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Interaction between Monetary and Fiscal Policy:
Evidence from India and Pakistan
Imran Muhammad
20338310
Econ 606
Abstract:
This study investigate the level of coordination among the monetary and fiscal policies in India
and Pakistan, using data from 1981-2009. Empirical results are based on fixed effects, SUR, and
Vector Auto regression (VAR). VAR results are interpreted using Impulses Response Function
(IRF). Fixed effect and SUR results suggest that there is a higher level of coordination among
Pakistani fiscal and monetary policy makers compared to coordination level among Indian policy
maker, but IRF results show an evidence of weak coordination between Pakistani policy makers
in response of a shock to macroeconomic variable, but Indian policy makers show a better level
of coordination in case of shock to macro variable. In case of Pakistan variable converge to their
long term path after the gap of 20 to 26 years, whereas Indian variables converge to their long
term path in 8 to 14 years, showing that there is a strong response of Indian policy makers to
each other policies. The difference in SUR and VAR results can be due to difference in political
structure in Pakistan and India. VAR and IRF results suggest that there is weak coordination
between Pakistan policy makers and this can be major reason for recent economic problems in
Pakistan after great recession.
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1. Introduction:
The objective of macroeconomic policies is to obtain noninflationary, stable economic growth.
Fiscal and monetary policies are major components of macroeconomic policy. In many countries
central banks choose monetary policy with a certain degree of independence with literally no
direct control from government. On the other hand fiscal policy is chosen by governments using
tax levels and government spending. While fiscal and monetary policies are chosen by two
different bodies independently, theoretically, these policies are not independent. Due to
conflicting objectives tension can rise between governments and central banks on what each will
do to stabilize the economy during a downturn and achieve economic stability and growth.
The experience of the recent recession fortifies the need for coordination between policy makers
from both institutions to effectively tackle the economic shocks. An agreement between two
authorities on the target level of inflation, output, deficits, and unemployment will result in
coordinated fiscal –monetary policies. These coordinated policies will give response at rapid
pace to tackle the economic shocks and can lead economy closer to the targeted level of output in
a much faster manner compared to a non-cooperative fiscal-monetary policies outcome. Dahan
(1998) also mentioned the need for coordination between monetary and fiscal policy in his study
of monetary implications of government‟s reaction and budgetary implications of central banks
actions.
As both authorities work to achieve similar objectives using different policy tolls it would be
advisable for both authorities to achieve some form of coordination between them. Countries
whose policies are not coordinated suffer from inflationary pressure, high unemployment, and
unstable financial markets due to high deficit. Monetary authorities are normally harsh on
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inflation and deficit because they prefer low inflation over high inflation to achieve price
stability1. On the other hand fiscal authorities‟ main objective is to get reelected and therefore
will be reluctant to choose policies which can increase prices and unemployment.
Each authority has two policy instruments to use to achieve its objective. The fiscal authority
may use the tax rate or increased government spending as policy instruments. Money stock or
interest rates can be used by a monetary authority as a policy instrument. The interaction
between fiscal and monetary authorities relates to the financing of the budget deficit and its
consequences for monetary management. An expansionary fiscal policy will increase aggregate
demand and hence have consequences for the rate of inflation. The monetary policy stance
affects the capacity of government to finance the budget deficit by affecting the cost of the debt
service and by limiting or expanding the available source of financing.
The debate on policy coordination is not new to literature, in fact - early debates reached a point
where a large number of economists asked for coordination between fiscal and monetary policies
to tackle rapidly growing deficits and high inflation.
There are different ways in which both policy makers can interact with each other, An intuitive
understanding of this can be gain by considering the following example2. In a typical
government budget session for the year 00, where stance of fiscal policy is being discussed,
assume a negative demand shock if foreseen for that year, while inflation is expected to stay at
the targeted level of 2%. Hence policymakers are faced with the choice between following
options three options:
1 Bartolomeo and Gioacchino: 2008
2This example is taken from “Monetary and Fiscal policy coordination and Macroeconomic stabilization”. A
theoretical analysis, Lambertini and Rovelli, working paper of University of Bologna.
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(1) Do nothing, let the automatic stabilizers work, with the perspective that monetary policy
would be set on a moderately expansive path, In this scenario, we will then observe a moderate
fiscal deficit and low interest rate: (2) Neutralize the fiscal stabilizers, hence hold the deficit
close to balance, and expect a more expensive monetary policy by lowering interest rates: (3)
Decide upon a more aggressive fiscal stance, resulting in a deficit with the expectation that
monetary policy would then be set on mildly restrictive tone, with high nominal interest rates. If
we assume that all of the above choices will result in the similar level of output and inflation
outcome, but generally path to achieve these outcome will not be equivalent.
In this paper, I will look at the coordination between monetary and fiscal policy authorities in
India and Pakistan. I have chosen these countries due to several factors; both countries have
introduced several structural reforms and liberalization of their financial sector in last two
decades. Due to these reforms both countries are classified as emerging market with India
topping the emerging markets list with China. India has achieved remarkable growth over the
last two decades with average growth rate of 8%, with a bright economic outlook in future.
On the other hand its neighbor, Pakistan‟s economy grew with a tremendous average growth rate
of 7-8% from 1999-2007. However, Pakistan was unable to sustain its economic growth. India is
still growing at an average rate of 8% a year compared to Pakistan whose growth has declined to
2% a year. There can be several factors behind this; one of the most important factors is that
India has achieved political stability in India over the last decade compared to Pakistan which
had five different governments during the same period.
Indian political stability and the continuation of incumbent policies by new office holders have
helped the Indian economy to grow. In Pakistan‟s case, we have seen a reverse scenario a sharp
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decline in economic growth, increased budgetary deficit, and higher level of unemployment.
Since coordination between both policies can be critical to an economy which is growing and
facing problems of price stability, analyzing India and Pakistan will provide some fruitful results.
On one hand is a country (India) that has been able to maintain economic growth with stable
price levels on the other hand its neighbor (Pakistan) has not been able to sustain its economic
growth and now is facing economic instability.
The rest of the paper is organized as follows. Section 2 presents the literature review. Section 3
discusses the theoretical model. Section 4 discusses the data and methodology. Section 5 which
highlights the results; and the last section, Section 6 provide the paper‟s conclusion.
2. Literature Review:
During the late 20th century, targeting inflation became a popular monetary policy instrument for
achieving price stability, with independence of central banks. In the introduction we emphasized
that monetary policy is committed to stable lower level of inflation and monetary policy makers
achieve these objects by monetary instruments discusses above.
This raises the question: Why should monetary policy maker coordinate with fiscal policy
makers, who want higher growth and lower unemployment levels? We can find numerous
studies in the area of inflation targeting to stabilize prices but in all these analyses the behavior
of fiscal policy is ignored. The debate on fiscal and monetary policy coordination is not new it
started around the same time, when monetarists were recommending the independence of
monetary policy in 1960. The analysis of coordination between monetary and fiscal policies was
initiated by Brainard (1967) and Poole (1970), who studied the behavior of policy makers under
economic constraints and uncertainties, but in their work the goals of fiscal policy makers were
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not explicitly discussed. Based on Poole‟s work Pindyck (1976) and Rible (1980) studied the
possibility of conflict between monetary and fiscal policy makers and analyzed the inefficiency
of uncoordinated policies.
Kydland and Prescott (1977) revolutionized the literature in this area; they focused on a game
between monetary policy makers and government. They incorporated rational expectations and
dynamic consistency. However, the major breakthrough to this literature came from Sargent
(1980) and Wallace (1981), who emphasized that the monetary policy and inflation level are not
exogenous to fiscal deficits, and to some extent, the path to government‟s fiscal deficits is
unsustainable and predetermined; their result is similar to the fiscal theory of price level by
Leeper (1991) and Woodford (1995). Work by Schmitt and Uribe (1997) and Cochrane (1998)
extended the fiscal theory for conditions under which either monetary or fiscal policy alone
determined the price level. They showed that if government expenditure, taxes are exogenous,
and Ricardian Equivalence holds, then monetary policy can alone determine the price level.
These conditions are normally violated in real economies, because if these conditions hold then
real interest rate will be determined by real resources. Real interest rates will be unaffected by
monetary policy, but we know that government spending and taxes affect the economic output
and prices, and higher prices can lead to higher expectation about real interest rate.
Using US data Nordhaus (1994) demonstrated that for independent monetary and fiscal policies,
the resulting equilibrium will have higher real interest rates and budget deficits then expectations
of monetary and fiscal policy makers. Similarly, Ahmed (1993) argued that there is a positive
correlation between budget deficits and inflation, through the expectation on price level. In
monetary policy regime the interest rate will raise if the expectations around future prices are
higher than the targeted inflation level, under this policy regime fiscal policy is not stable.
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Dixit (2000) and Lambertini (2001) analyzed the independence between central bank and
government in a model where central bank had limited control over inflation, and inflation was
directly affected by fiscal stances. They demonstrated that fiscal and monetary policy rules are
complement to achieve desired level of equilibrium output, inflation, and unemployment. Lewis
and Leith (2002) demonstrated that for stability, real interest rates should be reduced if there is
excess inflation due to government spending. Rovelli et al (2003) analyzed the coordination
between monetary and fiscal policies using Stackelberg equilibrium. They concluded that in a
preferable outcome, the fiscal authority appear as the leader in the policy game.
In the case of emerging countries Shabbir (1996), Zoli (2005) and Khan (2006) found that there
is fiscal dominance in India, Pakistan, China, Brazil and Argentina. They demonstrated fiscal
policy actions affect the movements in exchange rate with a higher degree compared to monetary
policy maneuvers, therefore the fiscal policy does affect monetary variables. Wyplosz (1999),
and Meltiz (2000) analyzed the behavior of both policies over the cycle and demonstrated that in
recessionary periods both policies are subtitles and in expansionary economic conditions, both
policies are complement to each other. Wyplosz and Meltiz concluded that a looser fiscal or
monetary stance can be matched by monetary or fiscal contractions.
Early empirical work in this area was mainly based on ordinary cross sectional, panel data or
game theory techniques. Game theory techniques were used to observe the behavior of both
policy makers and how they can achieve the best possible equilibrium results. On the other hand
to examine the relationship between monetary and fiscal policy over the cycle cross sectional and
panel data techniques were used. Recent empirical studies on monetary and fiscal policy
interaction have used Vector Auto Regression (VAR) or Seemingly Unrelated Regression
(SUR). VAR analysis provides the flexibility to analyze the different shocks to the economy
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under individual policy regimes or coordinated policies using the Impulse response function.
Muscatelli (2005) analyzed the G-7 countries for fiscal and monetary policy coordination using
the VAR and Bayesian VAR models and demonstrated using impulse response function that
fiscal shocks hit the economy with a higher magnitude compared to monetary shocks to the
economy, and the degree of dependence between both monetary and fiscal policies have
increased since the 1970‟s due to the increase in trade, investment, and coordination among
world economies.
Muscatelli demonstrated that the degree of dependence in fiscal and monetary policy vary among
countries and depend on several factors such as import and export level, budget deficits, capital
market structure, consumer debt level, how long current government is in office, and
unemployment level. SUR technique is especially for emerging markets, and used by Yashushi
(2005) to study the Interaction between Monetary and Fiscal and Policy Mix for Japanese
experience, he showed that during the recent deflation in Japan, policy makers from both
institutions had very low level of interaction in early days of deflation period, which improved at
later stage and helped to overcome the deflation.
Abidin (2010) also used the SUR techniques to investigate the level of coordination between
fiscal and monetary authorities in Asian Development Bank member countries and compared
those results with western economies. Abidin concluded that Asian economies have low level of
coordination between two authorities compared to western world, but if China, India, and South
Korea have seen improved level of coordination between two authorities and if the coordination
level grow at the same level in these three countries then these countries will achieve
coordination level similar to western world in next thirteen years.
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In terms of emerging markets, both Nasir et al (2009) and Khan (2004) from Indian and Pakistan
data, demonstrated a higher level of coordination is required between fiscal and monetary policy
makers in emerging countries compared to developed countries to sustain the current level of
economic growth. Khan demonstrated that over the period of 1975-2003 Indian policy makers
had increased the level of coordination and this had helped them to keep the economy growing
and on track during the 2001 recession. On the other hand Nasir et al found that the coordination
between Pakistani policy makers had declined over the same period and that due to this decline
in coordination, the Pakistani economy was not able to bear the different economic shocks. Also,
due to higher political instability it was unable to maintain its economic growth level of 1999-
2004 in 2005 and onwards.
All the studies that addressed coordination between monetary and fiscal policies emphasized
coordination among policy makers, because without coordination individual policy would not be
fully effective and economic stability would not be achieved. Therefore there should be a
mechanism or mechanisms for coordination between policy makers, as without coordination high
inflation and high budget deficit are expected to exist in the economy.
3. Theoretical Background
In standard treatment fiscal and monetary policy are taken as exogenous to economic system.
Real Business Cycle theory has endogenized both policies in for analysis purposes. In most
countries central banks set policies, which help to achieve low inflation level for price stability.
Arthur Burns (formed Fed Chairman) described the role of US, central bankers and government
in following words: “By training, if not also by temperament, central bankers are inclined to lay
great stress on price stability, and their abhorrence of inflation is continually reinforced by
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contacts with one another and with like-minded members of private financial community. On the
other hand, much of expanding range of government spending is promoted by commitment to
full employment („Maximum‟ or „full‟ employment), after all, higher level of income and high
level of employment had become the nation‟s major economic goal, not stability of the price
level.3”
This study is based on the game theoretic model proposed by Nordhaus (1994). Due to flexibility
in Nordhaus model, it proves rich set of possible outcomes, depending on the objectives, and on
level of independence or coordination between the two policy makers. Nordhaus used this model
to analyze the coordination level between policy makers in American Economy. Our study takes
analysis of Indian and Pakistan.
As discussed above that, the monetary authority use interest rate as policy instrument and fiscal
authority use tax rate and or fiscal surplus ratio. It is assumed that fiscal and monetary authorities
have preferences over macroeconomic outcomes, unemployment (u), and growth of potential
output (g), inflation (p). In addition, fiscal authority treat fiscal surplus ratio (s) and monetary
authority treat interest rate (i) as targets and both authorities has no interest in other parties
targets.
It is also assumed that two authorities desire inflation and unemployment levels which are lower
than feasible unemployment-inflation constrains. Using these assumptions the preferences of two
authorities can be written as
3 Burns, 1979 P4-16
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Where is the utility level of authority k ( ))
and is preference function.
Inflation is assumed to be a function of the expected rate of inflation and the unemployment rate.
This is simply the medium run Phillips curve:
We further assume, that the expected rate of inflation is mixture of a forward looking component
which is represented by actual rate of inflation and inflation inherited from past :
Where , putting equation (1.3) and (1.4) together,
If unemployment and output are unaffected by anticipated fiscal or monetary policies, then
unemployment is always equal to natural level rate of unemployment:
In short run, potential output growth is determined by investment ratio, equal to the ratio of
investment to output. The investment ratio is equal to government saving ratio and private saving
ratio . To simplify analysis, assume that the private saving ratio is unaffected by fiscal and
monetary policy, then investment ratio is simply equal to the exogenous private saving ratio plus
. Then, we can write the third target of policy to function of government saving rate:
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Combining equations (1.3) to (1.6) with preference given in (1.1) and (1.2), yield the preferences
for each policy making institution with respect to policy variables:
For new classical assumptions, and macroeconomic policies determine the price level,
hence, there only two policy variables, fiscal surplus ratio and interest rate that ultimately play a
decisive role in policy formulation: which gives
Where and are implicit preferences as the function of policy variables. The dots in the
parenthesis are reminder that the model describes that many variables are fixed for the period of
analysis.
This model can be illustrated by means of a diagram:
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Figure 1:
In figure 1, the axes are policy instruments, and the most preferred constrained outcome (bliss
point) for two policy makers are represented by circles. The bless points are determined by,
optimal government surplus optimal level of the government surplus, which determines the rate
of growth and the optimal level of demand, which determined the inflation and unemployment.
The F line shows the aggregate demand curve for fiscal authority, which is simply the optimal
level of output yield for given combination of r and S, Line M represents same thing for
monetary authority. This bliss point lie at the interaction of the aggregate demand lines and the
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desired level of fiscal surplus, because there are only two independent targets, the level of fiscal
surplus and the level of aggregate demand.
A little reflection shows, that the fiscal authority has an inclination to run fiscal deficit and
relative expansionary attitude towards aggregate demand. The monetary authority has more
contractionary target for aggregate demand, to keep inflation level low, along with higher
government surplus, as in non-cooperative equilibrium, the level of aggregate demand is
determined by monetary authority, which is more restrictive then anti inflationary fiscal
authority. Therefore, when monetary and fiscal authorities operate independently, then they will
tend to choose their own bliss point F-F and M-M line and then the resulting Nash equilibrium
for the game has higher deficit and high interest rate. The non-cooperative strategy is Pareto
dominated by cooperative strategy which is along the contract curve MB and FB, and in
cooperative strategy Nash equilibrium authorities can successfully achieve low inflation rate and
higher growth rate or simply economic stability.
Her Majesty‟s Treasury (HM Treasury) used Nordhaus model to explain the high inflation and
higher unemployment in Great Britain (GB) in 1970s and 1980s, they concluded that these were
direct result of noncooperation between fiscal and monetary policy makers in GB. Therefore, a
cooperative Nash equilibrium has more desired and stable macroeconomic outcome.
4. Empirical Methodology
In this section, I will outline the structure of model. The structure of model follows as: Gross
domestic output , is determined by three factors, exogenous forces, , fiscal policy
measured by government surplus /deficit , and exogenous real interest rate , at different
lags j.
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Unemployment rate is determined by Okun‟s law
Where X (t - j) is real domestic out and is natural rate of unemployment. The inflation
follow natural rate hypothesis,
to simplify the model, its assumed that government deficits completely crowd out domestic
investment. This leads us to following two models:
1.4.1 Model 1:
Model 1 is a simple SUR model, in which we can easily incorporate country specific fixed
effects:
Monetary authority response:
Fiscal authority response:
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1.4.2. Model 2:
We can describe monetary policy maker‟s reaction as VAR. The VAR function can be describe
as
VAR function also maps who the both policies have reacted to state of economy and unexpected
shocks. Due to multicollinearity interpretation of VAR results are not reliable, but we can use
VAR results to analyze behavior of different variables using impulse response function (IRF).
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Model 2 is frequently used in recent empirical studies to analyze the level of coordination
between monetary and fiscal authorities for developed countries. In our case, VAR analyzes is
not too helpful due to data constraints: as we are unable to find quarterly data on variables of
interest especially unemployment rate in India and Pakistan, which made us to use annual data
for study, we can still run the VAR model and use the results for IRF but these results will not be
much precise. Therefore, I will base my study on model 1, same time I will just provide
graphical results for IRF, so we can have visual analysis of coordination between policy
instruments over the period of analysis.
5. Data
Data collection for Pakistan is not an easy task, as there is no proper data collection system in
place in Pakistan. Quarterly data on unemployment, government surplus, and government debt is
not available. Therefore for this analysis, I will be using annual data for the period of 1981-2009.
Data is collected on inflation, gross domestic product, government debt to budget ratio, central
bank discount rate, and government surplus rate.
The main sources of the data are IMF‟s International Financial Statistics, Reserve Bank of India,
World Bank, and State Bank of Pakistan, Gathering data from different sources make our data
less precise, because each institution use different methodology for data collection purpose.
Table A in data appendix presents the descriptive statistics for all variables for both countries;
there is clear variation across both countries. Figure1, shows scatter plots for all the variables;
there is a positive relationship between deposit interest rate, inflation, unemployment and
government surplus. There exits Negative relationship between GDP and unemployment, GDP
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exhibit positive relation with government debt to GDP ratio and no relationship with government
surplus.
6. Empirical Results
We know turn to empirical results. I have estimated the fixed effect, SUR, and VAR models
using Indian and Pakistani data. Fixed effect regression is not suitable in this case, but can be
used as benchmark for SUR and VAR results.
Following is the base regressions, which we use to look for coordination Table 2 represents the
results for following pooled fixed effect regression for monetary response function equation
1.12.
Unless stated, fixed effect results are clustered by country. The results for monetary response
function are not different from our expectations; expect coefficients for inflation, previous period
inflation, and lag discount rate; none of the other covariates are statistically significant at 5%
level. This supports our earlier discussion that monetary authorities are only concerned to
achieve lower price level.
Table 2, also represents the results for fixed effect regression of fiscal authority response
function, here expect unemployment and lag surplus, no other coefficient is statistically
significant, which again support our earlier argument that fiscal authorities prefer to have high
level of employment over stable growth with lower price level.
Fixed effect analysis was also performed on Indian and Pakistani subsamples for 1981-1995 and
1996-2009. It is clearly observed that the coordination level between Pakistani monetary and
fiscal policy authorities have approved for 1996-2009 sample compared to 1981-1995, but
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coordination between Indian policy making institutes has declined. These results are quite
surprising, as we expected Indian authorities should have better coordination level then Pakistan.
Tables 2-4, reports the SUR results for equations 1.12 and 1.13. Using SUR technique has
improved our results, as mentioned earlier the fixed effect method is not suitable for our analysis
but can be used as benchmark. From pooled SUR results (Table 2), we can observe that for
period under the analysis monetary and fiscal authorities have higher level of coordination
between both countries then what we observed in fixed effect regression.
When SUR technique has used for Indian and Pakistan samples to observe the country level
coordination between policy making authorities, again results are similar to fixed effect
regression on individual sample, Pakistani policy making authorities have higher level of
coordination compared to coordination level between Indian authorities.
These results are quite surprising, Pakistani fiscal and monetary policy making authorities have
higher level of coordination compared to developed countries, and coordination between Indian
authorities is similar to coordination level in developed economies.
There can be different reason behind these results; one of the most important can be the political
structure in Pakistan. In Pakistan central bank‟s governor is chosen by Prime Minister and this
appointment is solely based on political loyalty rather than competency and each government
normally appoint their governor who is loyal to ruling party, same applies to secretary for
Ministry of Finance. This helps to improve the level of coordination between both policy making
institutions, but it‟s not helpful for economy i.e. current government in Pakistan which came into
power in April-2008, appointed new governor for State Bank of Pakistan in Oct-2008 and since
then the government‟s debt financed by state bank of Pakistan has increased by 350%. Therefore,
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VAR analysis will now play an important role for our empirical. I will use Impulse Response
Function (IRF) on VAR results for one standard deviation and then observe the behavior of both
policy making institutions.
6.1. Impulse Response Function (IRF): Temporary Shock
6.1.1. Response to Interest Rate Shock
Figure 2-3, presents the effects of one standard deviation shock in interest rate to different
variables for Pakistan and India.
In case of Pakistan, Interest rate declines due to an interest rate shock, because higher interest
rate results in increased capital inflow in to the country, this pushes the interest rates down.
However, the shock is absorbed over the period of 8 years and central bank discount rate
converges back to original level. Indian interest rate behaves similarly to shock but declining
slowly and converging with a higher rate to original level in 16 years time.
For both countries, Price level behave naturally due to interest rate shock, for first three years
price remain higher then original level, because higher borrowing costs lead to increased in cost,
in result to these higher costs producer initially increase the prices of final good, hence
increasing the overall price level. In case of Pakistan, in 4th
year price level start to decline and
go below the original level in 5th
year, Price level again increase and there are clear up and
downs fluctuations in price level but it converge to long run path (original level) in 19 years
time. In case of India, price level increases for first 2 years due to interest rate shock, but then
steadily starts to decrease in 3rd year and its below the original level in 5th
year and converges to
its long term path in 11 years. This smooth convergence of Indian price level shows better
coordination between authorities.
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For both countries in response to a price shock Fiscal surplus, first decline to due to higher
interest rate, as capital inflow due to higher interest rate leads to increase in GAP and lowering
the debt to GDP ratio, for Pakistan fiscal surplus decrease, increase from original level in 6th
year
and converges to long term path without much fluctuation after 7 years. Indian fiscal surplus
behave in better way in response of interest rate shock, and with little decline in 3rd
year
converges back to normal level in 8th year.
Response in unemployment due to interest shock is natural as well, due to increase in capital
inflow; we expect a GDP growth in country which keeps the unemployment at the same level for
first 2 years, then unemployment level start to increase but eventually converges to original level
of unemployment in 9th year. Unemployment level in India decreases from original level due to
an interest rate shock and is above the original level after the 8th
year and converges to original
level in 18th
year. This can be justified on basis of higher capital inflow increases the
employment level for some time and then gradually converges to natural level of unemployment.
6.1.2. Price Shock:
Higher price level is politically and socially undesirable; however for emerging economies to
grow there needs to be some optimal level of inflation, at least in short run.
Figure 4-5, represents the price shocks to other policy instruments graphically. In case of
Pakistan, In response of price shock, price level initially price decrease and the shows an upward
trend and ultimately converging to long term path but doesn‟t drop below long term path, Indian
Prices response to a price shock in similar fluctuating manner, it initially decrease below the
original price level, then increases in 4th
year and then converging to its long term path. The
initial decline in price can be due to decrease in demand in response of higher prices. Supplier
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response by decreasing supply in next period, this will result in excess demand in coming period
resulting in higher prices.
For both countries, interest rates response to a price shock is normal manner, for India interest
rate increase due to higher prices and then converges to its long term path in 13 year time. In case
of Pakistan, Interest rate first increase and then decreases below its normal level in 9th
year and
then converges to long term path in 21st year.
Indian government surplus increases due to price rate shock, as higher interest rate make fiscal
policy maker to increase fiscal surplus, Indian surplus converges to normal path in longer term.
Pakistani government surplus declines in result of price rate shock to economy, which shows
fiscal policy makers, are operating an expansionary fiscal policy when central bank is trying to
overcome price shock by contracting monetary policy.
Results for unemployment response shock due to price shock are the most interesting, Indian
unemployment level goes below the long term path in response to price shock. This is natural
because, initially supplier‟s increase supplies due to higher price level, but unemployment start
to increase in same period as price start to decline due to decrease in supply by suppliers. For
Indian economy unemployment level converges to longer term path in 11 years time. On the
other hand, in case of Pakistan fall in unemployment is very small then expected, it can be due to
expansionary fiscal policy. Pakistani unemployment level is above the normal unemployment
level in 6th
year and then converges back to long term unemployment level sometime after 28
years.
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6.1.3. Unemployment Shock:
Figure 6-7 represents the response for four policy variables for an unemployment shock for India
and Pakistan.
Indian price level first decline due to an unemployment shock, then there is an upward trend in
price level after 5th
year and converges to its long term path in 14 years time. On the other hand,
Pakistan price level also decline due to unemployment shock abut converges to its long part time
in similar time manner to India.
Interest rates behave in similar manner for both countries first decline then converges to long
term path, but the convergence period is longer in Indian case. This behavior of interest rate can
be deafened by following argument, as due to higher level of unemployment in the economy,
aggregate demand and investment is lower than normal level. This results in lower demand of
loanable funds, which pushes interest rate down. Later increase is due to expansionary fiscal
policy by government.
It is better to analyze, response of fiscal surplus and unemployment due to unemployment shock.
Pakistan fiscal surplus decline initially, but increase above normal level in 6th
year and in last
converges to normal level in 21 years time. This affects the unemployment level in Pakistan as
well, unemployment level increase, then decline below the normal level, and then converges to
long term path in 17 years. Indian fiscal surplus doesn‟t fluctuate much due to an unemployment
shock and converges to long term path in 12 years time. Indian unemployment start to decline
steadily in 1st year in response to unemployment shock and are below normal unemployment
level in 7th
year and then converges to long term path somewhere in 11th
year.
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6.1.4. Surplus Shock:
Figure 8-9, represent the behavior of different variables behavior to due to fiscal surplus shock.
There can be a positive shock due if fiscal authorities are operating a contractionary fiscal policy.
In case of Pakistan a positive surplus shock leads to increase in prices level, interest rate, and a
decline in unemployment level and it takes 24 years for all these variables to converge to their
long term path.
Indian policy variables behave in normal way, increase in fiscal surplus results in decrease in
interest rate, lowering the price level for first seven year. Lower prices in increase the demands
which results in lower unemployment level but all these variables converge to original level in
13 years time.
7. Conclusion
Results are little ambiguous for fixed effect and seemingly unrelated regressions, where we
observed higher level of coordination for Pakistani policy makers. In case of, IRF analysis on
VAR results clearly shows that in case of shock to economy due to any policy variable Indian
policy institutions have higher level of coordination, whereas Pakistani authorities have weaker
response level.
Pakistani macroeconomic variables converge to long term path after a very long time, but Indian
variable converges more quickly, which shows a weak response and coordination between
Pakistani monetary and fiscal authorities. Pakistani Monetary response to fiscal shock is very
slow, as price and interest adjust to normal level in more than two decades time, whereas Indian
interest rate and price level adjust to normal level in a decade time. Indian fiscal response to
25 | P a g e
monetary shock is quicker as well, Indian unemployment and fiscal surplus converges to long
term path in less than a decade time, in case of Pakistan it takes approx two decades for
unemployment and fiscal surplus to converge to long term path.
Fiscal and monetary policies are two polices which operates in similar manner as right and left
side of human body, which are interlinked in very complex way. To have long term growth in
economy, fiscal and monetary policy making authorities should have better coordination. In case
of Pakistan, due to political structure we may observe better coordination between both
authorities, but in case of shock to fiscal or monetary variable both institutions choose policies
which have opposite direction and resulting in longer time needed for variables to converge to
normal path. On the other hand, Indian policy institutions have better response level in case of
shock, which results in convergence of macroeconomic variable more rapidly than in case of
Pakistan. This higher level between Indian fiscal and monetary authorities can be one of the
major reasons for sustained economic growth in India. Pakistan was unable to sustain its
economic growth especially after the Great Recession of 2007, and this can be due to lower level
of coordination between monetary and fiscal policy institutions in case of a shock to economy.
In one liner, it is suggested that fiscal and monetary authorities should consider implications of
their policies on economy, rather than targeting only a single macro variable, and a close
coordination between fiscal and monetary policy making institutions is required to achieve their
economy wide objectives.
26 | P a g e
8. Reference:
Agha A.I. (2006). “An Empirical Analysis of Fiscal Imbalances and Inflation in Pakistan”, SBP
Research Bulletin 2.
Akcay O.C., and Ozmucur S. (2001) “Budget Deficit, Inflation and Debt Sustainability:
Evidence from Turkey (1970-2000)”, Working Paper Series, Department of Economics, Bogazici
University, Istanbul.
Ajayi, S.I. (1974). “An Econometrics Case Study of the Relative Importance of Monetary and
Fiscal Policy in Nigeria,” The Bangladesh Economic Review, Vol. 2, No.2. 559-576
Alesina, A. (1987), “Rules and Direction with Non-coordinated Monetary and Fiscal Policies”
Economic Inquiry, Vol. 25, 619-630.
Ansari, M.I (1996). “Monetary vs. Fiscal Policy: Some Evidence from Vector Auto regressions
for India,” Journal of Asian Economics, Vol. 2, 667-687
Blanchard, O and Perotti, R. ( 1996). “An Empirical Characterization of Dynamic Effects of
Changes in Government Spending on Output,” NBER Working Paper: 7296
Dixit, A and Lambertini, L. (2001) “Monetary and Fiscal Policy Interaction and Commitment
versus Directions in a Monetary Union”, European Economic Review, Vol 45, 997-987
Dixit, A (2002), “Fiscal Discretion Destroys Monetary Commitments”, American Economic
Review, Vol 4 1027-1042
27 | P a g e
Lambertitni L. and Rovelli R. (2003) “Monetary and Fiscal Policy Coordination and
Macroeconomic Stabilization: A Theoretical Analysis”, Working Paper 464, Department of
Science, University of Bologna.
Leeper, M (1991), “Equilibrium Under „Active‟ and „Passive‟ Monetary and Fiscal Policies”,
Journal of Monetary Economics, Vol. 27 (1), 129-147
Nasir, M., Ahmad, A., Ali, A., and Rehman, F. (2009), “Fiscal and Monetary Policy
Coordination: Evidence from Pakistan” Working Paper Series 2009, Pakistan Institute of
Development Economics.
Nordhaus W.D. (1994) “Policy Games: Coordination and Independence in Monetary and Fiscal
Policies”, Brooking Papers on Economic Activity, Issue 2, 139-216
Persson, T. and Tabellini, G. (1993), “Designing Institutions for Monetary Stability”, Carnegie-
Rochester Conference Series on Public Policy, Vol. 39, 53-84
Sargent, T. J. (1981) “Some Unpleasant Monetarist Arithmetic” FRBM Quarterly Review, 531
Shabbir T. and Ahmed A (1994) “Are Government Budget Deficits Inflationary? Evidence from
Pakistan” Pakistan Development Review, Vol 33-4. 955-967
Tabellini, G. (1987), “Central Bank Reputation and the Monetization of Deficits: The 1981
Italian Reforms”, Economic Inquiry, Vol. 25, 185-201
Walsh, C.E. (1995), “Optimal Contracts for Central Bankers”, American Economic Review,
Vol.85, 150-167
28 | P a g e
Woodfard, M. (2001) “Fiscal Requirements for Price Stability”¸Journal of Money, Credit, and
Banking, Vol. 33, 669-728
Zoli E. (2005) “How Does Fiscal Policy Affect Monetary Policy in Emerging Countries?” BIS
Working Papers 174, Bank of International Settlements.
29 | P a g e
Graph 1:
DepositInterest
Rate
CashSurplus
% ofGDP
unemployment
inflation
5
10
15
20
5 10 15 20
-4000
-2000
0
-4000 -2000 0
0
5
10
0 5 10
0
10
20
0 10 20
30 | P a g e
Graph 2: Scatter Plot by Country
DepositInterest
Rate
CashSurplus
% ofGDP
unemployment
inflation
gdp
5
10
15
5 10 15
-4000
-2000
0
-4000-2000 0
0
5
10
0 5 10
5
10
15
5 10 15
0
20000
40000
60000
0200004000060000
DepositInterest
Rate
CashSurplus
% ofGDP
unemployment
inflation
gdp
5
10
15
20
5 10 15 20
-1000
-500
0
-1000-500 0
4
6
8
10
4 6 8 10
0
10
20
0 10 20
0
5000
10000
15000
0 50001000015000
India Pakistan
Graphs by Country
31 | P a g e
Table 1; Fixed Effect Regression
Monetary
Response
Fiscal
Response
Monetary
Response
(Pakistan)
Fiscal
Response
(Pakistan)
Monetary
Response
(India)
Fiscal
Response
(India)
Deposit Interest
Rate(L1)
0.6612***
(0.0718)
---- 0.7182***
(0.115)
---- 0.5151***
(0.1721)
----
Deposit Interest
Rate
Dependent Var ---- Dependent Var --- Dependent
Var
---
Inflation 0.2064**
(0.0094)
---- 0.4603***
(0.1525)
--- 0.2497***
(0.08)
---
Inflation (L1) 0.0663*
(0.0044)
-11.468
(11.91)
-0.632
(0.1353)
-4.68
(3.69)
0.078
(0.89)
-32.974
(25.53)
Unemployment -0.4681*
(0.5205)
-22.246***
(5.831)
-1.066***
(0.3638)
-14.65
(11.742)
-0.0462
(-0.199)
-39.234
(67.43)
Unemployment
(L1)
0.3832*
(0.4372)
33.958**
(2.011)
0.9578**
(0.3565)
41.18***
(11.95)
0.0324
(0.18)
35.87
(59.17)
Cash Surplus .0007
(0.007)
Dependent VAR 0.01293**
(0.0063)
Dep Var 0.00022
(0.006)
Dep Var
Cash Surplus (L1) -.00009576
(0.0014)
0.70522***
(0.008)
-0.015*
(0.0081)
0.399*
(2.006)
0.0002
(0.009)
0.705**
(13.4)
GDP(L1) ---- -0.0278***
(0.05)
--- -0.0548
(1.108)
--- -0.0279
(5.3750
Constant 1.950
(0.3643)
107.15
(122.94)
1.0476
(1.8429)
-54.3340
(51.69)
2.25
(1.90)
107.15
(12.9438)
R Square 0.7958 0.90 0.8281 .941 0.839 0.8995
Observation 56 56 28 28 28 28
32 | P a g e
Table 2 ; Seemingly Unrelated Regression Results - POOL
Observations: 58
Unemployment Inflation Surplus Deposit Rate
Deposit Rate -3.95*** (-4.72)
1.28*** (5.88)
54.79** (2.34)
---
Deposit Rate (L1) .0012** (2.51)
-0.69*** (-3.01)
-44.97** (-2.03)
0.6754*** (8.09)
Cash Surplus .00126** (2.51)
-0.039*** (-2.89)
---- 0.00172** (2.34)
Cash surplus (L1) -0.021*** (-3.06)
0.004** (2.36)
1.31*** (17.02)
-0.00215* (-2.043)
Inflation 0.1808*** (3.95)
---- -35.31*** (-2.89)
0.3607*** (5.88)
Inflation (L1) -0.011 (-0.26)
0.1874 (1.54)
10.14 (0.85)
-0.0095*** (3.18)
Unemployment ---- 1.379*** (3.95)
85.46*** (-2.89)
-0.8435*** (-4.72)
Unemployment (L1)
.8137*** (11.74)
-1.206*** (-3.57)
10.142** (-1.86)
0.7015 (-0.14)
R-Sq 0.7671 0.3584 0.8741 0.7616
33 | P a g e
Table 3 : Seemingly Unrelated Regression – India
Observations: 28
Unemployment Inflation Surplus Deposit Rate
Deposit Rate -0.1224*** (0.211)
1.952*** (0.307)
66.82** (7.862)
---
Deposit Rate (L1) -0.064** (0.1947)
-0.590*** (0.377)
70.86** (-73.27)
0.4136*** (0.1427)
Cash Surplus 0.007** (0.6)
-0.008*** (0.011)
---- 0.005** (1.397)
Cash surplus (L1) -0.0015*** (0.08)
-0.004** (0.018)
1.383*** (0.1361)
-0.00215* (-2.04)
Inflation 0.1947*** (0.0329)
---- -21.71*** (31.28)
0.3776*** (0.0595)
Inflation (L1) -0.093 (0.358)
-0.1378 (0.1744)
2.50 (29.16)
-0.0745*** (7.5)
Unemployment ---- 0.1358*** (0.3834)
81.204*** (6.282)
-0.9435*** (0.1683)
Unemployment (L1)
0.7027*** (0.1082)
-0.153*** (0.3470)
-57.256** (4.18)
0.0829 (0.1526)
R-Sq 0.7879 0.4954 0.8557 0.8712
34 | P a g e
Table 4 : Seemingly Unrelated Regression – Pakistan
Observations: 28
Unemployment Inflation Surplus Deposit Rate
Deposit Rate -0.4413*** (0.071)
1.28*** (5.88)
24.26** (5.04)
---
Deposit Rate (L1) 0.333** (0.069)
-0.69*** (-3.01)
-17.666** (4.7948)
0.7329*** (0.966)
Cash Surplus 0.0097** (0.2)
-0.0362*** (0.003)
---- 0.0233** (4.8)
Cash surplus (L1) -0.0130*** (0.034)
0.0435** (0.56)
1.1856*** (0.08)
-0.0287* (0.63)
Inflation 0.3227*** (0.06)
---- -25.467*** (2.509)
0.7161*** (0.1123)
Inflation (L1) -0.111 (0.05)
0.3723*** (0.1199)
10.086 (3.182)
-0..2242*** (1.1)
Unemployment ---- 1.804*** (0.3629)
38.375*** (10.746)
-1.6697*** (0.277)
Unemployment (L1)
0.8356*** (0.0984)
-1.59*** (0.350)
-34.226** (10.312)
0.7161 (1.123)
R-Sq 0.8340 0.7679 0.9424 0.7827
35 | P a g e
-6
-4
-2
0
2
4
6
1 2 3 4 5 6 7 8 9 10
Interest Rate
-4
-3
-2
-1
0
1
2
3
1 2 3 4 5 6 7 8 9 10
Price
-3,000
-2,000
-1,000
0
1,000
2,000
1 2 3 4 5 6 7 8 9 10
Govt. Surplus
-2
-1
0
1
2
1 2 3 4 5 6 7 8 9 10
Unemployment
Response to Interest Rate Shock - Indian Case
-2
-1
0
1
2
1 2 3 4 5 6 7 8 9 10
Response of Interest Rate to Interest Rate Shock
-6
-4
-2
0
2
4
1 2 3 4 5 6 7 8 9 10
Response of Price level to Ineterst Rate Shock
-600
-400
-200
0
200
400
600
1 2 3 4 5 6 7 8 9 10
Response of govt. Surplus to Interest rate shock
-4
-3
-2
-1
0
1
2
3
1 2 3 4 5 6 7 8 9 10
Response of Unemployment to Ineterest rate shock
Response to Interest Rate Shock- Pakistan
Impulse Response Function Analysis- for 10 years
Response of Interest Rate Shock:
India: Figure 2
Pakistan: Figure 3
36 | P a g e
Response to Price Shock:
India: Figure 4
Pakistan: Figure 5
-3
-2
-1
0
1
2
3
4
1 2 3 4 5 6 7 8 9 10
Price
-4
-2
0
2
4
6
1 2 3 4 5 6 7 8 9 10
Interest Rate
-2,000
-1,000
0
1,000
2,000
1 2 3 4 5 6 7 8 9 10
Govt. Surplus
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Price Shock - India
-2
-1
0
1
2
1 2 3 4 5 6 7 8 9 10
Interest Rate
-4
-2
0
2
4
6
1 2 3 4 5 6 7 8 9 10
Price
-600
-400
-200
0
200
400
1 2 3 4 5 6 7 8 9 10
Surplus
-2
-1
0
1
2
3
4
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Price Shock - Pakistan
37 | P a g e
-4
-2
0
2
4
1 2 3 4 5 6 7 8 9 10
Interest Rate
-12
-8
-4
0
4
1 2 3 4 5 6 7 8 9 10
Price
-200
0
200
400
600
800
1 2 3 4 5 6 7 8 9 10
Surplus
-6
-4
-2
0
2
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Unemployment Shock
Unemployment Shock:
India: Figure 6
Pakistan: Figure 7
-4
-2
0
2
4
6
1 2 3 4 5 6 7 8 9 10
Price
-4
-2
0
2
4
6
1 2 3 4 5 6 7 8 9 10
Interest Rate
-2,000
-1,000
0
1,000
2,000
3,000
1 2 3 4 5 6 7 8 9 10
Surplus
-3
-2
-1
0
1
2
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Shock in Unemployment- India
38 | P a g e
-8
-4
0
4
8
12
16
20
1 2 3 4 5 6 7 8 9 10
Interst Rate
-10
-5
0
5
10
15
1 2 3 4 5 6 7 8 9 10
Price
-5,000
-2,500
0
2,500
5,000
7,500
10,000
1 2 3 4 5 6 7 8 9 10
Surplus
-12
-8
-4
0
4
8
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Fiscal Surplus Shock: Response
-10
-5
0
5
10
1 2 3 4 5 6 7 8 9 10
Interest Rate
-30
-20
-10
0
10
1 2 3 4 5 6 7 8 9 10
Price
-500
0
500
1,000
1,500
2,000
1 2 3 4 5 6 7 8 9 10
Surplus
-16
-12
-8
-4
0
4
1 2 3 4 5 6 7 8 9 10
Unemployment
One St. Dev Surplus Shock- Pakistan
Fiscal Surplus Shock:
India: Figure 8
Pakistan: Figure 9
39 | P a g e
IRF for Pakistan – for whole Sample Period
Pakistan: Figure 10
-20
-10
0
10
20
5 10 15 20 25
Interest Rate to Interest Rate
-20
-10
0
10
20
5 10 15 20 25
Interest Rate to Price
-20
-10
0
10
20
5 10 15 20 25
Insterest Rate to fiscal Surplus
-20
-10
0
10
20
5 10 15 20 25
Interest Rate to Unemployment
-30
-20
-10
0
10
20
30
5 10 15 20 25
Price to Interest Rate
-30
-20
-10
0
10
20
30
5 10 15 20 25
Price to Price
-30
-20
-10
0
10
20
30
5 10 15 20 25
Price to Fiscal Surplus
-30
-20
-10
0
10
20
30
5 10 15 20 25
Price to Unemployment
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Interest Rate
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Price
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Fiscal Surplus
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Unemployment
-12
-8
-4
0
4
8
5 10 15 20 25
Unemployment to Interest Rate
-12
-8
-4
0
4
8
5 10 15 20 25
Unemployment to Price
-12
-8
-4
0
4
8
5 10 15 20 25
Unemployment to Fiscal Surplus
-12
-8
-4
0
4
8
5 10 15 20 25
Unemployment to Unemployment
One Std. Dev Shock to Policy Variables- Pakistan
40 | P a g e
India: Figure 11
-2
-1
0
1
2
3
5 10 15 20 25
Interest Rate to Interest Rate
-2
-1
0
1
2
3
5 10 15 20 25
Interest Rate to Price
-2
-1
0
1
2
3
5 10 15 20 25
Interest Rate to Fiscal Surplus
-2
-1
0
1
2
3
5 10 15 20 25
Interest Rate to Unemployment
-2
-1
0
1
2
3
4
5 10 15 20 25
Price to Interest Rate
-2
-1
0
1
2
3
4
5 10 15 20 25
Price to Price
-2
-1
0
1
2
3
4
5 10 15 20 25
Price to Fiscal Surplus
-2
-1
0
1
2
3
4
5 10 15 20 25
Price to Unemployment
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Interest Rate
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Price
-400
-200
0
200
400
5 10 15 20 25
Fiscal Surplus to Fiscal Surplus
-400
-200
0
200
400
5 10 15 20 25
Fisccal Surplus to Unemployment
-2
-1
0
1
2
5 10 15 20 25
Unemployment to Interest Rate
-2
-1
0
1
2
5 10 15 20 25
Unemployment to Price
-2
-1
0
1
2
5 10 15 20 25
Unemployment to Fiscal Surplus
-2
-1
0
1
2
5 10 15 20 25
Unemployment to Unemployment
One Std. Dev Shock to Macro Variables- India
