By Maxwell Fry, Director of the Bank’s Centre for Central Banking Studies.
In many developing countries where I have worked, the fiscal situation dominates other areas of macroeconomic policy, including exchange rate and monetary policies. Specifically, large and sustained government deficits are typically accompanied by inflationary monetary expansion and exchange rate depreciation. In this paper, I put forward the hypothesis that this is systematically the case: a country’s monetary policy stance amplifies rather than offsets its fiscal stance, as defined by both the size of its deficit and how it is financed. I further suggest that the reason for this relationship between fiscal and monetary policy is that both are determined by the government’s competence in macroeconomic policy-making.
A government can finance its deficit in various ways. For example, the typical OECD country finances about 50% of its deficit from non-bank domestic sources, whereas the typical developing country finances only about 8% from this source (Fry (1997, page 4)). Here, I predict that the larger its deficit and the more a government finances it by borrowing from the domestic banking system, the less monetary policy will counteract the consequent inflationary pressures. So the size of the deficit and the methods by which it is financed together affect the stance of monetary policy.
To examine the relationship between fiscal and monetary policies, I estimate monetary policy reaction functions for groups of countries selected on their fiscal characteristics, drawn from a sample of 70 developing countries. The results support my hypothesis: they suggest that, far from offsetting expansionary fiscal policy, monetary policy tends to compound any inflationary fiscal stance in these countries. Larger deficits and greater reliance by governments on the domestic banking system are associated not only with less monetary policy neutralisation (that is, changes in government borrowing from the domestic banking system are not countered by equal and opposite changes in credit to the private sector), but also with less sterilisation of increases in foreign exchange reserves. In other words, more inflationary fiscal policies are accompanied by more accommodating and so more inflationary monetary policies.