journal of Monetary Economics, 54: 1069 – 1087.

Malik, W. S., (2007). Monetary Policy Objectives in Pakistan: An Empirical Investigation, Working Paper. 35, Pakistan Institute of Development Economics, Islamabad, Pakistan.

Mélitz, J., (1997). Some Cross-Country Evidence about Debt, Deficits and the Behaviour of Monetary and Fiscal Authorities. CEPR Discussion Papers 1653, C.E.P.R. Discussion Papers.

Milani, F. (2004). Adaptive Learning and Inflation Persistence. Mimeo, Princeton University.

Muscatelli, A. M., P. Tirelli and C. Trecroci (2001). Monetary and Fiscal Policy interactions over the Cycles: Some empirical Evidence. Cambridge University Press, Cambridge, United Kingdom.

Muscatelli, A. M., P. Tirelli and C. Trecroci (2004). Fiscal and monetary policy interactions in a new Keynesian Model with Liquidity constraints. Centre for Dynamic Macroeconomic Analysis, CDMC 04/02.

Muscatelli, V.A., and Tirelli, P., (2005). Analyzing the interaction of monetary and fiscal policy: Does fiscal policy play a valuable role in stabilisation? CESifo Economic Studies, 51 (4): 549–585.

Ortiz, A., Ottonello, P., Sturzenegger, F. and Talvi, E. (2009). Monetary and Fiscal Policies in a Sudden Stop: Is Tighter Brighter? In Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America, Report Draft, Inter-American Development Bank.

Rabanal, P., (2007). Does inflation increase after a monetary policy tightening? Answers based on an estimated DSGE model, Journal of Economic Dynamics and Control, 31(3): 906 – 937.

Ratto, M., Roeger, W., and Veld, J., (2009). Fiscal policy in an estimated open- economy model for the euro area. Economic Modeling, 26: 222 – 233.

Sim, C., (1994). A simple model for the determination of the price level and the interaction of monetary and fiscal policy, Economic Theory, 4: 381-399.

Smets, F., and Wouters, R., (2003). An estimated stochastic dynamic general equilibrium model of the euro area. Journal of the European Economic Association, 1: 1123 – 1175.

Smets, F., and Wouters, R., (2007). Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach. American Economic Review, 97(3): 586 – 606.

Tovar, C. E., (2009). DSGE models and central banks. Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, 3(16):1 – 31.