Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

Is fiscal policy always counter- (pro-) cyclical? The role of public debt and fiscal rules

We investigate the reaction of fiscal policy to the business cycle in a panel of 56 developed, emerging and developing economies over 1990–2011. While we strengthen the established finding that fiscal policy is counter-cyclical, additional outcomes emerge from this study. We reveal a non-linear response of fiscal policy to the business cycle, conditional upon the outstanding debt stock. Interestingly, when the public debt-to-GDP ratio goes beyond our endogenously estimated threshold of 87%, fiscal policy turns pro-cyclical. To tackle this effect, we explore the role of fiscal rules (FR). We unveil heterogeneous impacts among FR, as only some of them may mitigate fiscal policy procyclicality in high-debt contexts.     

Fiscal stabilizations: When do they work and why

This paper studies the determinants and channels through which fiscal contractions influence the dynamics of the debt-to-GDP ratio and GDP growth. Using data from a panel of OECD countries, the paper shows that the success of fiscal adjustments in decreasing the debt-to-GDP ratio depends on the size of the fiscal contraction and less on its composition. The rate of growth of output matters too, but higher GDP growth does not drive the success of a fiscal stabilization. In contrast, whether a fiscal adjustment is expansionary depends largely on the composition of the fiscal maneuvre. In particular, stabilizations implemented by cutting public spending lead to higher GDP growth rates. The effects of the composition on growth work mostly through the labor market rather than through agents’ expectations of future fiscal policy. Finally, the evidence suggests that successful and expansionary fiscal contractions are not the result of accompanying expansionary monetary policy or exchange rate devaluations.     

Measuring the time‐varying effects of fiscal policy on private saving in the process of financial integration

This paper investigates the effects of fiscal policy, measured as the extent to which private saving is offset by public saving, in the process of international financial integration. Using extensive panel data for 87 countries over the period 1970–2010, we find that the dynamics for the saving offset are highly nonlinear and time‐varying. While the saving offset has gradually declined in line with rapid financial integration in advanced economies, it has remained broadly stable in less financially integrated emerging and developing economies. This implies that the negative wealth effects of fiscal policy in advanced economies have been smaller owing to higher financial integration, which could help governments reduce their debt burdens through the well‐anchored domestic interest rates at the world level.     

A new test for fiscal sustainability with endogenous sovereign bond yields: Evidence for EU economies

In this paper we develop a new test for fiscal sustainability and propose a synthetic fiscal sustainability indicator. Conventional tests based on fiscal reaction functions assume a constant real interest rate. However, many empirical studies find evidence on a positive response of long-term rates to sovereign debt levels. We take this evidence into account and endogenize the long-term real interest rate in testing fiscal sustainability. We apply the new test for the European economies. We find that considering the response of interest rate to debt may change the assessment of fiscal sustainability. More specifically, our results indicate that fiscal sustainability is at risk in a number of European Union economies, even if the results of traditional approaches suggest sustainable fiscal policy.     

Interest rate volatility and macroeconomic dynamics: Heterogeneity matters

We examine the relation between real interest rate volatility and aggregate fluctuations for a diverse sample of countries. Compiling a new dataset including emerging and advanced countries, the substantial variation in our data yields novel results: (a) stochastic volatility outperforms Markov‐switching in representing interest rates, (b) some advanced economies can be more volatile than emerging markets, and (c) creditors take on more debt following volatility shocks. We show how an equilibrium business cycle model with uncertainty shocks can generate these facts. Sample heterogeneity produces significant parameter differences, playing an important role in distinguishing the effects of volatility shocks.     

Political and Fiscal Risk Determinants of Sovereign Spreads in Emerging Markets

Using a panel of 46 emerging market economies from 1997 to 2008, this paper investigates the key determinants of country risk premiums as measured by sovereign bond spreads. Unlike previous studies, the results indicate that both political and fiscal factors matter for credit risk in emerging markets. Lower levels of political risk are associated with tighter spreads, particularly during financial turmoil. Efforts at fiscal consolidation narrow credit spreads, especially in countries with high initial public debt levels. The composition of fiscal policy also matters as higher public investment lowers spreads as long as the fiscal position remains sustainable and the fiscal deficit does not worsen.     

Post COVID-19 exit strategies and emerging markets economic challenges

We study emerging markets' 1980s lost growth decade, triggered by the massive reversal of the snowball effect in the US during 1974–1984, finding that higher flow costs of servicing debt overhang explain the dramatic decline in growth rates of exposed emerging markets. We also show how lowering the US cost of servicing its public debt has been associated with higher US, Japan, and Western Europe real output growth rates during the post WWII recovery decades, 1946–1956, and validate that fiscal adjustments of large countries have strong growth and volatility spillovers effects on exposed emerging markets and developing countries.     

Limits to government debt sustainability in OECD countries

The recent euro area sovereign debt crisis has shown the importance of market reactions for the sustainability of debt in advanced economies. This paper calculates endogenous government debt limits given the markets assessment of the probability to default. The estimated primary balance reaction function to growing debt has the “fiscal fatigue” property (a loosening fiscal effort makes the primary balance insufficient to support rising debt) at high debt levels. The combination of this feature of the primary balance reaction function with the market interest rate reaction to growing debt determines the government debt limit beyond which debt cannot be rolled over. An application to OECD countries over the period 1985 – 2013 with a model-based risk-premium shows that current debt limits are high for most of the OECD thanks to particularly low risk-free interest rates. It also shows for some countries that current debt levels are not sustainable without a change in government behaviour. Most importantly, the framework illustrates the state contingent nature of debt limits and therefore the vulnerability of governments to a change in macroeconomic conditions and to market reactions. Last, computations with an estimated interest rate reaction to public debt illustrate that debt limits are lower in the euro area than in other countries because of a sharper market interest rate reaction to rising debt.     

How is the Debt Managed? Learning from Fiscal Stabilizations

This paper examines public debt management during episodes of fiscal stabilization when long–term interest rates are generally higher than governments' expectations of future rates. We find that governments increase the share of fixed–rate long–term debt denominated in the domestic currency, the higher is the conditional volatility of short–term interest rates, the lower are long–term interest rates, and the stronger is the fall in long–term rates that follows the announcement of the stabilization program. This evidence suggests that governments tend to prefer long to short maturity debt because they are concerned about refinancing risk. However, when long–term rates are high relative to their expectations, they issue short maturity debt to minimize borrowing costs.
JEL classification : E 63; H 63     

PRICE-BASED MEASUREMENT OF FINANCIAL GLOBALIZATION: A CROSS-COUNTRY STUDY OF INTEREST RATE PARITY

Abstract.   We characterize the relationship between ex post exchange rate depreciation and the interest differential for both developed and emerging market economies. The measured ex post uncovered interest differentials in terms of both levels and absolute values are then related to a set of variables that capture macroeconomic and policy conditions. We find that a wide diversity in the coefficient relating depreciations and interest differentials can be attributed to differences in inflation volatility, financial development, capital account openness, legal development and the nature of the exchange rate regimes. The robust results are mainly found in the emerging market country grouping.     

Interest Rate Volatility Regimes in Selected Asian Countries:A Univariate Markov Switching Analysis

Business cycle dynamics are determined by relatively large volatilities in output,consumption,and investment,which leads to cyclical fluctuations in interest rates.Using the Markov switching model,we model the nominal interest rate movements to explain the volatility regime shifts in a set of selected emerging Asian economies.The estimated results provide significant evidence of regime-dependent means,variances,and probabilities in both stable and volatile regimes in selected countries,confirming the existence of two distinct regimes in nominal interest rate movements.In addition,the smoothed probability results of switching autoregressive model show that the model is capable of capturing the two regimes for the corresponding nominal interest rate behaviors.Besides,the results reveal that the stables regimes have higher durations than the volatile regimes.This study also shows the advantage of Markov switching models over conventional regression models,allowing the identification of different regimes for the cyclical behavior of interest rates.     

Foreign interest rate shocks and exchange rate regimes in East Asia

Using a theoretical dynamic stochastic general equilibrium model and an empirical panel vector autoregression, we assess the transmission of foreign real interest rate shocks on the volatility of various key macroeconomic variables in nine small open economies in East Asia taking into account the role of exchange rate regimes. Both the theoretical and empirical findings confirm the hypothesis that flexible exchange rate may work as a shock absorber when the economy is hit by foreign real interest rate shocks. The findings suggest a clear trade-off between the volatility of real exchange rate and real output to foreign interest rate shocks, both the US and G7 real interest rates, where the responses of real output are mitigated in countries that have more flexible exchange rate regime.     

EXCHANGE RATE REGIME AND MONETARY POLICY INDEPENDENCE IN EAST ASIA

Abstract.  This paper investigates whether the choice of exchange rate regimes influences the sensitivity of domestic interest rates to international interest rates. We empirically analyse this issue in the context of East Asian economies by employing a regime switching model. We find that the sensitivity of local interest rates to international interest rates declined in Korea and Thailand after they adopted floating exchange rate regimes. We also find that Japan, with a floating exchange regime, has greater independence in monetary policy than a pegged economy such as Hong Kong. These empirical findings suggest that exchange rate flexibility provides greater monetary independence.     

Institutional arrangements and public debt threshold limits

Inter-governmental Organisations, such as the IMF and OECD, advocate a medium-term reduction in deficit spending and public debt accumulation among advanced economies to satisfy conditions of fiscal sustainability. Buttressing the need for fiscal austerity, Reinhart and Rogoff claim to have identified a so-called tipping point, beyond which public debt accumulation negatively affects economic growth. While recent data seem to indicate that some Eurozone (non-sovereign) economies have reached a tipping point, for other advanced (sovereign) economies, such as the US, UK and Japan, this is not clear. The mainstream tipping point literature however does not recognise the importance of institutional arrangements for the conduct of fiscal and monetary policy. Furthermore, the literature sheds little light on the transmission mechanism between high public debt and low economic growth. This article draws on the principles of Modern Monetary Theory to discuss institutional arrangements and to justify the theoretical and empirical focus on Eurozone economies. The empirical analysis unpacks the transmission mechanism(s) to reveal that Eurozone economies have reached a public debt threshold limit with respect to long-term interest rates.     

Public capital,deficit financing,and economic growth in a stochastic economy

This paper examines the relationship among deficit-financing fiscal policy, risk and economic growth in a stochastic endogenous growth model with private and public capital. We show that there are positive balanced-growth rate and a debt-to-GDP ratio that depend on deep parameters such as the income tax rate and the standard deviation of the growth rate of private and public capital. Investment and fiscal shocks influence the mean and variance of the growth rate and the debt dependency rate through portfolio changes and capital accumulation. In particular, an increase in the risk of private investment destabilizes the economy and reduces the mean growth rate if the portfolio change is drastic, and this increase in risk increases the debt-to-GDP ratio. In contrast, an increase in the income tax rate stabilizes the economy, increases the mean growth rate, and has a positive or negative effect on the debt-to-GDP ratio according to the ratio of public to private capital if the income tax rate is sufficiently small.     

Exchange market pressure and primary commodity – exporting emerging markets

This paper studies short-term sensitivity between exchange market pressure and various domestic and external factors in primary commodity-exporting emerging markets. The paper focuses on the top country-commodity groups in sugar, cereal, fuels, ores and coffee during the pre-peak and post-peak commodity price periods across floating and pegged exchange rate regimes, using the price of crude oil as a general benchmark. Employing a panel model and panel VAR analysis, the paper finds the heterogeneity of response patterns unique to country-commodity groups and exchange rate regimes. According to the results, in flexible regimes, volatility occurs via the foreign exchange market, interest rates, and domestic credit cycles, feeding into the social costs for structurally weaker economies. Hard exchange-rate pegs often result in a drain on international reserves as the terms of trade deteriorate following post-price peaks, leading to unpopular depreciation. These results accentuate concerns over uneven international trade patterns, an open economy’s short-term foreign exchange policy, and speculative capital flows. Such sensitivity has broad implications for macroeconomic balance and the sustainability of implied exchange rate targets in the presence of a foreign exchange constraint across emerging markets.     

Exchange Rate Policy and Sovereign Spreads in Emerging Market Economies

This paper empirically analyzes the relationship between exchange rate policy and sovereign risk premia in emerging market economies, considering both officially declared regimes and actual exchange rate behavior. The results show that countries that announce a fixed exchange rate regime face lower spreads than countries that announce a floating regime or intermediate flexibility. When the actual exchange rate behavior is considered, this relationship persists between intermediate flexibility and pegs but countries that allow their exchange rates to freely float do not face higher spreads. The difference between the results is due to the fact that many countries deviate from their declared exchange rate policy. The countries that announce a floating regime do not face higher spreads than pegs when they actually allow a high degree of flexibility as they announced. However, intermediate flexibility leads to higher spreads independently of whether this is the announced policy or the actual behavior.     

Revisiting the interest rate–exchange rate nexus: a Markov-switching approach

In this paper the interest rate–exchange rate nexus and the effectiveness of an interest rate defense are investigated empirically. I present a reduced form evidence which characterizes the empirical relationship between interest rates and exchange rates. I use a Markov-switching specification of the nominal exchange rate with time-varying transition probabilities. Empirical evidence from six developing countries: Indonesia, South Korea, the Philippines, Thailand, Mexico, and Turkey indicates that raising nominal interest rates leads to a higher probability of switching to a crisis regime. Thus, the empirical results presented here may support the view that a high interest rate policy is unable to defend the exchange rate. Unlike other studies which consider linear models only, my findings are robust and consistent over different countries and crisis episodes (Asian 1997 crises, Mexico 1994 crisis, and Turkey 1994, 2001 crises). In order to explain the empirical findings, I construct a simple theoretical model by incorporating an interest rate rule in the model proposed by Jeanne and Rose (2002) [Jeanne, O., Rose, A.K., 2002. Noise trading and exchange rate regimes, Quarterly Journal of Economics. 117 (2) 537–569]. The model has multiple equilibria, and under plausible conditions, higher exchange rate volatility is associated with higher interest rates.     

THE EFFECTS OF ALTERNATIVE EXCHANGE RATE REGIMES ON REAL EXCHANGE RATE VOLATILITY: EVIDENCE BASED ON A NEW DATASET

Do alternative exchange rate regimes affect short‐term real exchange rate volatility differently? The existing empirical evidence is quite mixed with slightly more papers supporting that they do. We show that such lack of consensus is mainly due to current literature limitations regarding the measurement of real exchange rates (RERs), the identification of exchange rate regimes (ERRs), and the control for the incidence of real and nominal shocks. To address these limitations, we construct a novel monthly dataset for 63 countries over the period 1946–2007, which includes market‐determined multilateral RER and a proxy for terms of trade. We find that ERRs indeed affect short‐term real exchange rate volatility differently. While the evidence is generally consistent with Mussa's sticky prices argument, we find that for nonadvanced countries in post‐Bretton Woods there exists a “U‐shape nominal flexibility puzzle of RER.” We also find evidence of a “short‐run RER volatility puzzle.” Having controlled for the incidence of real and nominal shocks, nonadvanced countries' RER volatility remains between 25% and 150% greater than that of the advanced economies. Moreover, the key literature finding that short‐term RER volatility is higher in Bretton Woods (BW) than in post‐Bretton Woods (PBW) for industrialized countries vanishes when using market‐determined multilateral RER instead of official bilateral RER. (JEL F31, F33, F41)