Testing the fiscal theory of price level in case of Pakistan.
Javid, Attiya Y. ; Arif, Umaima ; Sattar, Abdul 等
The study tests the fiscal theory of price determination for
Pakistan's economy for the period 1970 to 2007. The evidence is
less clear cut to infer that authorities are following a certain type of
regime fiscal dominant or monetary dominant during the sample period.
The liabilities responses negatively to the innovation in surpluses,
that is in the subsequent period the liabilities decreases in face of
increase in surplus. This characterises monetary dominant regime, the
events that give rise to surplus innovation are likely to persist
causing the rise in the future surpluses and surpluses pay-off some of
the debt causing the fall in the liabilities. By analysing the behaviour
of nominal GDP, an innovation in surplus reduces nominal income and
decreases the level of debt in the subsequent periods, this analysis
also confirms the Ricardian analysis. On the other hand, the study finds
that, as predicted by the fiscal theory of price determination, the
occurrence of wealth effects of changes in nominal public debt may pass
through to prices by increasing inflation variability in case of
Pakistan. The implication that comes out of this study is that nominal
public liabilities, as reflected either in money growth or in nominal
public debt, matter for price stability in case of Pakistan. The
authorities may be following different regimes for different time
periods during the 1970-2007.
JEL classification: E52, E62, E63, E31
Keywords: Fiscal Theory of Price Level, VAR, Fiscal Policy,
Monetary Policy
1. INTRODUCTION
There are two competing views of the interaction between monetary
and fiscal policy and their effects on price stability for
policy-maker's point of view. In the classical view, in Ricardian
regimes it is the demand for liquidity and its evolution over time that
determines prices. In such a regime fiscal policy is passive, which
implies that government bonds are not net wealth [Barro (1974)], and
monetary policy works through the interest rate or another instrument to
determine prices. In the opposite view which is more recent, a
non-Ricardian regime will prevail whenever fiscal policy becomes active
(1) and does not accommodate or adjust primary surpluses to guarantee
fiscal solvency. As a result, the Ricardian equivalence do not hold, and
the increase in nominal public debt to finance persistent budget
deficits is perceived by private agents as an increase in nominal
wealth. In fiscal dominant regime the government's fiscal policy
becomes sustainable through debt deflation that is an increase in prices
that wash away the real value of public debt and in turn the real value
of financial wealth until demand equals supply and a new equilibrium is
reached. In this regime prices are determined by fiscal policy, and
inflation becomes a fiscal phenomenon. If, on the other hand, primary
surpluses follow an arbitrary process, then the equilibrium path of
prices is determined by the requirement known as fiscal solvency; that
is, the price level has to jump to satisfy a present value budget
constraint called non-Ricardian regime. The basic distinction between
the two regimes is that in non-Ricardian regime fiscal policy plays the
role where as in Ricardian regime monetary policy provides stability in
prices. In FTPL, the results of fiscal and monetary policies depend on
which policy has dominant characteristics. The consequences of policies
differ depending on the active and passive characteristics of the policy
and depending on the characteristics of the following policy. If the
policy mix is such that monetary policy is active and fiscal policy is
passive, fiscal policy accommodates monetary policies; these policies
are called dominant monetary policy by Sargent and Wallace (1981) and
Ricardian regime by Woodford (1994, 1995). In contrast when the policy
combination is passive monetary policy and active fiscal policy,
monetary policy accommodates fiscal policy by considering budget
deficits as a constraint in the political decision process. This policy
combination is defined by Sargen and Wallace as dominant fiscal policy
and Woodford call it non-Ricardian policy.
In Pakistan like many developing economies monetary policy is under
the pressure of budget deficit and fiscal policy shocks that may play
role in the determination of prices [Woodford (1994) and Sims (1994)].
In this situation Ricardian policies lose their validity that can be
seen commonly in developing markets (2) as well as most periods in
developed economies (3). Therefore, an anti-inflation policy followed
independently by the central bank could result in deflationary or
inflationary spirals depending on the active and passive characteristics
of fiscal policies [Loyo (2000)]. (4) In economies with fiscal dominant
regimes, where domestic debt is subject to indexation and speculation,
active anti-inflationary monetary policies result in hyperinflation [Favero-Giavazzi (2002)]. In such cases Leeper (1991) favors
discretionary policy. Benhabib, et al. (1999, 2001) propose interest
rate rule under fiscal dominant regime and find that Taylor rules are
destabilising and price stability can only be achieved by an active
monetary policy with passive backing by fiscal polices. Woodford (2000)
views that collective movement of inflation, nominal interest rates and
primary surpluses also hold in Ricardian and non-Ricardian regime.
Price stability is an important goal of monetary policy in
Pakistan. The present study attempts to uncover empirical evidence on
the relative importance of fiscal policy and monetary policy for price
stability in Pakistan. This seems interesting because firstly, data
indicate that public debt and fiscal imbalances are on the rise (5)
causing concerns about fiscal sustainability. This suggests that some
form of fiscal dominance become an issue for Pakistan, Therefore
considering the relevance of the issue in recent economic scenario, it
is important to study the application of fiscal theory of price level to
Pakistan's economy. Secondly, so far, no systematic empirical work
to discriminate between these two regimes monetary dominant and fiscal
dominant, has been conducted. The only literature available [Hussain
(1982); Massood and Ahmad (1980); and Saqib and Yasmin (1987)]
investigates the relative importance of fiscal and monetary policy on
aggregate economic activity. In fact, there is need to probe this issue
in detail and look for evidence on fiscal dominance in Pakistan by
estimating simple and parsimonious model such as autoregressive system
proposed by Canzoneri, Cumby and Diba (2001).
Thirdly, the principles of fiscal theory of price level require
that it is necessary to have appropriate fiscal policy and also an
adequate monetary policy to achieve price stability. Unless specific
measures are taken to ensure an appropriate fiscal policy, the objective
of price stability may not be achieved despite the independence of State
Bank of Pakistan and its commitment to low inflation. This motivates to
assess the empirical plausibility of both fiscal and monetary dominant
regimes in case of Pakistan's economy. The present study
distinguishes between these two regimes with Vector Autoregressive (VAR)
approach following Canzoneri, et al. (2001). There exists long run
relationship between primary surplus and public liabilities which
implies that these two series cannot move away from each other [Trehan
and Ramos (2002)]. This suggests that time-series techniques are useful
in providing testing procedures for application of fiscal theory of
price level.
The plan of rest of study is as follows: Section 2 reviews briefly
the empirical literature on the relative importance of fiscal and
monetary policy for price stability. The empirical methodology to
differentiate between monetary and fiscal dominance and data are
discussed in Section 3. The empirical results are provided in Section 4
and the last section offers conclusion.
2. LITERATURE REVIEW
The interaction between monetary and fiscal policy is well
researched area for developed countries where the dimensions of
investigation includes the issues related to the coordination of
monetary and fiscal policy [Alesina and Tabellini (1987); Debelle and
Fischer (1994); Dixit and Lambertini (2001) and Buti, et al. (2002)]; on
optimal monetary and fiscal policy [Lucas Stokey (1983); Chari, et al.
(1991); Benigno and Woodford (2003); Beetsma and Jensen (2002);
Schmitt-Grohe and Uribe (2004) and Correia, et al. (2003)] and the
channels through which fiscal actions affect monetary variables and
focuses on the constraints imposed by fiscal policy on the monetary
authority [Calvo and Guidotti (1992, 1993) and Fair (1994)].
Sargent and Wallace (1981) influential study is the first attempt
to show how the government intertemporal budget constraint may affect
monetary policy conditions and, in particular, price dynamics After this
study a number of papers have tried to assess from an empirical
perspective how monetary and fiscal policies interact and, explicitly or
implicitly, have looked for evidence of fiscal dominance. Melitz (1997,
2002) jointly estimate the reaction functions of the monetary and fiscal
authorities on a pool of nineteen OECD countries over the period 1960-95
and finds that monetary and fiscal policy have tended to move in
opposite directions. Favero (2002) concludes that stabilisation of
inflation has been achieved independently in Europe from the lack of
fiscal discipline, supporting the idea that the monetary authorities in
Europe have been able to affect inflation rates. A study by Favero and
Monacelli (2003) also finds some evidence of fiscal dominance in the
United States for limited periods of time 1960-87. They conclude that it
is possible to identify time windows where an empirical model based on
both monetary and fiscal regime is able to track the dynamics of
inflation better than a regime based on a monetary rule only. Blanchard
(2004) and Favero and Giavazzi (2004) argue that when the public debt is
large, an increase in interest rates aimed at keeping inflation within
the target raises the cost of debt service, the debt level, the default
probability and the country premium, triggering capital outflows and
leading to a depreciation of the exchange rate, that affects inflation
expectations and, eventually, inflation itself.
The fiscal theory of the price level identifies another channel
through which the central bank can lose control of inflation, even in
the case of an independent monetary authority that need not accept
seignorage targets dictated by the fiscal authority. Cochrane (1998,
1999), Auernheimer and Contreras (1990), Leeper (1991), Woodford (1994,
1995, 1996, 1998, 2000), Sims (1994, 1995, 1997, 1998), Canzoneri and
Diba (1998), Canzoneri, et al. (1997a,b, 2001, 2002), Dupor (1997),
Bergin (2000), Christiano and Fitzgerald (2000), Schmitt-Grohe and Uribe
(2000) and Benhabib, et al. (2001) are some studies done on this issue.
This theory has found mixed empirical support. Canzoneri, et al. (2001)
for example conclude that post-war US data are more consistent with a
regime where monetary policy, and not fiscal policy, determines the
price level. On the other hand, Cochrane (1998) argues that the US data
from 1960 are consistent with the fiscal theory of the price level
determination. Sala (2003) finds that the fiscal theory of the price
level characterises at least one phase of the post-war US history,
specifically the period 1960-79. Afonso (2002) finds that the fiscal
theory of the price level does not support in case of fifteen European
economies.
Very few empirical work is conducted on emerging economies includes
Tanner and Ramos (2002), who evaluate the policy regime in Brazil during
the 1990s can better characterised as fiscal dominant, and IMF (2003),
estimating a separate fiscal policy reaction function for a group of
developed economies and a set of emerging markets finds that primary
surpluses respond much more strongly to public debt in the developed
countries. For Brazil the study by Loyo (2000) find evidence consistent
with the fiscal theory of the price level where a tight monetary policy
along with lose fiscal policy resulted in hyperinflation even without
seinorage increase. Baldini and Ribineiro (2008) find in case of
Sub-Saharan Africa for the period 1980-2005 a mixed finding as some
countries are dominated by fiscal regime, some by monetary regime and
some have no clear result. Tufail (2008) shows that the fiscal policy in
Pakistan is weakly sustainable for the period 1960 to 2006. There exists
a long run relationship between government revenues and expenditures
however; revenues are adjusting more than expenditures to keep the
fiscal policy on the trajectory towards sustainability. The results of
these studies seem to suggest that fiscal dominance might be an issue
for emerging economies more than for developed ones. This motivates to
test the fiscal dominance in case of Pakistan.
3. METHODOLOGICAL FRAMEWORK AND DATA
To analyse the applicability of FTPL theory in accordance with the
Ricardian equivalence theorem the methodology suggested by Canzoneri, et
al. (2001), and Tanner and Ramos (2002) is adopted using the Pakistani
data. The systematic relationship between public liabilities to GDP ([w.sub.i]) and surplus to GDP ([s.sub.i]) is estimated by an
unrestricted Vector Autoregressive Model (VAR) model to assess whether
primary balances are set exogenous or dependent on public liabilities.
The advantage of this methodology is that it only requires the
estimation of a relatively small number of parameters and it does not
impose any restrictions on the economy. The VAR models are characterise
with no a priori distinction between endogenous and exogenous variables
and forecast performance is better than the one obtained by simultaneous
equation model.
Canzoneri, et al. (2001) describe the relationship between
liabilities to GDP [w.sub.i] and surplus to GDP ratio [s.sub.i] is for
period i as follows:
[w.sub.i] = [s.sub.i] + [[alpha].sub.i][w.sub.i+1] ... ... ... ...
... ... ... (1)
The Equation (1) states that the ratio of the total government
liabilities to GDP has to be equal to the primary surpluses (including
central bank transfers) to GDP ratio plus the discounted value of next
period liabilities to GDP ratio. The discount factor is the ratio of
real growth in GDP to the real interest rate. In the equation [w.sub.i]
is liabilities to GDP ratio, [s.sub.i] is surplus to GDP ratio
[[alpha].sub.t] is discount factor. Woodford (1995) iterating Equation
(1) one period ahead from the current period t and taking expectations
conditional on information available in period t, the relationship
becomes:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]. (2)
The fiscal theory of price determination treats Equation (2) as
equilibrium condition that must be satisfied. The Hamilton and Flavin (1986) procedure is adopted to empirically test Equation (2) and they
test as a government solvency condition. In this case, if primary
surpluses are determined by an arbitrary process unrelated to primary
debt, then nominal income and/or discount factor must jump in
equilibrium to satisfy (2), called non-Ricardian or fiscal dominant
regime. If on the other hand, primary surpluses are determined in such a
way (2) is always satisfied no matter what nominal income and discount
factor are determined elsewhere in the model, called the Ricardian or
monetary dominant regime. Canzoneri, et al. (2001) suggest the following
fiscal policy rule lead to Ricardian regime, let the sequence [s.sub.t]
is expected to follow the rule:
[s.sub.i] = [c.sub.i][w.sub.i] + [[epsilon].sub.i] ... ... ... ...
... ... ... (3)
Where [c.sub.j] is time varying response parameter
[[epsilon].sub.i] is random variable which represents political factors
and/or economic conditions. The fiscal rule (3) implies that the
relationship (1) for any arbitrary value of wj and fiscal rule (3)
results in Ricardian regime.
For empirical analysis primary surpluses [s.sub.i] is affected by
past and current values of other variable [w.sub.j]; in the same way
public liabilities are effected by current and past values of [s.sub.i],
therefore the relationship is explained by the system given below:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (4)
First, considering the temporal relationship running from current
liabilities to future primary surpluses, a monetary dominant regime is
ruled out if future primary surpluses respond negatively to increases in
current liabilities, or if there is no relationship between the two
variables, indicating that primary surpluses are exogenous. A positive
relationship between current primary surpluses innovations and future
liabilities indicate that higher primary balances are created to
compensate for positive changes in liabilities in order to limit debt
accumulation, which would be consistent with a monetary dominant regime.
However, according to the fiscal theory of the price level, such
positive relationship could arise also under a fiscal dominant regime,
in which the price level falls, and the real value of liabilities
increases, in anticipation of future higher primary surpluses. Next
consider the temporal relationship running from current primary surplus
to future liabilities. Under a monetary dominant regime, current
innovations to primary surpluses should be negatively related to future
government liabilities, because rises in the primary surpluses would be
used to pay the debt. On the other hand, under monetary dominant regime,
there would be no relationship between shocks to current primary surplus
and future government liabilities.
To discriminate between monetary dominant and fiscal dominant
regime the VAR model is estimated over primary surpluses and
liabilities. To account for possible lags in the variable response,
impulse responses functions are used to trace the effect over time of
current innovations in the primary surplus on future liabilities and of
current innovations in liabilities on future primary surplus. According
to Ricardian equivalence changes in government budget and public
liabilities do not have effect on aggregate demand. The reverse is the
case with non-Ricardian regime where the aggregate demand variation
resulting from fiscal shocks cause variation in the real level of
economic activity and in the interest rate and inflation rate. To
examine the behavior of nominal GDP to the innovation in surplus VAR is
estimated with order (In (liabilities), surpluses and Ln(GDP)). In the
next stage the model is extended by adding discount rate and VAR is
estimate surpluses to GDP, liabilities to GDP and discount factor to
make sure that the impulse responses on the original model survive after
controlling for the discount factor.
According to FFPL the main source of change in the price level can
be explained by the wealth effect of private consumption which increases
the nominal debt growth [Woodford (1998)]. Therefore a positive shock in
domestic debt makes household believe that they can afford more lifetime
consumption and leads to more demand for goods which drive up the
prices. To assess which of the two policy variables: money growth or
nominal debt growth can best explains inflation variability in Pakistan,
after controlling for the aggregate demand measured by real output gap.
To test for the existence of these wealth effects, a VAR is estimated
with the following order (nominal debt growth, growth rate of reserve
money, real output gap and inflation rate). Then the variance error
decompositions for inflation are computed. These decompositions separate
the variation in inflation into component shocks to the VAR, thus
providing information about the relative importance of each random
innovation in affecting inflation. If the forecast error is explained by
shocks to nominal debt growth, it is argued that changes in the price
level could be explained by the wealth effects of nominal debt growth,
which would support the fiscal theory of price level. If instead the
forecast error is explained by shocks to money growth, it is argued that
monetary policy is passive and has accommodated shocks in debt through
debt monetisation, ultimately causing inflation. The quantity theory of
money says that this inflation channel would be associated with a fiscal
dominant regime. (6)
Data
The data series for this study are extracted from International
Financial Statistics (IFS) CD-ROM.(2008) issued by International
Monetary Fund, Pakistan Statistical Year Book 2008, Pakistan Economic
Survey (various issues). The data set includes government expenditure,
government revenues, consumer price index, reserve money, discount rate,
and gross domestic product for the period 1971-2007. All data series are
converted in to year 2000 rupees. Primary surplus is difference in
overall public revenues and public expenditures (deducing the interest
payments) all divided by nominal GDP. Public liabilities are defined as
debt plus money base divided by nominal GDP. The real output gap is
measured as deviation of actual GDP from potential GDP, where potential
GDP is the fitted values of the quadratic trend on GDP series.
4. EMPIRICAL RESULTS
For estimation, first step is to test the stationarity of each
variable. The Augmented Dickey-Fuller (ADF) unit root test is applied on
primary surpluses, public liabilities, debt, inflation, reserve money,
seigniorage and output gap including a constant and a trend. The ADF
test results show the acceptance of the unit root in all series, that
is, all the series are non-stationary at level, which is indicative of
I(1) process, therefore all the variables are taken in first difference
for further analysis.
The methodology of Canzoneri, et al. (2001) is applied based on
unrestricted VAR analysis which allows to identify monetary or fiscal
dominant regimes by estimating the impulse response functions and
variance decomposition. This test is based on impulse-responses analysis
of future liabilities to GDP to a shock in surplus to GDP, conditional
on the persistence of the surplus to GDP, estimated by its
autocorrelation. A surplus to GDP with a positive autocorrelation up to
5 lags (7) is considered positive and persistent; otherwise the surplus
is considered negatively autocorrelated, indicating low persistence. (8)
The two possible ordering of the surplus to GDP and liabilities to
GDP are used in the model because the VAR methodology reveals possible
inconsistency in the results due to the ordering adopted in the model.
The order in which the surplus to GDP comes first allows for
contemprenous effect to innovation on liabilities/GDP, which is
consistent with non-Ricardian or FD regime (where the nominal GDP should
jump in equilibrium to cause the existing liabilities to equal the
present discounted value from the surpluses). The order in which
liabilities to GDP come first does not allow the contemprenous effect on
the liabilities, which makes more sense in the Ricardian regime.
The VAR is estimated with two lags and a constant and the Figure 1
represents the plots of impulse response function estimated for both
ordering of variables. In the first ordering where Surplus to GDP comes
first, the response of liabilities to an innovation in surplus to GDP is
negative. In fact, the response of Liabilities to GDP is negative for 10
years, regardless of the ordering used. The univariate autocorrelations
and the corresponding Q-statistics for surplus reported in Table 1
indicate that there is significant positive autocorrelation for all
first lags of surplus to GDP ratio. If the surpluses to GDP are
positively correlated and liabilities to GDP in period t+l onwards
decreases, the results are in conformity with Ricardian or MD regime.
[FIGURE 1 OMITTED]
The result of impulse response functions from the VAR are given in
Figure 2 which shows that an innovation in surplus to GDP in period 0
tends to produce negative responses. The liabilities to GDP response is
negative but not significant confirming that this response is followed
by MD regime. The liabilities to GDP is one and more periods forward to
an innovation in surplus to GDP is negative, that is in the subsequent
period the debt decreases again with a surplus in each period that
produces another surplus and so on. This characterises the MD or
Ricardian regime.
[FIGURE 2 OMITTED]
To confirm the result, following Canzoneri, et al. (2001) analysis
has been done by assessing the behavior of GDP. According to Ricardian
equivalence, changes in the government budget and public liabilities do
not exert an effect on aggregate demand. In contrast, in non-Ricardian
regime in the presence of nominal rigidity, it is believed that the
aggregate demand variations resulting from fiscal shocks causes
variation in the level of real economic activity and in real interest
rate, as well as fluctuation in the inflation rate. To examine whether a
positive innovation in the surplus to GDP reduces the nominal income in
the same period and increases government liabilities, VAR is estimated
with surplus to GDP, natural logarithm of liabilities and natural
logarithm of GDP. As nominal GDP is expected to respond to the
innovation in surplus in case of non-Ricardian regime, the impulses
response functions are analysed with ordering In(liabilities), surplus
to GDP, ln(GDP). The results of impulse response in Figure 3 indicate
that the innovation in the surplus to GDP reduces the nominal income but
also decreases the level of liabilities in the subsequent period. This
suggests that these findings confirm the existence of Ricardian regime.
This analysis indicates that there is commitment in the authorities
towards surplus generating polices in order to reduce liabilities.
[FIGURE 3 OMITTED]
In the next stage, VAR is estimated involving surplus to GDP,
liabilities to GDP and discount rate as proposed by Canzoneri, et al.
(2001) to examine whether or not impulse responses survive after
controlling for discount rate. Figure 4 shows impulse responses to an
innovation in surplus to GDP. In the top panel the ordering goes from
surplus to GDP, liabilities to GDP, discount rate in line with
non-Ricardian regime. In the bottom panel the ordering is liabilities to
GDP, surplus to GDP and discount rate consistent with Ricardian regime.
The response of liabilities/GDP to surplus shock is negative for four
periods following the shock. The response of discount rate is positive
and insignificant. The response of surplus to GDP and liabilities to GDP
is as persistent as obtained without including discount rate, that is
basic results are robust to controlling for discount rate that is
non-Ricardian regime is not working. These results are consisting with
emerging market results for example by Fiallo and Partugal (2005) for
Brazil, Baldini and Ribeiro (2008) for some Sub-Saharan African
countries (Cameroon, Keynia, Nigeria, Rewanda and South Africa).
[FIGURE 4 OMITTED]
The wealth effect pass through analysis on price is done by
decomposition of inflation variability reported in Table 2 and by
impulse responses pictured in Figure 5 for ten periods. The analysis is
undertaken that which of the two policy variables, reserve money growth
or nominal debt growth better explains the inflation variability in case
of Pakistan after controlling for aggregate demand channel captured by
real output gap. The VAR is estimated following the ordering domestic
debt growth, reserve money, real output gap and inflation rate. The
results suggest that in case of Pakistan, inflation variability is
mostly explained by the debt growth (10.92 percent), than by the reserve
money growth (1.16 percent). Canzoneri, et al. (2001) approach
identifies MD regime in Pakistani case. The average percentage of
inflation variability explained by debt growth is more than what is
explained by reserve money growth suggesting that the type of MD regime
seems to be explained by fiscal theory of price level. Baldini and
Ribeiro (2008) come up with same findings in case of Ethiopia, Lesotho,
Mauritius, Uganda and Zambia where the pass through analysis indicates
the inflation variability is more closely associated with nominal debt,
while analysing Sub-Saharan African countries. The results indicates
that the forecast error is more explained by shocks in debt growth and
suggest that changes in price level are explained by wealth effect of
debt growth supporting the prediction of fiscal dominance. However, in
case of Pakistan the increase in the domestic debt may be caused by
several other factors, exogenous shocks and due to endogenous shocks for
example political instability, 2005 earthquake or war on terror etc.,
causing imbalances in the supply and demand for goods increasing need
for government deficit financing increasing domestic debt.
[FIGURE 5 OMITTED]
5. CONCLUSION
The present study provides quantitative evidence for application of
fiscal theory of price level. For Pakistan, the evidence is less clear
to infer that authorities are following a certain type of regime during
the sample period 1970-2007. The liabilities respond negatively to the
innovation in surpluses, that is in the subsequent period the
liabilities decreases in the face of increase in surplus. This
characterises MD regime, the events that give rise to surplus innovation
are likely to persist causing the rise in the future surpluses and
surpluses pay-off some of the debt causing the fall in the liabilities.
By analysing the behavior of nominal GDP, an innovation in surplus
reduces nominal income and decreases the level of debt in the subsequent
periods; this analysis does not confirm the non-Ricardian analysis. On
the other hand, the study finds that, as predicted by the fiscal theory
of price determination, the occurrence of wealth effects of changes in
nominal public debt may pass through to prices by increasing inflation
variability in case of Pakistan. In addition, the results show that as
predicted by fiscal theory of price determination the discount rate is
decreasing in response to positive shock in inflation. The reverse also
happens as the reserve money growth also responds negatively as
predicted by the MD regime. Therefore, the implication that comes out of
this study is that nominal public liabilities, as reflected either in
money growth or in nominal public debt, matter for price stability in
case of Pakistan. The authorities may be following different regimes for
different time periods during the 1970-2007.
There are certain limitations of the Canzoneri, et al. (2001)
approach. For instance, it does not allow to identify a predominant
regime if both FD and MD regimes are alternating during the sample
period covered. This may result in having positively correlated
surpluses but inconclusive impulse-response analysis. It would be
appropriate to apply VAR techniques that allow to identify when regimes
are switching [Leeper and Troy (2006)] for a theoretical model, and for
an application to Brazil [Fialho and Portugal (2005)]. The use of
different econometric tests and approaches to underpin the relative
importance of monetary and fiscal determinants of inflation should
improve the reliability of the results.
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Attiya Y. Javid <
[email protected]> is Senior Research
Economist, Pakistan Institute of Development Economics. Umaima Arif
<
[email protected]> is Staff Economist, Pakistan Institute of
Development Economics. Abdul Sattar <
[email protected]> is
Statistical Officer, Federal Bureau of Statistics, Islamabad.
(1) The fiscal theory of price level (FTPL) is developed by
Woodford (1994, and 1998), Leeper (1991), Sims (1994), and Cochrane
(1998, 2001), for the extension of the OTPL to an open economy [Daniel
(2001): Loyo (2000); Canzoneri and Diba (2001) and Dupor (2000)].
(2) For Brazil the study by Loyo (2000) and Tanner and Ramos (2002)
find evidence consistent with the fiscal theory of the price level.
Baldirici and Erisin (2006) finds that fiscal dominance in Turkey
increase after 1980s as a result of increasing cost of capital.
(3) Cochrane (1998) argues that the US data from 1960 are
consistent with the fiscal theory of the price level determination. Also
Sala (2003) finds that the fiscal theory of the price level
characterises at least one phase of the post-war US history,
specifically the period 1960-79. Favero and Monacelli (2003) also find
some evidence of fiscal dominance in the United States for limited
periods of time 1960-87.
(4) He argues that Brazilian economy is subject to fiscal or
non-Ricardian policies combined by active monetary policy rules
resulting in hyperinflations in late 1980s.
(5) In fact, public debt in has grown quite sharply over the years,
35.7 percent of GDP in 1960 to 61.3 percent in 1970s and this percent
has remained the same about 61.7 percent in 1980s. The public debt went
up at an unprecedented rate during 1990s and on average it was 77.6
percent of GDP. The public debt has shown an increasing trend in 2000s
however as a percentage of GDP it shows a decrease which is average 66.4
percent of GDP (Economic Survey).
(6) The fact is that the increase in domestic debt could also be
caused by an abrupt fall in output due to a shock exogenous to the
economy (nationalisation of industries during seventies) or,
endogenously, by (political instability and 2005 earthquake). These
types of shocks would cause imbalances in the supply and demand for
goods, and in turn lead to lower taxation, thereby increasing the need
to finance the government deficits by increasing domestic debt.
(7) There is no consensus in the literature of fiscal theory of
price level on the minimum number of lags to measure a high persistence
of surplus. Canzoneri, et al. (2001) find positive autocorrelation at
lag up to 9 years for US. For emerging market economies Zoli (2005) and
Baldini and Ribeiro (2001) argue that the fiscal policy is more volatile
than developed markets and they use 5 lags. The average length for
developing countries to complete business cycle is three years [Rand and
Tarp (2002)].
(8) Assessing how public liabilities respond to a shock in the
surplus to GDP, conditional on surpluses being positively and
persistently autocorrelated, in a monetary dominant regime, an increase
(or positive shock in the current surplus leads to a fall in future
liabilities to guarantee fiscal solvency. As a result, a monetary
dominant regime is identified by a negative relationship between current
surpluses and future liabilities. Under a fiscal dominant regime,
however, the fiscal surpluses are assumed to be exogenous, and therefore
future liabilities should be either unresponsive to a current increase
in surpluses or lead to an increase. The other possibilities do not
allow identifying any of these two regimes, therefore unidentified or
ambiguous results.
Table 1
Autocorrelation of Primary Surplus/GDP
Lag Autocorrelatio Q-Stat P-value
1 0.73 21.75 0.00
2 0.50 32.31 0.00
3 0.37 38.16 0.00
4 0.35 43.78 0.00
5 0.41 51.67 0.00
6 0.37 58.21 0.00
7 0.35 64.34 0.00
8 0.33 69.78 0.00
9 0.28 73.85 0.00
10 0.25 77.31 0.00
11 0.15 78.52 0.00
12 0.08 78.87 0.00
13 0.02 78.89 0.00
14 -0.01 78.89 0.00
15 -0.02 78.91 0.00
16 -0.07 79.27 0.00
Table 2
Variance Decomposition of INF
Period S.E. TD RMG GAP INF
1 3.622000 2.828269 6.410895 0.036414 90.72442
2 4.557845 8.129574 5.995868 0.856532 85.01803
3 4.773789 9.085645 5.929916 0.787413 84.19703
4 4.848207 11.10081 6.402905 0.833709 81.66257
5 4.905158 11.94281 6.857647 1.317685 79.88186
6 4.966387 12.95595 7.125952 1.568167 78.34993
7 5.017416 13.57980 7.360034 1.698986 77.36118
8 5.056073 13.99127 7.446559 1.703622 76.85855
9 5.076649 14.17347 7.443538 1.690049 76.69294
10 5.085825 14.23960 7.417234 1.728435 76.61473
Cholesky Ordering: TD RMG GAP INF.