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Fiscal Policy And Macroeconomic Imbalances

The Alert Mechanism Report is the starting point of the annual Macroeconomic Imbalance Procedure (MIP). The MIP aims to identify potential risks early on, prevent the emergence of harmful macroeconomic imbalances and correct the imbalances that have already materialised.

Fiscal Policy and Macroeconomic Imbalances

In May, the Commission publishes a country report for each Member State. The reports take stock of implementation of the recovery and resilience plans, analyse the economic and social developments and challenges facing Member States and provide a forward-looking analysis of their resilience. For those Member States selected in the Alert Mechanism Report, the country report includes the summary of the findings of the so-called "in-depth review" analysing potential macroeconomic imbalances in the Member State.

Specific monitoring is a form of intensified dialogue between the European Commission and national authorities that aims to help EU countries address macroeconomic imbalances that could negatively affect their own economic stability or that of the euro area or the EU.

According to a well established view of the crisis in the European Monetary Union (EMU), its seeds were planted well before the world financial collapse of 2007-08 and the subsequent Great Recession. The seeds, "macroeconomic imbalances" in the Brussels language, lie in the lack of real convergence across member countries. The idea is that as long as countries are on divergent trajectories of growth of GDP, productivity and incomes, 1) large and unsustainable current account imbalances will also emerge, 2) the ensuing capital movements may suddenly stop triggering bank and financial crises, 3) national fiscal policies will also be put under pressure by the need to bailout faltering banking systems while countries on a low growth path will also face harder convergence towards the 60% debt target, with higher interest rates and heavier fiscal effort.The Commission is entirely devoted to pro-growth and convergence policies, and the surveillance on macroeconomic imbalances figures prominently among the new tools of European governance. Prof. Roberto Tamborini, Department of Economics and Management of the University Trento (UdT is a network partner of EconPol Europe), says: "Formalising the convergence process is an important goal in the road map towards the completion of Europe's Economic and Monetary Union. Higher growth across Europe is of course a valuable aim. But are convergent, tendentially uniform, growth rates really a sine-qua-non condition in a monetary union? Is there any economic tendency towards this outcome? Are, otherwise, such calamities as 1), 2), and 3) inevitable?"

This chapter provides a framework for determining the appropriate mix of monetary, fiscal, and exchange rate policies for correcting macroeconomic imbalances. It discusses the design of macroeconomic adjustment programs and the appropriate actions required of policy agencies facing imperfect coordination.

On the basis of the definitions of internal and external balance given above, the different combinations of macroeconomic imbalances can be broadly classified into four categories, as shown in Table 2.1.

To design appropriate domestic macroeconomic and exchange rate policies to move the economy from a combination of imbalances to internal and external balance, one must first know how to estimate the equilibrium real exchange rate to decide whether the exchange rate needs to be changed. In the literature, three approaches have been followed; (1) simulations based on macroeconomic models; (2) estimates based on partial-equilibrium current account models; and (3) estimates based on cointegrating equations (see Clark and others, 1994; Montiel, 1999; and Williamson, 1994b).

The first approach is more feasible for industrial countries. In this approach, an empirical dynamic macroeconomic model is first established. Model simulations are then performed for specified paths of policy and exogenous fundamentals to generate steady-state values of the real exchange rate over time. The steady-state real exchange rate is considered to be the equilibrium real exchange rate that satisfies the internal and external balance conditions (see, for example, Clark and others, 1994, and Williamson, 1994a).

The four quadrants in Figure 2.1 show four different combinations of imbalances, which correspond to those in Table 2.1. Imbalances can be caused by domestic or external shocks, structural rigidities, or inappropriate policies. The design of adjustment policies must take these underlying causes into account. For example, imbalances may or may not be associated with a real exchange rate misalignment (that is, a real exchange rate that is different from R* in Figure 2.1), which, in turn, could be policy induced. An overly appreciated real exchange rate, for example, could reflect an unsustainable expansionary fiscal policy or a monetary policy favoring disinflation. It could also be caused by changes in international interest rates or speculative movements in the foreign exchange market. Again, the appropriate exchange rate policy will depend on the underlying causes of the misalignment.

It is well known that, under a fixed exchange rate system, a change in government expenditure or taxation can have a multiplier effect on the level of income in the short run, although direct evidence on such relationships is scarce for developing countries. Moreover, unlike monetary policy, which operates through the cost and availability of credit, fiscal policy affects income streams directly. Recent studies have shown that different types of government expenditure in developing countries can have different effects on private investment, and hence on output. For example, increased public investment in infrastructure can stimulate private investment, whereas other forms of public investment can crowd out private investment.

The comparative effectiveness of the monetary and fiscal policy tools for influencing domestic demand and output and the balance of payments depends largely on the degree of exchange rate flexibility. In this context, it is useful to review the Mundell-Fleming model, which is basically an open-economy version of the IS-LM model, with capital mobility.7 The major conclusions of the Mundell-Fleming model can be summarized as follows.

First, under a fixed exchange rate regime with imperfect capital mobility, fiscal policy is more effective than monetary policy in dealing with internal imbalance (that is, in influencing income). The impact of monetary policy on income tends to be limited because monetary policy is dedicated to maintaining the fixed exchange rate. A credit restraint, for example, would increase net foreign assets both because of a decrease in imports and because of an increase in net capital inflows caused by higher domestic interest rates. The increase in net foreign assets would need to be converted into money supply in order to maintain the fixed exchange rate, thus offsetting the contractionary effect of credit tightening. By the same token, monetary policy is more effective than fiscal policy in restoring external balance (in terms of the overall balance of the balance of payments), because the effects of monetary policy on the current and capital accounts tend to be reinforcing, as described above. By contrast, the favorable effect of a tight fiscal policy on the current account through a reduction in imports tends to be offset, at least partially, by its adverse effect on the capital account through a decrease in domestic interest rates. An expansionary fiscal policy, on the other hand, would worsen the current account, although it might improve the capital account.

Second, under a floating exchange rate regime with less than perfect capital mobility, monetary policy could affect income through changes in the exchange rate and domestic interest rates. For example, an expansionary monetary policy would lower domestic interest rates. This, in turn, would stimulate private investment, leading to an increase in income and output. At the same time, the lower interest rates would discourage net capital inflows, resulting in an exchange rate depreciation, which would improve the current account position and, hence, increase income and output. By contrast, the expansionary impact of fiscal policy on income would likely be at least partially offset by a decrease in private investment and a worsening of the current account, as a result of higher domestic interest rates and an exchange rate appreciation.8

From the previous discussion, it can be generally concluded that, in a small, open economy with limited exchange rate flexibility (including fixed but adjustable exchange rate and managed floating systems) and some capital mobility, fiscal policy is relatively more effective in affecting domestic demand or inflation, whereas monetary policy is relatively more effective in dealing with the balance of payments. Although exchange rate policy can affect domestic demand or inflation, its comparative advantage lies in its effect on the current account. With these concepts in mind, one can now consider the appropriate mix of the three policies in dealing with different combinations of imbalances.

When faced with a combination of internal and external imbalances, policy authorities normally first try to decide whether the exchange rate needs to be changed, mainly because of the pervasiveness of its effect on the entire economy and its complementarity with the otherwise costly adjustment of monetary and fiscal policies. Once this question is decided, they need to formulate monetary and fiscal policies based on the considerations discussed earlier, taking into consideration the impact of the change in the exchange rate, if any, in determining the magnitude of monetary and fiscal adjustments. In so doing, they must not only consider the effects of the change on the external sector position, but also its effects on production, domestic demand and prices, government budgetary operation, and the valuation of foreign assets and liabilities in the banking system. 041b061a72


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