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EFFECTS OF FISCAL POLICY ON THE CONDUCT AND TRANSMISSION
MECHANISMS OF MONETARY POLICY IN ZIMBABWE
BY
WILLIAM KAVILA
DEPUTY DIRECTOR, ECONOMIC RESEARCH DIVISION
RESERVE BANK OF ZIMBABWE
ABSTRACT
This paper provides an analysis of the effects of fiscal policy on the monetary policy
transmission mechanism in Zimbabwe under a dollarised environment. The analysis was
conducted using an Unrestricted Vector Autoregression model to identify shocks to fiscal
variables and their impact on the monetary policy transmission mechanism. The variables
analysed are interest rates, budget deficit, inflation, money supply and a proxy for economic
activity over the period 2009 to 2014. The impulse response functions and variance
decompositions are used to study the effects of identified shocks. The results suggest that
nominal interest rates respond positively to a fiscal deficit shock. Furthermore, the results
suggest that the response of inflation and money supply are muted, reflecting the limited role
played by fiscal policy in influencing money supply and inflation under the dollarized
environment.
Keywords: Structural VAR, Fiscal deficit, Monetary Policy, Transmission Mechanism
JEL classification: C32, E52, E62
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Table of Contents
1. INTRODUCTION ............................................................................................................................. 4
2. TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE .............................................................. 7
Revenue Performance ................................................................................................................... 7
Expenditure Performance .............................................................................................................. 8
Fiscal and Monetary Policy Interaction in Zimbabwe ................................................................ 10
3. LITERATURE REVIEW ................................................................................................................ 11
Theoretical Literature .................................................................................................................. 11
Empirical Literature .................................................................................................................... 14
4. METHODOLOGY........................................................................................................................... 18
Data and Estimation Method ....................................................................................................... 19
5. EMPIRICAL RESULTS .................................................................................................................. 20
6. CONCLUSION AND POLICY RECOMMENDATIONS ............................................................. 27
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1.
INTRODUCTION
The efficient coordination of fiscal and monetary policies is a pre-requisite for sustainable
economic growth in the context of achieving both internal and external balance. Prudent
macroeconomic management allows for mutually reinforcing objectives of both fiscal and
monetary policies. On the contrary, inefficient coordination give rise to sub-optimal
economic outcomes. As highlighted by Balino and Enoch (1998), the necessary condition for
effective coordination between monetary and fiscal policies is that each policy should be on a
sustainable path. Even with effective coordination, unsustainability in one policy has negative
spillover effects on the other, making the entire macroeconomic framework unsustainable. In
addition, coordination also looks at the credibility of the overall policy mix. In this regard, the
effectiveness of monetary and fiscal policies is dependent upon significant coordination.
The coordination of fiscal and monetary policy is crucial since the two policies operate in
different time frames. Monetary policy can be adjusted more frequently and is normally used
in fine tuning the economy. On the other hand, it takes a long time to change the fiscal stance.
In this regard, the issue of coordination of fiscal and monetary policies had been prominent in
the context of macroeconomic stabilization programmes (Niemann, 2008). The need for
fiscal and monetary policy coordination has become pertinent especially given that most
countries have established independent central banks. As a result, central banks around the
globe have moved to primarily focus on price stability through inflation targeting (Sehovic,
2013). Central bank independence has resulted in increased disassociation between fiscal and
monetary goals, implying that economic policy management increasingly focuses on the
coordination of fiscal and monetary policies.
The importance of coordination between fiscal and monetary policy also came to the fore
during the global financial crisis of 2008. The crisis showed that financial instability and
weak fiscal policies can have a negative impact on each other. Crucially, the financial-fiscal
feedback loop negatively affects the smooth operation of the monetary policy mechanism.
The crisis highlighted that sound fiscal and monetary policies are critical for sustainable
growth (European Central Bank, 2012). The coordination of fiscal and monetary policies also
gained prominence as countries endeavoured to deal with the global financial crisis. Several
countries carried out unconventional monetary and fiscal policies. Notably, monetary
authorities turned to quantitative easing, while fiscal policies were highly expansive
characterised by increased government spending and reduced taxes. Against this background,
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efficient coordination of monetary and fiscal policy becomes a necessity to ensure a
sustainable policy mix in the aftermath of the crisis (Liborioa, 2011).
The euro area sovereign debt crisis also showed that if fiscal and monetary policies are
operating at cross purposes, the overall policy mix would be unsustainable. In the euro area,
in particular, unsustainable fiscal policy including high debt levels, adversely impacted on the
monetary policy transmission mechanism (ECB, 2012). In this regard, fiscal and monetary
policy should be in harmony. The euro area crisis highlights that fiscal and monetary
coordination should be an integral part of countries moving towards or are in a monetary
union. In this regard, as the Common Market for Eastern and Southern Africa (COMESA)
strides towards a currency union it becomes imperative to review and examine the state of
fiscal and monetary coordination in the respective member countries.
The need for fiscal and monetary coordination increases under monetary union arrangements.
As highlighted by Suarez and Panico (2007), in a monetary union without fiscal federation,
fiscal policy is the only policy instrument which can be deployed to deal with asymmetric
shocks. Under a monetary union, the existence of only one monetary authority with several
fiscal authorities requires significant measures to ensure adequate monetary and fiscal policy
coordination. In a monetary union, coordination is required at two levels, that is, coordination
among fiscal authorities of member states and in the coordination among monetary and fiscal
policy authorities (Tirelli and Muscatelli, 2005).
It is against this heightened requirement for greater coordination of fiscal and monetary
policy for countries moving towards or in a monetary union that it becomes imperative to
assess the interaction of fiscal and monetary policy in Zimbabwe. The assessment of fiscal
and monetary coordination in Zimbabwe is, however, an interesting case since the country
adopted the multicurrency system in 2009. In the multicurrency system, the country uses an
array of foreign currencies, in which the principal currencies include the United States of
America dollar (US$), British pound, South Africa rand, Botswana Pula and the Euro. It
should be noted that while Zimbabwe is under a multicurrency system, the US$ is the unit of
account and the majority of the transactions (over 90%) are in US$. All goods and services
are priced in US$. The adoption of the multicurrency system resulted in the loss of monetary
policy autonomy. This implies that the country is unable to use traditional monetary policy
and exchange rate instruments to fine tune the economy. In this regard, the role of monetary
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policy has become limited, implying that the interaction between monetary and fiscal policies
in Zimbabwe takes a different dimension. Fiscal policy is dominant under the multicurrency
system, therefore there is need for the Zimbabwean Authorities to ensure that there is fiscal
sustainability.
Historically, Zimbabwe faced significant fiscal challenges as exhibited by huge fiscal deficits
averaging more than 9% of GDP for the period 1980 to 2008. The country adopted the
multicurrency system in 2009 to stabilise the economy and this resulted in economic activity
rebounding, on the back of an improved business environment. In this regard, growth in gross
domestic product rebounded to an overage of 10.6% over the period 2009 to 2012, while
annual inflation was below 5%. Fiscal performance also improved since the inception of the
multicurrency system, with fiscal deficits averaging less than 3%. This was aided by the
concomitant implementation of the cash budgeting framework since 2009.
In the absence of a local currency, the impact of fiscal policy on the smooth functioning of
the monetary policy is expected to be minimal. It should, however, be noted that fiscal policy
can affect monetary policy through its impact on interest rates and financial stability. Despite
adopting a cash budgeting system in 2009, Government of Zimbabwe (GoZ) has since 2013
turned to domestic borrowing on the back of declining revenues. The increased recourse to
domestic borrowing, may have resulted in higher market lending rates and the crowding out
of private investment.
There are few studies on the interaction between fiscal and monetary policy in Zimbabwe and
these have mainly concentrated on the impact of fiscal deficits on inflation. Most of the
studies were done for the period prior to 2008. Makochekanwa (2011) examined the causality
between government deficits and inflation and observed that there exists a causal link from
the budget deficit to the inflation rate. He concluded that the monetisation of the budget
deficit impacted negatively on inflation. Kararach et al (2010) also argued that the prime
source of Zimbabwe’s hyperinflation was excessive money printing to finance huge budget
deficits.
The rest of the study is organised as follows: Section II, provides an overview of trends in
fiscal developments including institutional arrangements. Section III reviews theoretical and
empirical literature, while methodological issues are addressed in Section IV. Section V
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analyses the results based on the empirical findings. Section VI proffers policy
recommendations.
2.
TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE
This section reviews fiscal trends in Zimbabwe since independence in 1980. In addition, the
section also analyses the observed relationship between fiscal and monetary variables as a
prelude to the econometric analysis of the effects of fiscal policy on the conduct and
transmission mechanism of monetary policy in Zimbabwe.
Zimbabwe’s fiscal performance was largely poor over the last 3 decades, starting in 1980,
with fiscal deficits averaging well above 5% of GDP. The high fiscal deficits were mainly
attributed to elevated Government expenditures.
Figure 1 shows developments in
Government revenues, expenditures and deficits since 1979.
Figure 1: Developments in Government revenue, expenditure and fiscal deficit as a % of
GDP from 1980 to 2014.
80
60
40
20
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
-20
1980
0
-40
Expenditure
Revenue
Deficit
Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)
Revenue Performance
Government revenue averaged 26% of GDP between 1980 and 2014. Value-Added Tax
(VAT) dominated the revenues, accounting for about 30% of the total revenue collected
between 1980 and 2014. Equally important were individual and corporate taxes which also
contributed about 28% of total revenues over the same period.
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In a bid to improve revenue collection, GoZ made several institutional changes. Notably, the
GoZ established the Zimbabwe Revenue Authority (ZIMRA) in 2001 a semi-autonomous
institution, which merged the former Department of Taxes and Department of Customs and
Excise. This resulted into a leaner organisation and boosted revenue collections.
To increase the contribution of indirect taxes as well as to expand the tax base, the country
introduced value-added tax (VAT) in 2004. The introduction of VAT at a 15% standard rate
improved the performance of indirect taxes. Over the years, the GoZ has been introducing
and refining tax policy with the view to improve revenues. In light of the increasing
informalisation of the economy, government introduced presumptive tax to cater for business
that do not keep proper books of accounts such as informal and cross border traders, transport
operators, hair dressing saloon operators and small scale miners.
Government also introduced the Large Client Office in 2010 aimed at providing a one-stopshop service to large clients in the administration of Income Tax, Pay As You Earn (PAYE)
and Value Added Tax (VAT). In the same year, the GoZ also introduced VAT fiscalisation
process for operators with a certain threshold. This involved the configuration of fiscal
devices to enable them to record sales and other tax information on the read-only fiscal
memory at the time of sale for use by the tax authorities in Value Added Tax (VAT)
administration.
Expenditure Performance
Government expenditures have been elevated, averaging about 36% of GDP between 1980
and 2014. Recurrent expenditure has dominated Government spending since 1980, with
expenditure on social spending and employee compensation accounting for an average of
80% of total expenditure. The huge recurrent expenditures crowded out productive capital
expenditures such as spending on infrastructure. Figure 2 below shows the composition of
government expenditure since 1980.
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Figure 2: Composition of Government Expenditure: 1980-2014
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
-
Capital Expenditure
Net Lending
Recurrent Expenditure
Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)
Salaries and wages have been the largest single expenditure head since 1980. The wage bill
increased from around 39% of total expenditures in 1980 to about 70% in 2014. Figure 3
below shows the proportion of employee compensation to recurrent expenditure.
Figure 3: Employee compensation versus other Government expenses
1.00
0.80
0.60
0.40
0.20
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Salaries and Wages
Other Expenses
Source: Ministry of Finance and Economic Development, Zimbabwe, (Various Publications)
With government spending dominated by recurrent expenditures, capital expenditure received
low allocations, impacting negatively on infrastructure development over the years.
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Government expenditure performance has also been affected by expenditure overruns by
respective line Ministries. With a view to control expenditure overruns, Government set up
the Implementation and Control of Expenditure Unit which validates expenditure requests
from line Ministries and also ensures that the ministries do not overshot their budgetary
allocations.
In 2009, Government adopted the cash budgeting system in a bid to foster fiscal discipline
among line Ministries. This went a long way in reigning in expenditures by line Ministries
and resulted in lower deficits. While adoption of multicurrency in 2009 improved revenue
collection, it did not alter Government’s spending pattern, as expenditure remained tilted
towards employee compensation. Wages and salaries have remained the most dominant
component of expenditure from 2009 to 2014.
Fiscal and Monetary Policy Interaction in Zimbabwe
The GoZ’s fiscal deficits reached peaks of 20% and 22%, of GDP in 1998 and 2000,
respectively. The deficits were difficult to address since the main expenditure head was in the
form of salaries and wages. During the 1980s and 1990s the budget deficit was financed
through both domestic and external sources. As a result, the country contracted huge
domestic and external debt. Government faced challenges in meeting external debt
obligations since 1999, resulting in the country accumulating external payment arrears.
Faced with huge budget deficits and limited financing options, the GoZ made recourse to the
monetisation of fiscal deficits. The excessive recourse to bank finance by the fiscus fuelled
money supply growth, which led to an upsurge in inflation. The recourse to central bank
financing impaired the smooth functioning of monetary policy, with the central bank
recording significant losses as a result of financing fiscal deficits. Kovanen (2004) and
Kramarenko (2010) found the prevalence of fiscal dominance in Zimbabwe prior to 2008.
Munoz (2007) highlighted that as a result of money printing central government losses
reached 75% of GDP in 2006. The negative impact of the fiscal deficits on monetary policy
were more evident during the period 2000 to 2008, when inflation reached a peak of 231
million per cent in July 2008.
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The GoZ’s failure to service its external debt led to the accumulation of external payment
arrears, which were estimated at 86% of public and publicly guaranteed debt in 2012. The
perceived unsustainability of fiscal policy and debt could have had a negative impact on the
credibility and confidence in monetary policy and the overall policy mix. In 2007 and 2008,
the lack of confidence in monetary policy manifested itself through unofficial dollarisation
and the emergence of a parallel market for foreign exchange which affected the efficiency of
monetary policy. The lack of confidence in monetary policy also negatively impacted on
financial stability.
The adoption of the multicurrency system in 2009 subordinated the role of monetary policy to
fiscal policy. Under the multicurrency regime GoZ can no longer seek recourse to central
bank financing. This effectively means that the government has to finance its deficits by
borrowing from other financial institutions other that the central bank and from non-bank
domestic sectors.
Since 2009, Government has been pursuing cash budgeting in a bid to nurture fiscal
discipline. Cash budgeting was critical for fiscal consolidation between 2009 and 2011, when
the economy was recovering at a fast pace. The cash budget system, however, exhibited
greater vulnerabilities as the economy slowed down in 2012. Reflecting the slowdown in the
economy, the GoZ increased borrowing to finance fiscal expenditure overruns.
The limited fiscal space that characterised the study period forced Government to seek
alternative sources of finance such as issuance of TBs to finance deficits. The issuance of
TBs impacts on monetary policy variables such as interest rates. In this regard, there is need
for close coordination between fiscal and monetary authorities to ensure that fiscal deficits
are financed on a sustainable basis.
3.
LITERATURE REVIEW
Theoretical Literature
Fiscal and monetary policies are the traditional tools used by governments to achieve
macroeconomic stability. Fiscal policy refers to the control of government revenue
collections and expenditures to influence economic activity. Monetary policy on the other
hand refers to the control of money supply or interest rates by the central bank to achieve
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stated macroeconomic objectives. Monetary and fiscal policy are implemented by two
different bodies and, therefore, coordination of the policies is required.
A change in either fiscal or monetary policy will influence the effectiveness of the other,
thereby, affecting overall policy direction. Fiscal policy affects the conduct of monetary
policy through several channels, notably interest rates and exchange rates. Under fiscal
dominance, for example, fiscal policy sets the general environment in which the central bank
conducts monetary policy. Fiscal dominance implies that even when the central bank is
independent, monetary policy can be severely limited by the stance of fiscal policy.
Sargent and Wallace (1981) focused on the impact of fiscal indiscipline on monetary policy.
They argued that monetary policy and price level stop being exogenous when the fiscal
deficit is predetermined and unsustainable. In this regard, fiscal sustainability is a
precondition for monetary stability.
The authors also introduced the concept of fiscal
dominance, a scenario in which an extreme case of fiscal indiscipline has significant negative
implications for monetary policy. In a broad sense, fiscal dominance occurs when it is the
fiscal authorities who determine the extent to which budget deficits are financed through
bond issuance and seignorage. In the face of fiscal dominance monetary authorities lose their
ability to control inflation, whenever the real interest rate exceeds the growth rate of the
economy (Sargent and Wallace 1981).
Leeper (1991); Sims (1994); and Woodford (1994) popularized the ‘Fiscal Theory of the
Price Level’ which emphasizes the role of fiscal policy in macroeconomic stabilisation.
According to the Fiscal Theory of the Price Level, government’s inter-temporal budget
constraint is important in the determination of the price level. The theory posits that there is a
set of unique prices that tend to equate the present value of future budget surpluses with the
current stock of government debt. Leeper (1991) categorized policies into “active” and
“passive” policies. Passive policies are also known as Ricardian fiscal policy, which ensures
the satisfaction of the government’s intertemporal budget constraint. An active monetary
policy is the one that pursues its inflation target notwithstanding the Government's financial
position, but passive monetary policy accommodates fiscal policy.
Davig and Leeper (2009) argued that monetary and fiscal policies fluctuate between active
and passive behavior. Lack of fiscal discipline results in increases in debt and inflation.
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Under such a case, even if the central bank raises interest rates aggressively, it is not able to
reduce aggregate demand and inflation.
The “perverse effect of fiscal policy” (Beetsma and Bovenberg, 1999) is another theoretical
strand on the interaction and coordination of monetary and fiscal policy. Beetsma and
Bovenberg (1999) assert that a more anti-inflationary oriented central bank has a perverse
effect on the incentive of the fiscal authorities to reduce the level of debt.
The other strand of literature on monetary and fiscal policy coordination focuses on the
distortions that may emerge on the conduct of monetary and fiscal policy based on either
rules or discretionary policy. Beetsma and Uhlig, (1999) found that a distortionary fiscal
policy causes blockage between the natural and actual output forcing the monetary authority
that would otherwise want to stabilize output around the natural level, to resort to inconsistent
policies that can be inflationary. Dixit and Lambertini (2003) tested the relation between the
monetary and fiscal policy and showed that fiscal policy authorities who have discretionary
powers can undermine monetary policy authorities by running own policy based on rules.
This, constrains the use of monetary commitment and monetary policy based on rules.
Buti et al. (2001) posited that the relationship between monetary and fiscal policy depends on
the type of shock which the economy is facing. Coordination is particularly desirable in
cases when the economy is faced with shocks on the supply side, while the opposite is true
for shocks occurring on the demand side.
Hilbers (2004), also states that there are direct and indirect channels in which fiscal policy
may influence monetary policy. For instance, if a country is running an expansionary fiscal
policy, which usually results in deficits, there are two possibilities which the government may
resort to, in order to carter for its deficits. First, government can finance the deficit through
money printing or borrowing from the market. In many instances the government may
resolve to finance the deficit through the printing of money which implies monetary policy
expansion. Expansion in monetary policy results in inflationary pressures in an economy
which may lead to a devaluation of a nation’s currency, balance of payments challenges as
well as a banking crisis.
13
Second, Government may resort to finance the deficits through the domestic banking market,
thus affecting the monetary policy’s credit transmission channel. High budget deficits are
often associated with the crowding out of the private sector in the money market, as fiscal
authorities finance budget deficits by borrowing from the banking sector. This results in an
increase in lending rates as demand for credit outstrips supply. As the cost of credit increases,
so does the cost of production and the general price level (Hilbers, 2004). In addition, fiscal
measures, such as introducing or changing a consumption tax or value added tax, have a
direct effect on inflation. A once off rise in indirect taxes may put pressure on prices and this
could lead to a price-wage spiral which could trigger adverse inflationary expectations and
eventually lead to high inflation. Furthermore, perceptions or expectations about government
activities, may have an indirect impact on monetary policy. Expectations that the government
may struggle to sustain its financial position may constrain the potency of monetary policy.
Perceptions and expectations of large and on-going budget deficits and resultant huge
borrowing requirements may also trigger a lack of confidence in the economic prospects of a
country. This may become a risk to stability in financial markets. Such lack of confidence in
the sustainability of the financial position of the government may become a potential
destabilising factor on bond and foreign exchange markets, eventually leading to the collapse
of the monetary regime, (Hilbers, 2004).
Empirical Literature
Several studies have been done on the interaction of between monetary and fiscal policy,
particularly in the aftermath of the Global Financial Crisis. Most of the studies, for example,
Sehovic (2014), Lanmann (2014), Schroth (2013), Mortensen (2013) and Galí and Monacelli
(2008), have focused mainly on the coordination of fiscal and monetary policy in the
European Monetary Union (EMU).
Tomšík (2012) ascertained that fiscal policy has an impact on the monetary policy’s interest
rate channel as noted in the case of the Czech Republic, whose government bond yields have
a significant impact on long-term interest rates. When government bond yields rise, the risk
of a sovereign debt crisis increases, leading to an escalation in long-term lending rates. This
relationship, however, was weakened by the Global Financial Crisis, especially when it came
to credit advances to large corporations and deposits. Dunn et al. (2011) investigated the
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monetary policy transmission mechanism in Pacific Island Countries (PICs) and found that
lower fiscal deficits, coupled with lower public debt are correlated with lower average
inflation and higher output growth. Furthermore, lower inflation was related to lower interest
rates and lower costs of production.
Rukelj (2010) examined the interactions of fiscal policy, monetary policy and economic
activity in Croatia using monthly data for the period 1997 to 2008. The researcher used a
structural Vector Error Correction Model (VECM) to identify permanent and transitory
shocks on government expenditures, money aggregate M1 and the index of economic
activity. The main conclusion made was that fiscal and monetary policy move in the opposite
direction, which indicates that they can be used as substitutes.
Deskar-Škrbić and Šimović (2013), employed a structural Vector Autoregressive (VAR)
model to analyse the dynamic effects of discretionary fiscal shocks on economic activity of
the private sector in Croatia from 2000Q1-2012Q2. They showed that government spending
had a positive and statistically significant effect on private aggregate demand and private
consumption which affects inflation and therefore, the conduct of monetary policy.
There are, however, few studies on the coordination of fiscal and monetary policy in Africa
and even developing countries in general. Nyamongo et al. (2008) studied the monetary-fiscal
policy interactions in Kenya for the period 1979 to 2007 and concluded that the fiscal and
monetary policies were coordinated on a number of years but there were also several years
with no evidence of coordination between the two policies. The study also shows a greater
degree of monetary policy dominance in Kenya using a non-structural VAR analysis. The
study also estimated the output gap as a way to gauge the cyclical behaviour of both the fiscal
and monetary policies and it was observed that fiscal and monetary policy displayed both
procyclical and countercyclical behaviour.
Frankel et al. (2008) showed that South Africa’s fiscal policy had been predominantly
procyclical, while monetary policy had been mildly countercyclical. They concluded that
fiscal policy should be made more countercyclical to ensure macroeconomic stability.
Swanepoel (2004) found that monetary policy had been mainly anti-cyclical in South Africa
but highlighted the challenge of coordination between fiscal and monetary policy in the
country. The results were also confirmed by Du Plessis et al. (2007) using a structural vector15
autoregression approach to assess the cyclicality of fiscal and monetary policy in South
Africa since 1994. The study concluded that monetary policy had contributed markedly to the
stabilisation of the South African economy. Specifically, Du Plessis et al. (2007) concluded
that monetary policy had been largely countercyclical since 1994, while fiscal policy had
been largely pro-cyclical.
Chukwu (2010) examined the monetary and fiscal policy interactions in Nigeria using
quarterly data between 1970 and 2008. The interactions of monetary and fiscal policy was
analysed using both VAR model and State-space with Markov-switching. Using a VAR
model,
Chukwu (2010) simulated generalised impulse responses and observed that
there is evidence of a non-Ricardian fiscal policy in Nigeria. As a step further, the study
applied a State-space model with Markov-switching to estimate the time-varying parameters
of the relationship between monetary and fiscal policies. The State-space model showed that
monetary and fiscal policies in Nigeria have interacted in a counteractive manner for most of
the sample period (1980-1994). The study also observed some of form of accommodativeness
of monetary policy between 1998 and 2008. Overall, Chukwu (2010) found the existence of
fiscal dominance in Nigeria, implying that inflation, predominantly results from fiscal
problems, and not from lack of monetary control.
Obinyeluaku and Viegi (2009) examined the relationship between fiscal balances and
monetary stability in ten SADC countries based on the dynamic response of inflation to
different shocks. The study showed evidence of fiscal dominance in five out of ten countries
throughout the period 1980-2006, while the remainder revealed monetary dominance.
Crucially, the study also observed that fiscal policy affects price variability through aggregate
demand. The main conclusion from the study was that fiscal policy matters for achieving and
maintaining price stability in the SADC region.
There are also few studies on the interaction of fiscal and monetary policy in Zimbabwe.
Munoz (2007) highlighted that high government fiscal deficits led to increased central bank
quasi-fiscal losses which interfered with monetary management from 2003 to 2007. Munoz
(2007) estimated the quasi-fiscal losses at about 75 percent of GDP in 2006. The deficits
were financed by money creation or the issuance of RBZ securities, resulting in high
inflation.
16
Makochekanwa (2008) argued that the relatively high fiscal deficit experienced by Zimbabwe
was the root cause of the high inflationary environment in the years 2005 to 2008. The study
found a causal link running from budget deficit to the inflation rate using Johansen cointegration technique over the period 1980 to 2005. Makochekanwa (2008) concluded that
the monetization of budget deficits led to hyperinflation.
Easterly and Schmidt-Hebbel (1993) also studied the relationship between fiscal deficits,
inflation and interest rates for developing countries including Zimbabwe for the period 1978
to 1989. For Zimbabwe, the authors concluded that a percentage point increase in the deficit
to GDP financed through money creation increased inflation by 10 percent. Despite
Zimbabwe maintaining interest rates control in the 1980s, Easterly and Schmidt-Hebbel
(1993) found that a percentage point increase in the deficit to GDP financed through domestic
financing increased interest rates by 2.7% through simulations. This implied a negative
impact on the operation of monetary policy.
Kramarenko (2010), and Kovanen (2004) found evidence of fiscal dominance in Zimbabwe,
particularly in the 2000s. They argued that the high fiscal deficits experienced by the country
since 2000 impacted negatively on the economy, including impeding the normal functioning
of monetary policy.
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4.
4.1
METHODOLOGY
Model Specification
A review of empirical literature on African countries shows that most studies used variants of
Vector Autoregression (VAR) to examine effects of fiscal policy on the conduct and
transmission mechanisms of monetary policy (Chukwu, 2010; Nyamongo et al. 2008; and
Du Plessis et al. 2007).
In light of the above, this study applies an Unrestricted Vector Autoregression model to
assess the effects of fiscal policy on the monetary policy transmission mechanism in
Zimbabwe. The VAR model is specified, following Sims (1980) and expressed as follows:
𝑌𝑡 = 𝑐 + 𝐴1 𝑌𝑡−1 + ⋯ … … 𝐴𝑝 𝑌𝑡−𝑝 + 𝜇𝑡
(1)
Where Yt is a vector of endogenous variables with linear dynamics, A1 … … Ap is a vector of
autoregressive coefficients and μt is an n-dimensional Gaussian white noise with covariance
matrix. E(μ1t μt ) = φ, c = (c1 … . cn ) is an n– dimensional vector of constants. To keep the
model parsimonious, five variables, namely fiscal deficit, money supply, interest rates,
inflation and index of economic activity are simulated to assess their response to a fiscal
deficit shock. Precisely the model is described as follows:
0
𝑀𝑡
𝐶1
𝑎21
𝐺𝑡
𝐶2
𝑌𝑡 = 𝐶3 + 𝑎31
𝑅𝑡
𝐶4
𝑎41
[ 𝐼𝑡 ] [𝐶5 ] [𝑎51
𝑏11
0
𝑏31
𝑏41
𝑏51
𝑐11
𝑐21
0
𝑐41
𝑐51
𝑑11
𝑑21
𝑑31
0
𝑑51
𝑎1𝑝
𝑒11
𝑀𝑡
𝑎2𝑝
𝑒21
𝐺𝑡
𝑒31 ∗ 𝑌𝑡 + ⋯ + 𝑎3𝑝
𝑅𝑡
𝑒41
𝑎4𝑝
0 ] [ 𝐼𝑡 ]
[𝑎5𝑝
𝑏1𝑝
𝑏2𝑝
𝑏3𝑝
𝑏4𝑝
𝑏5𝑝
𝑐1𝑝
𝑐2𝑝
𝑐3𝑝
𝑐4𝑝
𝑐5𝑝
𝑑1𝑝
𝑑2𝑝
𝑑3𝑝
𝑑4𝑝
𝑑5𝑝
𝑒1𝑝
𝑒2𝑝
𝑒3𝑝
𝑒4𝑝
𝑒5𝑝 ]
𝑀𝑡−𝑝
𝜀1,𝑡
𝐺𝑡−𝑝
𝜀2,𝑡
𝑌
∗ 𝑡−𝑝 + 𝜀3,𝑡
𝜀4,𝑡
𝑅𝑡−𝑝
𝜀5,𝑡 ]
[
[ 𝐼𝑡−𝑝 ]
where: Mt is represents money supply, Gt, budget deficit, Yt, economic activity, Rt interest
rates and It, inflation.
18
The VAR model isolates purely exogenous shocks and gets the responses of the endogenous
variables after the economy is hit by these shocks. Getting the structural model is also called
identification. According to Sims (1980), identification is the interpretation of historically
observed variation in data in a way that allows the variation to be used to predict the
consequences of an action not yet undertaken. The VAR, therefore, allows for identification
of shocks to a variable, which are then used to assess the impulse response of other variables
from the identified shock.
The impact of fiscal policy is represented by a shock to fiscal deficit, while that of monetary
policy is represented by a shock to money supply and interest rates. In the case of a dollarized
economy like Zimbabwe, where the country does not have monetary control, a significant
foreign capital inflow or outflow not related to the national output, which increases money in
the system, can be taken as a typical example of a monetary policy shock.
4.2
Data and Estimation Method
The analysis is conducted using monthly seasonally adjusted data for the fiscal deficit,
consumer price index, money supply, interest rates and a proxy for economic activity for the
period 2009 to 2012. The VAR requires all variables to be either stationary or cointegrated to
ensure unbiased coefficients. As such, the unit root tests and Johansen cointegration tests are
conducted to test for stationarity of variables as well as the cointegrating properties of the
data. The lag length also matters and is determined using both the Akaike information
criterion (AIC) and Final Prediction Error (FPE).
The variables used were obtained from Ministry of Finance and Economic Development and
Reserve Bank of Zimbabwe. To enable the interpretation of estimated coefficients as
19
elasticity variables were expressed in logarithms. The analysis was only limited to the multicurrency era to avoid bias in estimated coefficients emanating from distortions caused by the
transition from hyperinflation to the multi-currency regime.
5.
5.1
EMPIRICAL RESULTS
Unit Root Tests
As a preliminary analysis, the statistical properties of the data were assessed using unit root
tests and Johansen cointegration tests. The number of lags was automatically selected by the
Akaike Information Criterion (AIC) and Final Prediction Error (FPE). The unit root test
results obtained from Augmented Dickey Fuller tests are shown in Table 1 below.
Table 1: Unit root tests
Variable
Level
First Difference
Economic activity
-5.376***
-6.5496***
(0.000)
(0.000)
-3.1562**
-9.3339***
(0.0267)
(0.000)
-0.6489
-6.4464***
(0.8523)
(0.000)
-3.8716***
-5.4761***
(0.0037)
(0.000)
-8.9793***
-9.9827***
(0.000)
(0.0001)
Money supply
Inflation
Interest rate
Budget deficit
Source: Researcher’s own Computations
The unit root test results in Table 1 above shows that economic activity, money supply
interest rate, and budget deficit variables are stationary in their levels, while inflation,
measured by consumer price index is only stationary after first differencing. The appropriate
20
lag length was determined to be 6 using both the AIC and FPE approaches. Table 2 below
shows the results from lag length tests.
Table 2: Determination of appropriate lag length
Lag
LogL
LR
FPE
AIC
1
684.5354
NA
2.80e-16
-21.62411
2
720.3050
59.81140
1.99e-16
-21.97721
3
748.2863
42.20139
1.87e-16
-22.07496
4
770.9199
30.42548
2.18e-16
-21.99737
5
813.2494
49.96269*
1.41e-16
-22.56555
6
845.4358
32.71406
1.37e-16*
-22.80117*
Source: Researcher’s own Computations
Note: * indicates lag order selected by the criterion, LR: sequential modified LR test
statistic (each test at 5% level), FPE: Final prediction error, AIC: Akaike information
criterion, SC: Schwarz information criterion, HQ: Hannan-Quinn information criterion
5.2
Impulse Responses
The impulse response functions and variance decompositions for the length of 24 periods for
all three cases were considered and the response of individual variables to the identified fiscal
policy shocks in all three cases are presented in Figure 4 below.
21
Figure 4: Impulse response functions
Response of inflation to budget deficit shock
Response of interest rates to budget deficit shock
.04
.006
.03
.004
.02
.002
.01
.000
.00
-.002
-.01
-.02
-.004
2
4
6
8
10
12
14
16
18
20
22
24
2
Response of money supply to budget deficit shock
4
6
8
10
12
14
16
18
20
22
24
Response of output to budget deficit shock
.015
.06
.010
.04
.005
.02
.000
.00
-.005
-.02
-.010
-.015
-.04
2
4
6
8
10
12
14
16
18
20
22
24
2
4
6
8
10
12
14
16
18
20
Source: Researcher’s own Computations
The results in Figure 4 above suggest that the nominal interest rates respond positively to a
fiscal deficit shock. Specifically the results indicate that a 1% fiscal deficit shock leads to a
0.02% increase in nominal interest’s rates over a period of four months, with the impact
disappearing after 10 months. In addition, output increases in the short term, following a
fiscal deficit shock. The results, therefore, suggests that a shock in government budget deficit
has a transitory positive impact on interest rates and output. The inflation rate and money
supply are, however, not responsive to a fiscal deficit shock.
The results confirm the assertion that in dollarized economies, inflation developments mainly
mirror that of a country whose currency is being used. As such, domestic policy becomes
ineffective in influencing inflation developments. Fiscal policy affects interest rates through
the crowding out effect. The positive response of interest rates to a budget deficit shock is
22
22
24
expected since government has in most cases been financing the mismatches in its revenues
and expenditure through the issuance of Treasury bills. Money supply in a dollarized
economy is mainly affected by changes in capital flows, implying that fiscal policy affects
money supply in cases where government borrows externally. External borrowing by the
Government was, however, limited during the period under review due to outstanding arrears
to external creditors. As a result, the insignificant impact of fiscal policy on money supply
was expected.
5.3
Variance Decomposition Results
The forecast error variance decomposition was applied to assess the relative importance of
individual shocks in explaining forecast error variances of the observed variables.
Specifically, the variance decomposition analysed are the decomposition of interest rates,
inflation, money supply and economic activity to a fiscal deficit shock. The results are shown
in Tables 5-8 below.
23
Table 3: Variance Decomposition of Interest Rates
Period
S.E.
Deficit
Interest
Inflation
Money Supply
Output
1
2
3
4
5
6
7
8
9
10
11
12
0.185674
0.197201
0.202708
0.203312
0.203724
0.203766
0.203835
0.203858
0.203879
0.203893
0.203904
0.203912
0.050148
1.733573
8.883989
14.10107
17.93303
19.84094
20.68622
20.95296
21.00515
20.98315
20.94364
20.90354
99.94985
81.18590
64.32536
55.68852
51.21738
49.21157
48.16467
47.59824
47.26249
47.05654
46.92165
46.82815
0.000000
4.637394
7.646598
8.157283
7.851259
7.604188
7.453526
7.369404
7.318508
7.286137
7.263823
7.247699
0.000000
12.00760
17.60983
19.06936
19.38546
19.73783
20.16426
20.58465
20.93946
21.21397
21.42128
21.57893
0.000000
0.435534
1.534220
2.983768
3.612869
3.605467
3.531327
3.494740
3.474392
3.460205
3.449604
3.441669
Source: Researcher’s own Computations
The variance decomposition of interest rates in the Table 5 above suggests that about 21.6
percent of the variation in interest rates is explained by money supply, while 20.9 percent is
explained by budget deficit. The interest rate variable itself explain a greater proportion of the
variation, accounting for 46.8 percent. Inflation and output explains 7.2% and 3.4% of
variation in interest rates respectively.
The variance decomposition of inflation suggests that about 93.5 percent of the variable is
explained by the inflation variable itself as shown in Table 6 below. This suggests that
inflation persistence has mainly been due to inflation expectations, with fiscal and monetary
policy playing a limited role in explaining the inflation dynamics under a multiple currency
regime.
24
Table 4: Variance Decomposition of Inflation
Source: Researcher’s own Computations
The budget deficit only explains a paltry 1.2 percent of the variation in inflation, while
interest rates and money supply explain only 4.1 percent and 0.13 percent. The results
suggest that inflation under the multiple currency regime has predominantly been influenced
by other factors besides fiscal and monetary policy variables.
The variance decomposition of money supply suggests that the budget deficit only explained
0.37 percent of the variation in money supply, while inflation and interest rates explained
14.8 percent and 13.6 percent respectively. Money supply variable itself explain about 70.9
percent of the forecast error variation. The variance decomposition are shown in Table 7
below.
25
Table 5: Variance decomposition of money supply
Source: Researcher’s own Computations
Table 8 below shows the variance decomposition of output. It shows that about 22.6 percent
of the variation in economic activity is explained by fiscal variable, 17.3 percent by inflation
and 53.1 percent by the economic activity variable itself.
26
Table 6: Variance decomposition of output
Source: Researcher’s own Computations
6.
CONCLUSION AND POLICY RECOMMENDATIONS
This paper attempted to assess the effects of fiscal policy on monetary policy transmission
mechanism in Zimbabwe. Zimbabwe makes an interesting case to study, given its limited
capacity to influence policy through monetary policy following the adoption of the multicurrency regime. The VAR model was applied to assess the response of relevant monetary
policy variables, notably, interest rates and money supply to fiscal policy shocks.
The effects of fiscal policy shocks on monetary policy variables were examined using
impulse response functions and variance decompositions. The results from the impulse
response functions suggest that the effects of fiscal policy shocks on money supply and
interest rates is positive.
The variance decomposition of monetary policy variables suggest that fiscal policy has to a
lesser extent influenced interest rates and money supply under the multicurrency regime.
27
Specifically the impact on money supply has been largely insignificant. The results are
consistent with most empirical findings which suggest that in a dollarised economy, money
supply becomes highly endogenous. The results also suggest that inflation dynamics have
largely been influenced by inflation persistence and other factors besides fiscal and monetary
policy variables. The large proportion of the variation in economic activity explained by
fiscal policy shock, suggests that fiscal policy has been instrumental in influencing economic
activity under the multiple currency environment.
The results suggest the need for Government to properly sequence its Treasury Bill issuance
to avoid volatility on monetary conditions, explained by changes in real interest rates and real
effective exchange rate, through the crowding out effect. Moreover the need for coordination
between monetary and fiscal policy remains highly critical. Given the dominance of fiscal
policy under the multicurrency regime, it is imperative that the government effectively
implements its fiscal policy to impact positively on the economy. Future work on this topic
could give a more precise definition of fiscal and monetary policy shocks. Moreover, a more
sophisticated model is needed with additional variables, including the real effective exchange
rate and government revenues to assess the implications of fiscal policy on the monetary
policy transmission mechanism.
28
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