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Comparative Analysis of Monetary and Fiscal Policies

Paper type: Analysis
Pages: 11 (2566 words)
Categories: Economics, Finance, Inflation
Downloads: 4
Views: 351

Empirical investigation on the comparative potency of monetary and fiscal policies is still dubious among two major schools of thought in economics so called classical and Keynesian. Hence, this paper investigates the relative effectiveness of monetary and fiscal policies in affecting economic growth by employing Auto-Regressive Distributive Lag Model (ARDL) for the time spanning from 1975 to 2017. The proxies used in this study for monetary and fiscal policy were Broad money supply (M2) and government consumption expenditure respectively while real GDP at constant prices in 2010 is used as proxy for economic growth in Ethiopia.

Anderson and Jordan (1968) St. Louis equation has been used to estimate the comparative potency of monetary and fiscal policies. The empirical results indicate that both the monetary and fiscal policies have equal statistical significant and positive impact on economic growth in Ethiopia with different significance level and magnitude.

Besides of equal effectiveness, the elasticity of real output with respect to fiscal policy variable is greater than the elasticity with respect to money supply which show fiscal policy is more effective than monetary policy in influencing Real GDP in the long-run.

However, in the short run, the fiscal policy is effective while that of the monetary policy proxy by money supply is ineffective in affecting output growth in Ethiopia. Therefore, to have continuous and sustainable economic growth, the coordination of monetary and fiscal policies are vital and the lack of this coordination leads to a sharp downturn of overall economic performance, even can hurt the economy.

Key Words: Monetary policy, Fiscal policy, ARDL, Economic Growth, Ethiopia

INTRODUCTION

Background of the study

Unquestionably, macroeconomic policies act a vital part in promoting and achieving maintainable and adequate economic environment which creates it conceivable for an economy to achieve a more rapidly, steady and persistent growth without aggravating inflation. This essential role is undertaken by the two leading tools of macroeconomic policy so called Monetary and fiscal policies in an economy. Responding to the economic fluctuation is regarded as the main aim of using monetary and fiscal policy tools by policymaker. Even though well-known formulation of monetary policy is towards controlling inflation and fiscal policy designed to the issue of public finance, both policies can be employed to respond to economic activity (?en and Kaya, 2015).

However, the relative effectiveness of both monetary and fiscal policies has been left to argument between two schools of thought namely the Keynesians and Monetarists since 1960s. In this point of view, there is still on-going debate and argument among different scholars from both theoretical and empirical perspectives. According to Keynesians argument, conducting fiscal policy as compared to monetary policy is strong and more effective in boosting economic activity through increasing aggregate demand, whereas the Monetarists in contrast claiming that monetary policy is more powerful effect on macroeconomic variables. According to monetarists, monetary urge is the most imperative factor contributing for fluctuation in output, employment and prices. As argued by Milton Friedman (1974) money stock is all that matters for variation in nominal income and for the short run deviations in real income as an overstatement and forwarded that pure fiscal policies namely increasing government expenditure or reduction in tax cannot effect real output.

Their justifiable empirical and theoretical based disagreement between two main extreme schools of thought has never come up with clear-cut conclusion and has been continued unending investigation among academic, economists and policymakers. The early seminal paper by Andersen and Jordon (1968) developed empirical policies debate on issue that which police is more powerful and effective in effecting output growth. In throughout literature review, still there is no credible evidence based empiric has been found in relation to the relative effectiveness of monetary and fiscal policies on economic activity (?zer and Karag?l, 2018).

Moreover, more recent global recession occurrence since 2008 financial crisis have acknowledged a renewed debate about the relative effectiveness of monetary and fiscal policies on economic activity though there had been widely believed statement among different scholars that implementing fiscal policy is more complex process and controversy than applying monetary policy instrument which is easily managed and controlled by certain authorized body in behalf of government (Sen and Kaya 2015). In contrast to aforementioned argument, as is mentioned by (Guerguil et al., 2017) and (?zer and Karag?l, 2018), due to large and prolonged growth and employment costs of the crisis, monetary policy has limited effect when interest rates are wedged at the zero lower-bound, and the essential of increased public expenditure to tackle a “secular stagnation” in this economic phenomena, there is a tendency of agreement among economists and policy makers for the powerfulness of fiscal policy as a countercyclical macroeconomic policy tool.

The aim of this paper is to examine the relative effectiveness of monetary and fiscal policies on output growth in Ethiopia over the period of 1980 and 2016/17 by using ARDL Bounds test approach to co-integration via the St. Louis approach. To the best of our knowledge, this study will be the first attempt to provide empirical evidence on comparative efficiency of monetary and fiscal policies on output growth in case of Ethiopia which is long-lasting debate among academics and policy makers. Moreover, the data will be used in this research are more updated and cover wider span of time providing more degrees of freedom and power that enables to obtain more efficient parameter estimates from model.

Research question

Does the monetary policy is relatively more effective than fiscal policy in changing real output of Ethiopia?

Is there exists a strong relation between fiscal and monetary policy variables and economic growth in Ethiopia?

How can macroeconomic stability be achieved in Ethiopia?

The general objective of this study is to examine the relative effectiveness of monetary and fiscal policies in affecting economic growth in Ethiopia using annual data from 1980 to 2017.

Specific objective

To examine the short-run and long-run impact of Monetary and fiscal policies on economic growth in Ethiopia

To investigate the relative effectiveness of monetary over fiscal policy on economic growth of the country

This study explores examine the relative effect of monetary and fiscal policies in affecting economic growth in Ethiopia. To achieve this objective, time series data ranging from 1981/82 to 2016/17 are chosen. The whole period is chosen due to the availability of published data for all the variables involved in the model and to avoid using multiple data sources for the same variable.

We believe that study is important because it attempts to fill the gap in the literature in which study can be taken as reference for those who will undertake a study on the area of relative effect of monetary and fiscal policies on economic growth. Moreover, the result of this study is expected to provide relevant information for policy makers in formulation of macroeconomic policies issue and their intervention to achieve macroeconomic objectives for instance economic growth.

EMPERICAL LITERATURE REVIEW

In this section we focus on the empirical studies because recent literature comprises a lot of studies which have outlined the effects of monetary and fiscal policies on output growth and its investigation has been ongoing as well. Particularly, in last two or three decades, a plenty of studies analyzing the relative effect of fiscal policy and monetary policy on real macroeconomic variables has widely increased throughout the world. This may be contributed towards increasing position of fiscal policy in fighting economic problem and stagnation which were manifested in a number of both developed and developing countries.

As pointed out in (?zer and Karag?l (2018), The relationship between fiscal and monetary policies and growth has conducted a lot of number of empirical investigation come up with mixed conclusion across different cross sectional, time series and panel data, such as, OLS, Panel data models, VAR model, VEC Model and ARDL Model. The majority of the finding confirmed that fiscal and monetary policies are certainly affect growth. In the studies, the outcome the variation of outcome largely accounted by the estimation techniques employed and/or the types of variable used in model.

Study conducted by Andersen and Jordan (1968) takes different measures of monetary and fiscal policy measures effectiveness in the United States using quarterly data, and implied that monetary policy proxied by money supply has greater, faster and more predictable impact on economic performance than fiscal policy instruments proxied by government expenditure. They concluded that forwarded that to stabilize the economy it is better to use monetary policy.

Early study by Owoye and Olugbenga (1994) analyzed the comparative effect of monetary and fiscal policies on output growth in sample of ten African countries namely Burundi, Ethiopia, Ghana, Kenya, Morocco, Nigeria, Sierra Leone, South Africa, Tanzania and Zambia?by using a Trivariate Vector Autoregressive (VAR) model over the year from 1960 to 1990. They found that effect of monetary policy stronger than fiscal variables in 5 of 10 countries whereas fiscal policy is more significant than monetary policy for the rest five countries. Regarding to their finding, the argument was that it is not allowed to provide conclusion of a particular macroeconomic policy stimulate economic growth. Another later cross-country study by Petrevski et al. (2015) investigated the relative importance of monetary and fiscal policies in increasing output in three South Eastern Europe economies: Bulgaria, Croatia, and Macedonia by using the recursive VARs to the quarterly data for 1999-2011, their result confirmed that positive fiscal shocks encourage higher output growth in the all countries, inferred to the expansionary effects of fiscal consolidation.

Moreover, more recent period different study conducted in different countries study; one confirms fiscal policy tool others support monetary policy, for instance, study by Jawaid et al. (2010) analyzed the relative outcome of the two powerful macroeconomic policy instrument on economic performance in Pakistan during the period 1981-2009 come up with the existence a positive relationship between both policies and growth in long-run. Conversely, their finding revealed that monetary policy is more potent effect than fiscal policy in accelerating growth.

An additional topical country-specific study by Havi and Enu (2014) analyzed the relative importance of monetary and fiscal policy on growth in Ghana by using estimation of OLS techniques for the period1980-2012. Their study showed that although the effect of monetary policy is more powerful, both policies positively affect growth in the case of Ghana. Similar result was obtained by ?en and Kaya (2015) who confirmed that both monetary and fiscal policies are positive and significant effects on output performance in Turkey. However, regarding to relative effectiveness, they found that the monetary policies has larger outcome in stimulating economic growth than monetary policies. Based on the finding they suggested that both policies significantly affect growth in which they should be implemented mutually in an efficient way to accelerate growth.

In more recently, Bokreta and Benanaya (2016) investigated the relative effectiveness of monetary and fiscal policy in case of Algeria employing co-integration and vector error correction model, and found that there is strong positive statistically significant impact of government expenditures on output growth, whereas the effect of taxes is found to be negative sign in long run, inferring that fiscal policy has strong effect than monetary policy in promoting economic growth in Algeria. The same conclusion has drawn by Okorie et al., (2017) used the auto regressive distributed lag (ARDL) model to determine the relative importance of monetary and fiscal policies in Nigeria using a quarterly time-series from 1981-2012. They confirmed that those both monetary and fiscal policies have significant positive impact national income. However, comparatively, this monetary policy outcome is stronger than income faster than fiscal policy in promoting economic growth in short run but, in the long-run fiscal policy dominates its effect that is total impact of fiscal policy is greater than that of monetary policy and concluded that they supports the use of both policies to achieve macroeconomic objectives primarily economic performance depends on the objective the authorities want to achieve.

Similarly, the study conducted by ?zer and Karag?l (2018) who analyzed the relative growth effectiveness of fiscal and monetary policies in Turkey over the period 1998 and 2016 by using the techniques of ARDL Bounds testing, structural Granger causality tests and their result indicates that Monetary policy variable is creating only short-run effects on growth; but, does not cause any Granger causality on it, that is fiscal policy variable has a long-run significant effect and causing to growth. As result they concluded that the fiscal policy seems to be more effective than monetary policy during examination period, implying the rethinking the implementation of both policies to achieve past economic growth.

Overall, in reviewing the related literature we can conclude that although there are the enormous studies examining the relative effectiveness of monetary and fiscal policies, the empirical findings of these studies are highly mixed. In other words, the empirical studies reveal inconclusive results with regard to the relative effectiveness of two potent macroeconomic policy tools. For instance, in some countries monetary policy is dominant to fiscal policy or vice versa, while in others the results is inconclusive. These results do not allow us to make a generalization with regard to the relative effectiveness of monetary and fiscal policies. The contradictory empirical results which emerged from the studies above may be attributed to a number of factors, depending on country-specific elements such as institutional, developmental, political and so on as well as methodological approaches, variables chosen, treatment, etc.(Sen and Kaya, 2015).

DATA AND MODEL SPECIFICATION

Data type and source

Regarding data type, the study used secondary time series data for about 35 years obtained from internal and external sources. The selection of this sample size is made based on the availability of data for each of the variable included in the model for the entire time horizon while its sufficiency is taken into consideration as well. The major sources of data for the problem under investigation were Ministry of Finance and Economic Cooperation (MoFEC), publications of National Bank of Ethiopia (NBE), Central Statistics Authority (CSA) of Ethiopia, Ministry of Education and Ethiopian Revenue and customs authority (ERCA). In addition to these domestic sources, some variables for which there are no sufficient data from the domestic sources, are collected from external sources, especially from IMF and WB databases.

Model specification

To analyze the relative effectiveness of monetary and fiscal policies on economic growth, we will employ the equation proposed by Andersen and Jordan (1968) which is so called St. Louis equation. The justification behind the use of this equation is that St. Louis has received much consideration from the policy maker’s researchers and academicians regardless of its drawback in relation to methodology and variables. Its mathematical expression can be represented as;

Y=f( M F W) (1)

Where: Y stand for the economic growth measures for well being of society; F represents fiscal policy variables; M monetary policy variables, and W represents other control variables influencing economic performance.

The from above equation, the explanatory variables will be used in the model comprises of government total final consumption as % of GDP proxy for fiscal policy, broad money supply as% of GDP proxy for monetary policy and other control variables are real interest rate, CPI inflation, nominal exchange rate and trade openness to address the problem of omitted variable biasedness from St. Louis equation where as economic growth measured by real GDP per capita. The equation could be rewritten in form of log-linear form to be employed in this study here as follows:

Cite this essay

Comparative Analysis of Monetary and Fiscal Policies. (2019, Nov 25). Retrieved from https://studymoose.com/comparative-analysis-of-monetary-and-fiscal-policies-essay

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