SEMINARIO PERMANENTE DE LAS IDEAS: Economía, Población y Desarrollo

1. SEMINARIOPERMANENTE DE LAS IDEAS: Economía, Población y Desarrollo Cuerpo Académico Número 41 www.estudiosregionales.mx 1

2. Public Finance and Monetary Policies as Economic Stabilizer: Unique or Universal Across Countries? DRA. ARWIPHAWEE SRITHONGRUNG PublicFinance Center; Wichita StateUniversity, Ciudad Juárez, Octubre 13 2014

3. OUTLINE • Introduction • Theoretical background • Methodology and data • Results • Discussion • Conclusion

4. Introduction • Motivation of the study • Does monetary policy work better than fiscal policy in developing countries? • Lack of systematic test for stabilization policy in developing countries • Non-industrialized countries • Low-to medium-income levels; • Research question • In what circumstances is monetary policy effective in stabilizing an economy and in what circumstances is fiscal policy a better tool to do the same? • Theoretical arguments • Asymmetric information in capital markets • Stabilizing economy at the least social cost

5. Theoretical background (1) • Musgrave, R. (1959): public finance functions and roles • Correct market failures • Public infrastructure • Public programs • Tax revenue, public budgeting, government consumption and investment • Redistribute resources from rich to poor • Social programs • Income tax structure • Current transfer payment • Stabilize macro-economy • Fiscal policy: tax, spending and deficit finance • Monetary policy: central bank interest rate

6. Theoretical background (2) • Basic roles of fiscal and monetary policies • Mundell-Fleming’s (1963) IS/LM Model • Sticky prices in short run • Fiscal and monetary policies to change output levels • Interest rate: directly change investment and consumption level • Public spending, taxes and deficit finance: indirectly change investment and consumption by re-shuffling resources • Open economy with fixed exchange rates • Fiscal policy: deficit finance and tax cut  investment/consumption  change interest rate  foreign investment change • Open economy with floating exchange rates • Monetary policy: interest rate foreign investment - domestic currency demands/supply export level

7. Theoretical Background (3) • Relax IS/LM Model by adding public debt accumulation • Two contrasting views: finite and infinite-horizon • Finite-horizon assumption • Beetsma & Bovenberg, 1995; Durham, 2006; Shabert, 2004; Piergallini; 2005; Bartolomeo & Gioacchino, 2008 • Fiscal policy: both fixed and floating exchange rates • Economic agents: • ---anticipate central bank’s inflation strategies • ---assume life-cycle cost; debt is postponed to the next generations • Government liabilities affect aggregate demand and thus generate wealth • Unintentional effect of monetary policy • ---agents guess central bank strategy • ---cut employment and inputs without necessary reasons • Counter-cyclical fiscal policy

8. Theoretical Background (4) • Infinite-horizon assumption • Kirsanova, Stehn, Vines, 2005; Clarida, Gali & Gertler, 1999; Romer & Romer, 1996; Stehn & Vines, 2007 • Monetary policy: both fixed and floating exchange rates • Economic agents • --expect inflation and recession in the future • --do not pass debt service burden to future generation • --do not react to tax and government spending • Taylor rule: set nominal interest rate to target real inflation and recession • --bad times: decrease nominal interest rates for several periods, followed by deficit finance • --good times: increase nominal interest rates for several periods; followed by tax increase • Unintentional effects of fiscal policies • --tax increase/surplus in early inflation period- dampens investment; agents expect future recessions • --deficit finance in early recession coupled with high debt accumulation -- higher interest rates- force public spending cut  negative impacts on employment and low-wage workers

9. Theoretical background (5) OECD Countries Non-OECD Countries • Typically high-income • Complete capital markets—controllable cash inflows • Relatively high human development index • Relatively high institutional quality • Relatively lower fiscal burden Mankiw, Wienzierl, Blanchard, Eggertsson, 2011; Christiano, Eichenbaum & Robelo, 2009 • Relatively high public debts • Relatively low government accountability • Relatively low government credibility • Incomplete trading system, opaque national account, high level of government deficits • Imcomplete capital markets Hasan & Isgut, 2009; Fielding, 2008; El-Shagi, 2012

10. Theoretical background (6) • Fiscal and monetary policies economic growth • Warren Smith (1957) • Structurally balanced economy: • Full employment and production is achieved in current year • In the following year, tax burden must be less than investment • The ratio of private investment to GDP is greater than the ratio of government revenue to total national income • Resource allocation between public and private sectors is optimal • Business cycles create random shocks but do not interrupt long-term growth • Rarely occurs; private investment depends on • Current-year investment level and profits • Profit tax • Government consumption • Current year investment over optimal level- inflation • Current year investment under optimal level -- recession

11. Theoretical background (7) • Fiscal and monetary policies economic growth • David Smith (1960), • Relaxes closed-economy assumption : • In addition to domestic investment and consumption • Balanced payment in national account due to a country’s levels of export, import and disposable income • Open economy allows for spillover effects • Maintaining balance of payments is key • Direct policy tools, e.g., tariff taxes, import controls, periodic exchange rate devaluation can control balance of payments • Monetary policy enhances growth • Indirectly changes investment levels especially when faced with foreign growth • Fiscal policy enhances growth • Tax increases discourage consumption • Cautions: in situations with incomplete capital markets and fixed tax systems fiscal policy is more effective

12. Theoretical background (8) • Hypothesis 1:In OECD countries, fiscal policy through deficit finance and public spending is ineffective [due to economic agents’ anticipation; while monetary policy is effective because interest rates provide incentives for private investment]

13. Theoretical background (9) • Capital markets / institutional quality of government (El-Shagi, 2012) • Intensity of cash inflow control • Quality and intention of capital market regulation • Western/industrialized or high-income countries • Capital markets designed to limit exposure to foreign risks • Capital market transparency • Inflow and outflow levels are compatible • Non-industrialized or medium-to low-income countries • Capital markets designed to enhance local cash supplies • Capital market rules and regulation is arbitrary • Transaction approvals are opaque

14. Theoretical background (10) • Quality of government and ability to monetize (Fielding, 2008; Calvo, Leiderman, Reinhart, 1996; Kaminsky, Rinehart & Vegh, 2004) • Western/industrialized or high-income countries • Capital inflows rising • Create domestic currency demands • Foreign investments increase; generating long term growth • Non-industrialized or medium-to low-income countries • Capital inflows rising • Create inflation pressure • Domestic currency appreciates; dampening export • Consequences for non-industrialized and medium to low-income economies • Low domestic currency demands, national saving -- inelastic rate • Public debt fails to absorb inflation, unless set extraordinary high

15. Theoretical background (11) • Summary for monetary policy • Mankiw, Wienzierl, Blanchard, Eggertsson, 2011 • monetary policy: counter-cyclical; • interest rate is an effective tool to mitigate inflation and recession • Kaninsky, Rienhart & Vegh, 2004 • fiscal policy tends to be cyclical • coupled with the incomplete capital market problems • Easterly and Schmidt-Hebbel (1993) • in developing countries, good financial management through well-planned taxing and spending leads to growth

16. Theoretical background (12) Hypothesis 2:In non-OECD countries, fiscal policy through public spending is effective in stabilizing economies, while monetary policy is ineffective [since current account balance does not readily adjust to reflect true levels of capital inflows]

17. Methodology and data (1) • Fischer (1993): where; is per capita real Gross Domestic Product (GDP), is inflation rate, bis balance account payment, is government spending rate, is interest rate and is capital accumulation rate

18. Methodology and Data (2) • Panel Vector Autoregression (PVAR) • Endogenous system of equations • Reproducing Fischer’s system • Addresses endogeneity • Needs appropriate lag length to reduce errors to white noise

19. Methodology and data (3) • Sample Countries

20. Methodology and data (3) • Summary Statistics: OECD Countries (with high income)

21. Methodology and data (3) • Summary Statistics-Non-OECD Countries (with medium- to low-income

22. Results: OECD group

23. Results: OECD Impulse Response

24. Results: OECD Impulse Response

25. Results: non-OECD group

26. Results: non-OECD Impulse Response

27. Results: non-OECD Impulse Response

28. Discussion (1) • OECD Countries • Central bank discount rate negatively related to economic growth • For every one standard deviation shock decrease (2.7%), real per capita GDP increases by about $495 (one standard deviation PC GDP = $846) • The monetary policy effect is persistent across 4-year period • No effect for monetary policy for the year in which the policy is introduced • No significant effect of fiscal policy

29. Discussion (2) • Non-OECD Countries • Government spending is positively related to economic growth • For every one standard deviation of government spending increase (1.2%), real per capita GDP increases by about $1,026 ( one standard deviation GDP = $1,172) • The fiscal policy effect on output is persistent across 6-year period • No effect of fiscal policy in the same year as the policy is introduced • Monetary policy is not statistically significant

30. Conclusion • Three viewpoints • Currency exchange system • Finite-horizon assumption/Infinite-horizon assumption • Capital market and institutional quality/openness and foreign growth and declines • Theoretical contribution • To choose economic policy, it’s not only about economic agents’ response and exchange rate systems,…………… but also quality/intention of capital market regulation • Practical contribution • For developing, fiscal policy stabilizes output while shifting wealth among sectors • Limitation • The model lacks exogenous variables • Fails to explain the path in which fiscal policy stabilizes output

31. SEMINARIOPERMANENTE DE LAS IDEAS: Economía, Población y Desarrollo Cuerpo Académico Número 41 www.estudiosregionales.mx 31