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BMS0054: Postgraduate Research Paper (Aaron Tan)
Research Paper Journal Article: 6,000-8,000 words
Mohamed Ashour (u1573932)
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u1573932 BMS005411516
Interactions of Fiscal, Monetary Policy and Output in the Advanced
Economies Before and After the Global Financial Crisis: A VAR Panel
Comparative Approach
ABSTRACT
This study investigates the interactions of fiscal policy, monetary policy and
output in the advanced economies by comparing the period before the crisis from
Q1 2000 to Q2 2008 to the period after crisis from Q3 2008 to Q4 2015. An
unrestricted VAR panel model of 3 endogenous variables is used based on
quarterly panel data of 26 advanced countries for the growth of real GDP as a
measure of output, interest rates as a measure of monetary policy and growth in
government expenses as a measure of fiscal policy. Impulse response functions
and variance decompositions are used to interpret and analyse results from the
VAR model due to the complexity of interpreting many coefficients in VAR
models which dynamically affect and depend on each other. The results imply
that the effectiveness of interest rates as a measure of monetary policy on the
growth of real GDP weakened significantly after the crisis. Moreover, variation
in monetary policy due to the growth of real GDP increased after crisis due to the
increase in utilizing interest rates to stabilize and boost the output in advanced
economies. In addition, the fiscal policy has a limited impact on output before
and after the crisis and no effect on monetary policy in both periods. Finally,
effect of output on fiscal policy weakened significantly after the crisis.
Mohamed Ahmed Ashour
12 September 2016
Thesis submitted to the University of Huddersfield
(Huddersfield University Business School)
in partial fulfilment of the requirements for the degree of
Master of Science in Economics
No portion of the work referred to in the research paper has been submitted in support of an application for another
degree of qualification of this or any other University or institute of learning
Total number of words excluding the abstract: 7997
1
1 INTRODUCTION
As achieving macroeconomic stability has become challenging in the advanced
countries after their economies were hit by the global financial crisis in 2008, it
is important to study the interactions between fiscal, monetary policy and output
in those economies and whether the effectiveness of the macroeconomic policies
is impacted compared to the period before the crisis or not.
Thus in this study, a 3 equations VAR panel model employing data from 26
advanced countries mostly from Europe and US in the period from Q1 2000 to
Q4 2015 is used to capture the dynamic interdependencies between fiscal,
monetary policy and output in the period before and after the crisis.
The study findings suggest that even though monetary policy is effective in
responding to output fluctuations before the crisis, its effectiveness weakens
significantly in the period after the crisis. Additionally, fiscal policy has a limited
effect on output before and after the crisis and no effect on monetary policy in
both periods. Nevertheless, contractionary monetary shock has a mixed effect on
fiscal policy before the crisis, i.e., government expenses increase in the short run
forecast horizon before decreasing in the longer forecast horizon, while after the
crisis the same effect is negative in the short run before being neutral in the long
run.
The rest of the study is organized as following: Section 2 reviews the literature
of coordination between fiscal and monetary policy in addition to debates
attributed to the fiscal and monetary policy before and after the crisis. Data
description is presented is section 3 followed by the econometric methodology in
section 4. Section 5 highlights the empirical analysis and interpretation of results.
Finally, the last section is for main conclusions.
2
2 LITERATURE REVIEW
2.1 Coordination between fiscal and monetary policy
The coordination between fiscal and monetary policy and the effectiveness of
both policies have been discussed extensively in the literature whether
theoretically or empirically. This section highlights a sample of this huge
published research with a special focus on how the conduct of both the fiscal and
the monetary policies might change with the occurrence of crises and
consequently affect the overall economy.
One of the pioneering studies in the area of fiscal and monetary policy
coordination is Friedman (1948) that proposes a framework involving both
policies. This framework suggests reforming the monetary system through
limiting discretion attributed to controlling money supply by the central bank. On
the other hand, the fiscal framework suggested is attributed to three aspects: the
government expenditure, social security benefits and the tax system. A common
trait among those fiscal aspects that Friedman (1948) stresses in his framework
is again related to supporting working within rules or targets rather than
discretionary actions that respond to cyclical fluctuations in the economy. This
provides a stable fiscal and monetary framework amid short run cyclical
fluctuations and avoids to a great extent uncertainty resulting from discretionary
responses (Friedman, 1948).
On the other hand, Alesina and Tabellini (1987) present an opposing view to
Friedman (1948) regarding rules vs. discretion. They show using a game
theoretic model that when monetary policy follows rules it produces a lower level
of output and public spending when coordination with fiscal policy is absent
compared to a scheme where the monetary regime follows discretion. Moreover,
Alesina and Tabellini (1987) highlight how the degree of coordination between
fiscal and monetary authorities under a discretionary regime leads to different
3
results attributed to output, government spending and taxes depending on the
level of independence of the central bank.
In their paper, Sargent and Wallace (1981) present two different scenarios for the
interaction between monetary and fiscal policy within a game theory scheme.
One in which the monetary policy is in the lead, while the other in which there is
a kind of fiscal dominance, where the monetary policy acts in response to the
fiscal policy. In the first scenario, the monetary authority sets the monetary
targets first. This results in fiscal policy being constrained by those targets when
planning the budget and setting the fiscal targets. Consequently, under this
scenario inflation is well controlled by the monetary policy, while in the second
scenario Sargent and Wallace (1981) propose another model where there is a kind
of fiscal dominance, in which the fiscal authority sets the budget and announces
all related fiscal targets. As a result, the monetary authority follows the fiscal
authority and is limited by the fiscal targets that should be achieved. This results
in higher inflation due to the increase in money supply created to meet the fiscal
needs.
Blinder (1982) builds on the idea of the two scenarios that Sargent and Wallace
(1981) presented and discusses which of the two policies or authorities should
have the higher hand. Blinder (1982) elaborates that it is challenging to decide
which authority is always right or superior over the other, therefore it is better to
balance the power between both authorities so that no authority is dominant over
the other. Moreover, Blinder (1982) illustrates why coordination might be weak
or absent between both policies which is due to the lack of a common objective
between the two policies or authorities. Under these conditions of uncertainty on
whether fiscal or monetary policy should be in control and the lack of common
objectives non-coordination between both policies might be the best option
(Blinder, 1982).
Another paper that tackles important issues and challenges related to
coordination between monetary and fiscal policies is Laurens and De La Piedra
4
(1998) which discusses policy coordination in the short and long run, the
consequences of lack of policy coordination, the importance of timing in
coordination, and how coordination differs under fixed vs. flexible exchange rate
regimes. Regarding policy coordination in the short and the long run, Laurens
and De La Piedra (1998) mention that priority should be given to the monetary
policy to achieve price stability, as well as management of the public debt.
Nevertheless, the next stage after attaining price stability is attributed to
achieving sustainable growth and controlling inflation. This takes place through
coordination between both policies, in the long run, to guarantee that any fiscal
deficits stay within the level, where they can be financed through capital markets
without resorting to external borrowing or increasing the money supply by the
central bank as it will result in inflationary pressures.
Weak or lack of coordination can lead to different scenarios similar to those
presented earlier by Sargent and Wallace (1981). First is a scenario in which the
monetary policy presented by the central bank determines its monetary targets
without accommodating the financing needs of the government. As a result, the
government would be restricted by the domestic and foreign borrowing available.
A second scenario that Laurens and De La Piedra (1998) mention is a scheme of
fiscal dominance where the fiscal authority presented by the ministry of finance
determines the fiscal needs solely which enforce the monetary authority to
finance those deficits through monetary base expansion which increases
inflationary pressures, in addition to pressures attributed to maintaining exchange
rate in fixed exchange rate regimes which result in distortion in the levels of
international reserves.
An important point which Laurens and De La Piedra (1998) state is related to
how both the monetary and fiscal policies function differently when it comes to
time. The same view is also shared by Arestis and Sawyer (2004a) who point out
that monetary policy is implemented in a quicker manner that is more flexible to
adjustments on a daily basis compared to fiscal policy which cannot be adjusted
5
as quickly and smoothly as the monetary policy due to political aspects related
to getting approvals through parliament for any government expenditures leading
to policy lags. In addition to other challenges such as the ‘ratchet effect’ which
is usually associated with the fiscal policy specifically when increasing
government expenditures is needed, but politically infeasible (Arestis and
Sawyer, 2004a).
Laurens and De La Piedra (1998) show that the room given to each policy differs
based on the exchange rate system, where in a fixed exchange rate regime the
role of the monetary policy is limited as it becomes mainly a follower to the
monetary policy of the economy to which the local currency is pegged to.
Therefore, most of the burden falls on the fiscal policy to stabilize the economy.
The opposite is completely true in a flexible exchange rate regime, where the
monetary policy has more space to operate and as a result is more effective.
Eggertsson (2006) elaborates that the coordination between fiscal and monetary
policy is preferable when the economy is witnessing deflationary pressures. This
coordination between both policies leads to maximizing social welfare that is
reflected in figures of fiscal multipliers for real and deficit spending which are
found to be higher under a coordinated policy compared to an uncoordinated one.
On the other hand, Eggertsson (2006) states that an uncoordinated scheme results
in the central bank operating independently to achieve inflation and output targets
without taking into consideration the implications on fiscal policy.
Niemann and Hagen (2008) agree with Laurens and De La Piedra (1998) that the
monetary policy is more effective compared to fiscal policy in stabilizing short-
run fluctuations in the economy. Besides, Niemann and Hagen (2008) elaborate
how fiscal policy can pressure the monetary policy and affect how it operates by
highlighting the concept of fiscal space presented also by Mates (2011), who
shows how the fiscal space size affected the room the fiscal policy had to function
during the global financial crisis. Moreover, Niemann and Hagen (2008)
demonstrate how both policies are interrelated especially in the long run.
6
Hutchison, Noy and Wang (2010) study 83 different crises in 66 countries by
setting a model that explains how output growth is affected by crises besides the
effect of fiscal and monetary policy. Hutchison et al. (2010) conclude that
contractionary fiscal and monetary policy during crises intensifies slowdowns
and may strongly lead to large output losses. Additionally, they find that
discretionary fiscal expansion does not lead to large output losses as usually
shown in the literature, while expansionary monetary policy has no clear effect.
Additionally, Li (2013) studies how effective fiscal and monetary policies are
during several crises from 1977 to 2010. Li (2013) finds that while expansionary
fiscal policy does not have any influence in shortening crises, a mild
expansionary monetary policy is influential in shortening the duration of crises
compared to an aggressive expansionary monetary policy which is impotent. On
the other hand, Li (2013) observes that contractionary monetary policy
exacerbates crises.
Arestis (2015) supports giving a wider room for fiscal policy, as he argues that it
is effective in increasing employment rates through its effect on aggregate
demand which could be boosted if coordinated with monetary policy.
2.2 Evolution of fiscal and monetary policy debates
This subsection reviews how ideas related to fiscal and monetary policy have
evolved recently, and how debates around both policies have intensified and
increased resulting in reviewing and reconsidering the conventional framework
specifically after the global financial crisis.
Arestis and Sawyer (2004a) and Arestis and Sawyer (2004b) highlight how in the
years before the global financial crisis the monetary policy had the upper hand
compared to the fiscal policy — a phenomenon which changed after the crisis
with the fiscal policy restoring some of its lost influence.
7
Some reasons behind this domination of the monetary vs fiscal policy as shown
by Arestis and Sawyer (2004b) are first the abandonment of targeting
unemployment as the main goal of the macroeconomic policy in favour of
inflation. Additionally, restricting the usage of fiscal policy to be used only as an
automatic stabilizer within a constrained budget, as well as the downgrade of the
fiscal policy in favor of the monetary policy in boosting the economy and dealing
with fluctuations since monetary policy is quicker in implementation compared
to fiscal policy.
2.2.1 Monetary Policy debates
Arestis and Sawyer (2004a) mention that the monetary policy developed from
trying to control the money supply to trying to target and control inflation through
interest rates as its main goal starting from the second half of the 1980s. This
approach continued until the occurrence of the global financial crisis which led
to some demands to widen the scope of the monetary policy, as suggested by
Arestis and Sawyer (2012), who contend that the main objective of monetary
policy and central banks should be the financial stability, not targeting of
inflation. This resulted from the attention given to financial regulation and
supervision after the disorder caused by shadow banking and financial
engineering during the crisis.
Blanchard (2012), Blanchard (2011a) and Blanchard, Dell’Ariccia and Mauro
(2013) reinforce the argument of Arestis and Sawyer (2012) that the crisis has
revealed that inflation and output should not only be the targets of monetary
policy and that policy rate is not the only instrument needed to maintain
macroeconomic stability. Moreover, according to Blanchard (2011b), the crisis
has shown how stable inflation and output which is near potential can distract
policymakers and economists from risky hidden imbalances such as those related
to highly leveraged financial institutions, high private debt, excess maturity
8
mismatches, etc., all of which have led to shedding more light on the importance
of using macro-prudential tools in order to monitor those imbalances and achieve
financial stability beside achieving macroeconomic stability through monetary
policy by using the policy rate as pre-crisis. (Blanchard et al., 2013; Blanchard,
2012; Blanchard, 2011a).
Stiglitz (2012) points out that one of the main the reasons that led to the crisis is
the dependence of economists on economic models that are not inclusive, which
affected the monetary policy decisions. Stiglitz (2012) elaborates this by
explaining how credit is used as equivalent to money in these times which is
acceptable in normal times since both variables are highly correlated. However,
during crises, this relationship is not valid or accurate. Another point that has to
be taken into consideration is the importance of coordination between different
instruments to achieve different objectives in policy-making, as the crisis
revealed how the absence of coordination can be inefficient to the final outcome
of the policy (Stiglitz, 2012).
A controversial topic that caught a lot of attention in academia after the crisis is
attributed to the monetary stimulus that a lot of countries worldwide undertook
after the crisis to stimulate their economies. The controversy arises from the
effectiveness of the stimulus and whether it is beneficial to put the economy back
on the right track or not. Mishkin (2009) argues that monetary policy is effective
during financial crises, and disagrees with those who claim that easing monetary
policy is ineffective. Mishkin (2009) claims that following a tight monetary
policy during the crisis would have made the slowdown worse as consumer
spending and investments would have been more constrained creating more
uncertainty and risk which would have been reflected in higher interest rates of
treasury securities.
Bouis et al. (2013) disagree with Mishkin (2009), arguing that monetary stimulus
can affect the recovery of the economy negatively as a result of rolling over risky
9
debt smoothly with the help of low interest rates which they state was observed
by different studies in some countries in the OECD.
To sum up, it is important to understand that the crisis revealed that the financial
sector and the economy are interrelated where any disruption in the financial
sector is reflected in the economy and vice versa. Therefore, macro-prudential
tools are needed in order to achieve financial stability which cannot be achieved
only by targeting inflation and output stability. Moreover, the crisis exposed the
dilemma of the zero lower bound which was earlier thought to be a phenomenon
that does not persist for a long time. However, after the crisis, the opposite was
proved which exposed the limits of conventional policy specifically in
responding to further shocks and prolonged slowdown. Lastly, though aggressive
monetary stimuli were implemented, it is important to understand that recovery
after recessions resulting from crises is not as rapid as after normal recessions —
in other words, V-shaped recoveries do not occur (Mishkin, 2011; Reinhart and
Reinhart, 2010).
2.2.2 Fiscal Policy debates
Moving to the evolution of the fiscal policy and how the global financial crisis
affected it, Blanchard, Dell’Ariccia and Mauro (2010) state that fiscal policy has
been inferior to monetary policy in the two decades ahead of the crisis, a view
which is supported by many others such as Arestis and Sawyer (2004a). This
retreat was due to many reasons according to Blanchard et al. (2010). The first
being the controversy surrounding the effectiveness of fiscal policy to stimulate
the economy due to the Ricardian equivalence. Additionally, the success of
monetary policy in stabilizing the output before the crisis during what economists
call the Great Moderation. Furthermore, the speed associated with the
implementation of monetary policy compared to fiscal policy which is hindered
by parliamentary decisions leading to lags which make the fiscal policy not as
10
suitable for short term fluctuations or slowdowns as the monetary policy.
Consequently, the usage of fiscal policy as a countercyclical tool ahead of the
crisis was most of the time limited to the automatic stabilizers, especially in
advanced economies which had the upper hand compared to the discretionary
fiscal measures (Blanchard et al., 2010).
According to Blanchard et al. (2010), the crisis was the main trigger behind
pulling back the fiscal policy from being inferior to the monetary policy to being
more or less equivalent in importance. This was due to the mainstream realization
that the monetary policy with all its conventional and unconventional instruments
had nothing more to offer, especially as time showed that the recession was not
going to be short, and therefore resorting to fiscal stimulus was inevitable.
Mates (2011) shows how fiscal policy has risen back to the main stage during the
crisis. The reaction towards fiscal policy has developed as the crisis passed
through different stages and events kept unfolding. Fiscal policy was limited at
the beginning to the implementation of the automatic stabilizers due to the fears
of increasing expenditures and indebtedness that could lead to fiscal deterioration
as a result of any discretionary fiscal measures (Mates, 2011).
Things started to change with the crisis starting to be felt on a larger scale after
the collapse of Lehman Brothers in 2008 and with discretionary fiscal stimuli
getting approvals in most of the advanced economies. However, pressures on
fiscal spaces started to accumulate in some countries like Greece which led again
to the controversy around fiscal discretionary relaxation and how it pressures
fiscal spaces especially in countries that face challenges attributed to their current
account and budget deficit figures (Mates, 2011).
Mates (2011) notes that the effect of automatic stabilizers together with monetary
stimuli was more substantial than that of discretionary stimuli, which contributed
to imbalances as well as debt problems in countries that do not have enough fiscal
space.
11
Indrawati (2012) states that introducing automatic stabilizers even if it is just
limited to a certain period of time is important for quicker fiscal effect. Moreover,
Indrawati (2012) highlights the importance of expenditure that generates
employment as well as capital expenditure which creates jobs and leads to output
growth.
An important challenge that rises with the crisis is attributed to fiscal
consolidation and its speed. Some strategies for fiscal consolidation include
expanding the tax base to increase tax revenues as an automatic stabilizer, besides
limiting discretionary spending and improving the quality of spending
(Indrawati, 2012).
Nevertheless, it is important to take into consideration that fiscal consolidation
can increase income inequality which is simply due to the decrease in output and
employment in the short run, which is reflected in lower consumption and
incomes (Arestis, 2015).
Finally, we can conclude that the crisis has shed light on the following fiscal
policy lessons. First, fiscal space is very important when it comes to using fiscal
stimuli in absorbing economic shocks: the larger the fiscal space the more fiscal
stimuli can be used to stimulate the economy and vice versa. Furthermore, the
crisis showed that fiscal policy can be used to stabilize the economy in the short
run when the monetary policy reaches its limits, as the crisis reinforced strongly
the evidence of fiscal policy effectiveness (Romer, 2012).
3 DATA
The dataset used in this study is a panel dataset which consists of 26 countries of
the advanced economies1 most of which are from Europe in addition to the United
States as per the classification of the World Economic Outlook database of the
1 List of the countries included are in Table A.1 in the Appendix
12
IMF. The focus on Europe and the United States in the dataset is due to the fact
that both represent the majority of the advanced economies that were affected by
the global financial crisis. The period of the study is from Q1 2000 to Q4 2015
consisting of 1664 observations divided into 2 parts to examine how the
interaction of fiscal policy, monetary policy and output differed before and after
the crisis in the advanced economies. Part 1 consists of 884 observations from
Q1 2000 to Q2 2008 representing the period before the crisis. Part 2 is from Q3
2008, which coincides with the collapse of Lehman Brothers in the US and is
considered the triggering event that led to the spread of the crisis worldwide, to
Q4 2015 representing the period after the crisis. The variables used in this study
are 𝒚𝒕 , 𝒊𝒕 and 𝒈𝒕. 𝒚𝒕 is a proxy for output which represents the year on year
(YoY) growth rate of real GDP on quarterly basis. The data for this variable is
extracted in this form from the International Financial Statistics Database (IFS)
of the IMF. The reason behind using YoY growth of GDP and not the absolute
value is to avoid the seasonality of numbers and to overcome the problem of GDP
figures reported in national currencies. 𝒊𝒕 is a proxy for monetary policy which
represents the official interest rate announced by the central bank in each country
on a quarterly basis. The data for this variable is extracted from the IFS database.
There are some challenges that were faced while extracting interest rate data —
firstly, although the central bank (CB) policy rate is the official rate for most of
the countries in the dataset of the study, for some countries it is not. Therefore,
the IFS notes were checked for countries to figure out what is the official interest
rate announced by central banks in those countries. It was found that in some
countries the official interest rate is the discount rate, for others it is the money
market rate and for some countries the official rate is the repo rate. Moreover, the
majority of the countries in the dataset are in the Euro Area, consequently the
central bank policy rate of the ECB is used for those countries starting from the
date of joining the Euro Area, which for most of the countries in the dataset is
before Q1 2000. However, for countries that joined after Q1 2000 or recently, the
official rate of their central banks is followed whether it is the discount rate or
13
the CB policy rate or the money market rate, etc. till the date of joining Euro Area
after which the CB policy rate announced by the ECB was followed as in the rest
of countries in the Euro Area. 𝒈𝒕 is a proxy for fiscal policy which represents the
YoY growth rate of government expenses of each country on a quarterly basis.
General government expenses quarterly figures are extracted from the IFS
database in absolute figures then YoY growth rates for the quarterly figures were
calculated in order to overcome the fact that the data is available only in national
currencies. Additionally, this avoids seasonality of data that could occur if the
growth rate for quarterly government expenses is calculated on Quarter on
Quarter (QoQ) basis and not YoY basis. The choice of the 3 variables 𝒚𝒕 , 𝒊𝒕 and
𝒈𝒕 is based on the related literature specifically on Senbet (2011) and Mitreska
et al. (2010).
4 ECONOMETRIC METHODOLOGY
4.1 Background on VAR models
The main goal of this paper is to study how fiscal and monetary policy interacted
before and after the crisis in the advanced economies, and how this interaction
affects the output in these economies. This paper uses the vector autoregression
(VAR) model which has become commonly used in macroeconomic time series
modelling after Sims (1980) highlighted it as a technique that can be applied to
elaborate dynamic relationships and interdependencies among a group of
variables. The triggering point that contributed to the development of VAR
models to be used in macroeconomic modelling is attributed to the fact that
traditional simultaneous equation models that were used previously before Sims
(1980) introduced VAR models are associated with the problem of identification.
This is usually solved by enforcing some restrictions that according to Sims
(1980) have no solid justifications. As a result, an unrestricted VAR model was
developed by Sims (1980) in which all variables are treated equally without any
14
differentiation between endogenous and exogenous variables as in the restricted
conventional simultaneous equations model. In addition, the number of variables
should be equal in all equations within the VAR model (Gujarati, 2015).
A reduced mathematical form of the VAR panel model followed in this paper is
as following:
𝒚𝒕 = 𝜷𝟏 𝒚𝒕−𝟏 + 𝜷𝟐𝒚𝒕−𝟐 + ….+ 𝜷𝒑 𝒚𝒕−𝒑 + 𝜺𝒕
Where 𝑦𝑡 is a (k × 1) vector of endogenous variables, k is the number of
endogenous variables, 𝛽1 , 𝛽2 , …., 𝛽𝑝 are (k × k) matrices of coefficients to be
estimated, and 𝜖𝑡 is a (k × 1) vector of error terms, which is also called the shocks
or impulses. According to Canova and Ciccarelli (2013), the only difference
between VAR models and VAR panel models is the inclusion of a cross sectional
dimension in the VAR panel models.
4.2 VAR methodology and Fiscal and Monetary policy interaction
VAR models have been extensively used to study the interaction between fiscal
and monetary policies, their effectiveness and how they affect output. Coric,
Simovic and Deskar-Skrbic (2015) analyse the interaction of fiscal and monetary
policy in Croatia from 2004 to 2012 using a VAR model and find that both
expansionary fiscal and monetary policy contributed positively to the economic
growth in Croatia. Furthermore, Coric et al. (2015) demonstrate that the
coordination between both policies can help maintain price stability, in addition
to achieving economic growth.
Semmler and Zhang (2004) study the interaction of fiscal and monetary policy in
the Economic and Monetary Union of the EU (EMU), specifically in Italy,
Germany and France between 1979 and 1998 using a VAR model. Not only did
Semmler and Zhang (2004) find that there was a weak interaction between the
15
common EMU monetary policy and the individual fiscal policies of member
countries, but also both policies were found to be counteractive to each other.
Senbet (2011) examines how the fiscal policy presented by government expenses
and monetary policy presented by federal funds rate and non-borrowed reserves
affected the output in the USA between 1959 and 2010 using a VAR model.
Additionally, Senbet (2011) finds that monetary policy is more effective on
output compared to fiscal policy which did not have a solid impact on the output
in the USA.
Muscatelli, Tirelli and Trecroci (2002) use the VAR models to analyse how fiscal
and monetary policy in some countries of the G7 group respond to the
macroeconomic targets. They find that both policies acted as complements to
each other, meaning that when the policy is expansionary the other policy follows
the same route and vice versa. However, Muscatelli et al. (2002) find that fiscal
policy reaction to the business cycles has weakened since the 1980s.
Moreover, Petrevski, Bogoev and Tevdovski (2016) estimate a VAR model to
examine how the interaction between fiscal and monetary policy affect the South-
Eastern European Economies in the period from 1999 to 2011. Petrevski et al.
(2016) find that contractionary fiscal measures lead to an increase in economic
activity which contradicts with Coric et al. (2015) findings in Croatia. In addition,
Petrevski et al. (2016) point out that the monetary policy reaction to output and
inflation is not unexpected, i.e., monetary tightening has led to the decline of both
inflation and output. As well they highlight the fact that in the South-Eastern
European Economies under study both policies have been substitutes to each
other, i.e., monetary tightening is associated with fiscal expansion and vice versa.
4.3 Advantages of VAR methodology
The popularity that the VAR methodology has gained within macroeconomic
modelling to capture the interdependencies among different variables,
16
specifically those dynamic relationships between fiscal policy, monetary policy
and output is due to several qualities in VAR models. First, compared to the
conventional simultaneous equations method, the VAR is method is simpler and
all variables are usually treated equally, i.e., all variables are usually endogenous
(Gujarati, 2016). In just a few cases, exogenous variables are added to highlight
different seasons or a different point in time (Gujarati, 2016). Another point that
makes VAR models common in the literature of fiscal and monetary policy
interaction is the simplicity of estimating them, as the OLS method can be used
to estimate each equation in the model on a single basis, in addition to the more
efficient forecasts VAR models can provide compared to the simultaneous
equation models (Gujarati, 2016).
4.4 Model under study
In this study the following VAR panel model which consists of 3 endogenous
variables 𝒚𝒕 , 𝒊𝒕 and 𝒈𝒕 representing 3 equations is used to study how the
interactions between the fiscal, monetary policy and output in the advanced
countries differed before and after the global financial crisis:
𝒚𝒕= 𝜷𝟎 + ∑ 𝜷𝟏𝒊𝒚𝒕−𝒊 + ∑ 𝜷𝟐𝒊𝒊𝒕−𝒊 + ∑ 𝜷𝟑𝒊𝒈𝒕−𝒊 + 𝜺𝟏𝒕 (1)
𝒊𝒕= 𝜶𝟎 + ∑ 𝜶𝟏𝒊𝒚𝒕−𝒊 + ∑ 𝜶𝟐𝒊𝒊𝒕−𝒊 + ∑ 𝜶𝟑𝒊𝒈𝒕−𝒊 + 𝜺𝟐𝒕 (2)
𝒈𝒕= 𝜽𝟎 + ∑ 𝜽𝟏𝒊𝒚𝒕−𝒊 + ∑ 𝜽𝟐𝒊𝒊𝒕−𝒊 + ∑ 𝜽𝟑𝒊𝒈𝒕−𝒊 + 𝜺𝟑𝒕 (3)
Where the 3 endogenous variables are treated equally, as each of the endogenous
variables is presented by a separate equation which explains the interaction
between each variable, its own lags and the lags of other 2 variables. Equation
(1) shows how the YoY growth of quarterly real GDP (𝒚𝒕) of advanced
economies responds to the lags of the same variable (𝒚𝒕−𝒊 ), in addition to the lags
of quarterly interest rates (𝒊𝒕−𝒊 ) and the lags of YoY growth of quarterly
government expenditures (𝒈𝒕−𝒊 ) in the same countries. Equation (2) shows how
17
the quarterly interest rates in the advanced economies (𝒊𝒕 ) respond to its lags
(𝒊𝒕−𝒊 ) and the lags of YoY growth of quarterly real GDP (𝒚𝒕−𝒊 ), in addition to
the lags of YoY growth of quarterly government expenditures (𝒈𝒕−𝒊 ) in the same
countries. Equation (3) shows how the YoY growth of quarterly government
expenditures (𝒈𝒕 ) in the advanced economies respond to its lags (𝒈𝒕−𝒊 ), as well
as the lags of YoY growth of quarterly real GDP (𝒚𝒕−𝒊 ) and the lags of the lags
of quarterly interest rates (𝒊𝒕−𝒊 ).
Before proceeding to the estimation of the model, the Augmented Dickey Fuller
(Fisher) panel unit root test is used to test the 3 variables of the model 𝒚𝒕 , 𝒊𝒕 and
𝒈𝒕 for unit root. The hypothesis test for the ADF test is as following:
H0 : All cross sections in the panel have unit root
H1: At least some cross sections in the panel do not have unit root
The results reported below in table 1 show that all variables in both datasets
before and after the crisis are significant at 5% which means that the null
hypothesis can be rejected, as a result, all the variables in the model are stationary
at level. Consequently, according to Gujarati (2015), the unrestricted VAR model
can be used.
The lag length of 4 quarters is chosen for the 3 endogenous variables in the model
following Caldara and Kamps (2008) and Blanchard and Perotti (2002) who
apply this criterion to quarterly data. As a result, the VAR model will encompass
Table 1
Variable
Q1 2000 - Q2 2008 Q3 2008 - Q4 2015
165.953** 232.655**
125.141** 508.17**
224.466** 186.152**
** significant at 5%
ADF statistic
18
78 coefficients out of which 72 are attributed to the lags of the 3 endogenous
variables and the remaining 6 are intercepts before and after the crisis.
5 EMPIRICAL RESULTS
5.1 Results of coefficients
The 3 equation VAR model presented earlier is estimated by OLS using the panel
dataset which includes the advanced economies in Table A.12 and the following
results are obtained for the matrix of coefficients in model as shown in Table 2:
𝒚𝒕 before and after the crisis: Most of the significant coefficients in the 𝒚𝒕
equation do have the expected signs that comply with the economic theory.
However, the third and fourth lags of growth in government expenses, the fourth
lag of growth in real GDP before the crisis and the fourth lags of growth in real
GDP and interest rates after the crisis have unexpected signs.
𝒊𝒕 before and after the crisis: Most of the significant coefficients in the 𝒊𝒕
equation do have the expected signs that comply with the economic theory.
2 In the Appendix
Variable before crisis (1) after crisis (1) before crisis (2) after crisis (2) before crisis (3) after crisis (3)
0.560** 0.788** 0.022** 0.041** 0.002 0.006**
0.339** 0.113** 0.010 -0.008 0.001 -0.003
0.140** 0.015 -0.004 -0.004 0.001 -0.003
-0.143** -0.212** -0.014 0.009 0.004** 0.006**
0.293 -0.136 1.281** 0.683** 0.019** -0.013
-1.084** 0.106 -0.236** 0.260** -0.027** -0.007
0.326 -0.259 -0.065 -0.063 -0.001 0.006
0.290 0.255** -0.032 0.010 0.012** 0.013**
1.066 0.012 -0.002 0.172 0.154** 0.449**
2.581** 0.492 0.107 -0.091 0.358** 0.200**
-2.626** 0.093 -0.078 -0.290** 0.269** 0.209**
-3.010** -1.050 0.036 0.191 -0.249** -0.462**
Intercept 0.982** 0.446** 0.120** 0.023 -0.002 0.002
** significant at 5%
(1) refers to Equation 1
(2) refers to Equation 2
(3) refers to Equation 3
Table 2: coefficient matrix for the unrestricted VAR panel model
𝑦𝑡−1𝑦𝑡−2𝑦𝑡− 𝑦𝑡− 𝑡−1 𝑡−2
𝑡−
𝑡 𝑡𝑦𝑡𝑦𝑡 𝑡 𝑡
𝑡−
𝑡−1 𝑡−2 𝑡− 𝑡−
19
However, the second lag of interest before the crisis and the third lag of growth
in government expenses after the crisis have unexpected signs.
𝒈𝒕 before and after the crisis: Most of the significant coefficients in the 𝒈𝒕
equation do have the expected signs that comply with the economic theory.
However, the fourth lag of growth in government expenses before and after the
crisis have unexpected signs.
5.2 Results of impulse response functions and variance decompositions
As there are a lot of coefficients in VAR panel models — 78 coefficients in the
model of this study. Therefore, a better approach — to interpreting the data and
analysing in this case how the interactions between fiscal, monetary policy and
output have changed before and after the crisis — is using impulse response
functions (IRFs) and variance decompositions.
5.2.1 Interpretations of IRFs
The IRF captures how the dependent variables 𝒚𝒕 , 𝒊𝒕 and 𝒈𝒕 respond to shocks
in the error terms 𝜺𝟏𝒕, 𝜺𝟐𝒕, 𝜺𝟑𝒕 in equations (1), (2) and (3). A change in the error
terms will change current values of y, i and g, in addition to their future values
since the lagged variables of y, i and g appears in the 3 equations of the model.
A simple Mathematical formula for IRF is as following:
IRF = 𝛿𝑦𝑎,𝑡
𝛿 𝑏,𝑡−1
Which shows how variable a responds to a shock in variable b from time t to
time t-1.
20
Figures 1 and 2 show the IRFs for the model before and after the crisis. As shown
in Figures 1 and 2, while growth in real GDP before the crisis responds negatively
to the contractionary shock of monetary policy (increase in interest rates) from
the second quarter onwards. The response to the same effect after the crisis is not
as strong as before the crisis, which implies that monetary policy represented by
interest rates has become less effective — which is expected, given that interest
rates have hit their zero lower bound in most of the advanced economies in the
period after the crisis.
The response of growth in real GDP to an expansionary shock of fiscal policy
(increase in growth of government expenses) is nearly the same before and after
the crisis, where growth in GDP increases from the second quarter to the third
quarter before levelling off until the sixth quarter before starting to decline.
The response of monetary policy represented by interest rates to a shock in real
GDP growth is countercyclical before and after crisis as shown in Figures 1 and
2.
An expansionary shock of fiscal policy (increase in growth of government
expenses) has almost no effect on monetary policy before and after the crisis, i.e.,
no effect on interest rates, which is consistent with the results of Granger
causality presented in Table A.3.3
A shock to growth in real GDP leads to an expansionary fiscal policy (increase
in growth of government expenses) before the crisis, however, the response to
the same effect is weak after the crisis, i.e., nearly no significant effect as shown
in Figures 1 and 2.
Before the crisis, a contractionary shock of monetary policy (increase in interest
rates) leads to a short-term increase in growth of government expenses before it
drops from the third quarter, while after the crisis the response to the same effect
3 In the Appendix
21
is negative till the sixth quarter before responding slightly positively after that as
shown in Figures 1 and 2.
5.2.2 Interpretations of variance decompositions
Variance decompositions usually are used as a complementary method to IRFs
in analyzing VAR models as they show the breakdown of variation in
-1.0
-0.5
0.0
0.5
1.0
1.5
1 2 3 4 5 6 7 8 9 10
Response of growth in Real GDP to Interest Rates
-1.0
-0.5
0.0
0.5
1.0
1.5
1 2 3 4 5 6 7 8 9 10
Response of growth in Real GDP to growth in government expenses
-.2
-.1
.0
.1
.2
.3
.4
.5
.6
1 2 3 4 5 6 7 8 9 10
Response of Interest rates to growth in Real GDP
-.2
.0
.2
.4
.6
1 2 3 4 5 6 7 8 9 10
Response of Interest rates to growth in government expenses
Response of Growth in government expenses to growth in Real GDP
-.01
.00
.01
.02
.03
.04
.05
1 2 3 4 5 6 7 8 9 10
-.01
.00
.01
.02
.03
.04
.05
1 2 3 4 5 6 7 8 9 10
Response of Growth in government expenses to Interest Rates
Figure 1: Impulse Response Functions for the period before the Crisis
-0.4
0.0
0.4
0.8
1.2
1.6
1 2 3 4 5 6 7 8 9 10
Response of growth in Real GDP to Interest Rates
-0.4
0.0
0.4
0.8
1.2
1.6
1 2 3 4 5 6 7 8 9 10
Response of growth in Real GDP to growth in government expenses
-.1
.0
.1
.2
.3
.4
1 2 3 4 5 6 7 8 9 10
Response of Interest Rates to growth in Real GDP
-.1
.0
.1
.2
.3
.4
1 2 3 4 5 6 7 8 9 10
Response of Interest Rates to growth in government expenses Response of growth of government expenses to Interest Rates
-.04
.00
.04
.08
.12
1 2 3 4 5 6 7 8 9 10
Response of growth in government expenses to growth in Real GDP
-.04
.00
.04
.08
.12
1 2 3 4 5 6 7 8 9 10
Figure 2: Impulse Response Functions for the period after the Crisis
22
components of endogenous variables as a result of the shocks in the VAR system
(Lutkepohl, 2005).
Results in Table 3 show that the monetary policy represented by 𝒊𝒕 has become
less effective after the crisis on 𝒚𝒕, as shocks in 𝒊𝒕 explain just 0.68% of variation
in 𝒚𝒕 compared to 17.16% in the longer forecast horizon before the crisis.
Variation in 𝒚𝒕 due to shocks of fiscal policy represented by 𝒈𝒕 remained limited
and did not differ significantly before and after the crisis in the longer horizon —
it dropped from 1.22% to 0.75%, while variation in 𝒚𝒕 due to its own shocks
increased from 81.61% before crisis to 98.57% after the crisis.
Results in Table 4 show that shocks in output represented by 𝒚𝒕 have triggered
more usage of monetary policy in advanced economies after the crisis to stabilize
the output which is explained by increase in variation of 𝒊𝒕 due to 𝒚𝒕 in the longer
forecast horizon from 11.10% before the crisis to 21.57% after the crisis. As a
result, variation in 𝒊𝒕 due to its own shocks decreased from 88.86% before crisis
to 78.24% after the crisis. Effects of fiscal policy shocks on variation of monetary
policy are insignificant before and after the crisis, 0.04% and 0.18% respectively
in the longer forecast horizon.
1 100.00 0.00 0.00 100.00 0.00 0.00
2 99.57 0.35 0.08 99.93 0.07 0.00
3 98.05 1.28 0.67 99.87 0.08 0.05
4 96.85 2.62 0.53 99.47 0.41 0.12
5 94.86 4.67 0.47 99.36 0.52 0.12
6 91.91 7.67 0.42 99.24 0.62 0.13
7 89.17 10.19 0.64 99.12 0.68 0.20
8 86.42 12.81 0.78 98.86 0.68 0.46
9 83.87 15.19 0.94 98.71 0.68 0.61
10 81.61 17.16 1.22 98.57 0.68 0.75
Table 3
Forecast horizon
in quarters
Before Crisis After Crisis
Variance Decomposition of in %
23
Results in Table 5 show that variation in fiscal policy represented by 𝒈𝒕 as a
result of shocks in output represented by 𝒚𝒕 in advanced economies has declined
from 27.74% before the crisis to 1.71% after the crisis in the longer forecast
horizon. As a result, variation in 𝒈𝒕 due to its own shocks increased from 69.24%
before the crisis to 96.54% after the crisis. Effects of monetary policy shocks on
variation of fiscal policy is small before and after the crisis, 3.02% and 1.76%
respectively in the longer forecast horizon.
The empirical results from IRFs and variance decompositions show that the
effectiveness of interest rates as a measure of monetary policy on the growth of
real GDP weakened significantly after the crisis. Moreover, variation in monetary
1 0.26 99.74 0.00 0.37 99.63 0.00
2 1.04 98.96 0.00 3.09 96.77 0.14
3 2.29 97.70 0.01 5.46 94.40 0.14
4 3.77 96.22 0.01 8.22 91.61 0.16
5 5.11 94.86 0.03 11.58 88.27 0.15
6 6.47 93.49 0.04 14.64 85.21 0.15
7 7.76 92.19 0.04 17.24 82.59 0.16
8 8.97 90.99 0.04 19.21 80.63 0.15
9 10.09 89.87 0.04 20.65 79.18 0.17
10 11.10 88.86 0.04 21.57 78.24 0.18
Table 4
Forecast horizon
in quarters
Before Crisis After Crisis
Variance Decomposition of in %
1 0.71 0.62 98.66 0.03 0.09 99.88
2 1.19 2.22 96.59 0.49 0.40 99.11
3 1.93 2.02 96.05 0.56 1.04 98.39
4 3.62 2.02 94.36 0.48 1.46 98.06
5 8.37 1.94 89.70 1.04 1.60 97.36
6 11.75 2.15 86.10 1.18 1.65 97.17
7 16.72 2.19 81.09 1.30 1.64 97.06
8 21.43 2.25 76.32 1.65 1.61 96.74
9 24.59 2.70 72.71 1.68 1.67 96.65
10 27.74 3.02 69.24 1.71 1.76 96.54
Table 5
Variance Decomposition of in %
Before Crisis After Crisis Forecast horizon
in quarters
24
policy (interest rates) due to the growth of real GDP increased after the crisis due
to the increase in utilization of interest rates to stabilize and boost the output in
advanced economies. In addition, the fiscal policy has a limited effect on output
before and after the crisis and no effect on monetary policy in both periods which
is reflected as well in the results of Granger causality test in Tables A.2 and A.34.
Finally, output effect on fiscal policy decreased significantly after the crisis.
6 CONCLUSION
In this study the interaction between fiscal, monetary policy and output in a group
of an advanced economies was analysed using a VAR panel model in the period
before the crisis from Q1 2000 to Q2 2008 and the period after the crisis from Q3
2008 to Q4 2015 with an attempt to investigate whether the dynamic
interdependencies between the variables in the model representing each policy
have differed before and after the crisis or not.
Results from IRFs and variance decompositions show that though monetary
policy represented by 𝒊𝒕 is effective in stabilizing output represented by 𝒚𝒕 before
the crisis, in the period after the crisis its effectiveness on output in advanced
economies weakens significantly, which is expected, given that interest rates
have hit their zero lower bound in most of the advanced economies in the period
after the crisis. Moreover, a contractionary monetary shock has a negative effect
on fiscal policy on the longer forecast horizon which is clearer before than after
the crisis.
Results show that the effect of fiscal policy on output in advanced economies is
very limited on output before and after the crisis. Additionally, fiscal policy has
no significant effect on monetary policy in both periods before and after the
4 In the Appendix
25
crisis, which is reinforced by the results of Granger causality test which indicates
that 𝒈𝒕 does not cause 𝒊𝒕.
Furthermore, the results show that following an output shock in advanced
economies monetary policy reacted in a countercyclical manner before and after
the crisis, though as mentioned earlier the effectiveness weakens after the crisis.
Yet fiscal policy responds in an expansionary manner to a positive output shock
before the crisis, however, after the crisis the response to the same effect is weak,
i.e., the response is nearly absent.
Overall, it can be concluded that monetary policy in advanced economies is more
effective on output before the crisis and fiscal policy does not affect output
significantly whether before or after the crisis. Moreover, shocks in output lead
to changes in monetary policy before and after the crisis, however, changes in
fiscal policy as a result of output shocks are more significant in the period before
the crisis.
Finally, this study can be extended by taking into consideration some additional
aspects. One of those aspects that can be taken into consideration is introducing
variables that capture government revenues as an additional measure of fiscal
policy from the revenue side. Moreover, another extension to the study that is
associated with the fiscal policy side is to split both discretionary and non-
discretionary components (automatic stabilizers) of fiscal policy and investigate
how the interaction between fiscal and monetary policy might result in different
macroeconomic effects.
Further insights can be generated as well by introducing a variable such as growth
in base money that captures how the unconventional monetary policy measures
that were implemented after the crisis in the advanced economies such as
quantitative easing might have affected the interaction between fiscal, monetary
policy and output.
26
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30
Appendix
ID Country
1 Australia2 Austria3 Belgium4 Canada5 Czech Republic6 Denmark7 Estonia8 Finland9 France10 Germany11 Greece12 Iceland13 Ireland14 Italy15 Latvia16 Lithuania17 Netherlands18 Norway19 Portugal20 Singapore21 Slovak Republic22 Slovenia23 Spain24 Sweden25 United Kingdom26 United States
Table A.1: List of advanced countries in the panel dataset
Independent Variables Before Crisis After Crisis
Chi-sq Chi-sq
47.559** 11.319**
13.328** 4.354
** indicates presence of Causality
Dependent variable:
Table A.2: Granger Causality Test results
31
Independent Variables Before Crisis After Crisis
Chi-sq Chi-sq
11.581** 65.600**
0.213 7.739
** indicates presence of Causality
Independent Variables Before Crisis After Crisis
Chi-sq Chi-sq
57.544** 19.961**
19.078** 12.805**
** indicates presence of Causality
Table A.4: Granger Causality Test results
Dependent variable:
Dependent variable:
Table A.3: Granger Causality Test results