Essays on fiscal-monetary interdependence

Abstract

The core of this PhD dissertation consists of three research essays on issues related to fiscal and monetary interdependence. The general message across all three essays is that monetary and fiscal interdependence matters for economic stability. The first research essay explores the implications of fiscal and monetary interdependence on price stability. The essay is built upon a small open economy model which explains the link between fiscal deficits and inflation. The model is tested empirically using country level (Sri Lankan) data under several specifications. Overall, it finds strong evidence to support a positive link between fiscal deficit and inflation. However, the findings do not support the view that the fiscal deficit-inflation link becomes stronger when public sector wages are factored out. The second essay examines the case for relative independence between fiscal and monetary authorities. Despite the wide spread interest in reforms that ensures greater independence of central banks over the last few decades, there are still huge variations in the degree of central bank independence across countries. Investigating factors that underlie the level of central bank independence, the essay argues that relative independence between the two institutions is determined mainly by three concepts, i.e. inflationary bias, global cohesive pressure, and political incentives. The findings show that the relevance of these concepts in determining central bank independence across developing and developed country samples is very different. An inflationary bias hypothesis induces the relative independence of monetary authorities in developed countries, yet inhibits the same process in developing countries. In contrast, political incentives play a major role in granting independent status to monetary authorities in developing countries. The essay also measures the efficiency levels of central bank reforms and finds that, over time, only developed countries leap-frog upward on the efficiency scale of central bank reforms. The third research essay examines fiscal crises in two dimensions, crisis incidence and crisis duration in order to broaden the understanding of how fiscal and monetary policy actions contribute to a country's fiscal stability. Using macroeconomic, institutional, and demographic indicators, it is found that, in addition to the fiscal authority's own functions, the functions of the monetary authority, such as reserves accumulation and an inflation targeting monetary policy regime, reduce the probability of a crisis occurring, as well as its duration. The findings also show that policies that help prevent a fiscal crisis do not necessarily contribute to fast recovery from a crisis. This indicates the importance of applying specific policy measures during each stage of a fiscal crisis episode. - provided by Candidate.