Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 2 - Monetary Policy Framework : International Experience

Price Stability and Institutional Arrangements

It is increasingly realised that inflation expectations play a key role in determining actual inflation. Most of the reforms in the institutional design of monetary policy - central bank independence, transparency, communications and accountability -have been aimed at increasing the credibility of the central banks so that they can stabilise inflation expectations of the public at low levels. As Walsh (2003) stresses, the three most important ingredients of a successful monetary policy are credibility, credibility and credibility. The contemporary literature has, therefore, underscored the need for an official commitment to price stability - either in the form of a conservative central banker or in the form of an institutional/legislative commitment to price stability - to avoid political cycles which could entice governments to finance populist programmes by printing money during the elections. During the 1990s, the commitment to price stability has been reinforced by a legislative mandate in favour of price stability as the principal - if not the only - objective of monetary policy in a number of economies to stabilise inflation expectations. Central bank independence thus connotes the autonomy of instrument choice and not independence in regard to objectives. Governments reserve the right to determine the overall objectives of economic policy, including monetary policy. Studies suggest that central bank independence does help to lower inflation. The role of monetary policy in reducing output volatility, however, is a matter of debate. Apart from an improved monetary policy, a number of factors such as the increasing share of services in GDP, better inventory management and improved consumption-smoothing on account of financial innovations and deregulation are believed to have played a role. Good luck -absence of major supply disruptions and other such macroeconomic shocks in the recent decades - is also considered as one of the contributory factors(see Module 3).

Notwithstanding the institutional reforms granting independence to central banks, price stability and inflation expectations are ultimately dependent upon the fiscal regime in the economy. Expansionary fiscal policies and their accommodation by monetary policies are the major causes of inflation in many developing economies. Even in the context of the advanced economies, the steep increase in inflation during the 1970s is attributed, inter alia, to expansionary fiscal policy. The conduct of monetary policy is, thus, inextricably linked with the fiscal regime. As the unpleasant monetary arithmetic (UMA) proposition of Sargent and Wallace (1981) shows, if fiscal policy is imprudent and if the central bank does not finance the fisc initially, the end-result could still be inflationary as the public debt-GDP ratio would turn unsustainable over time (see Module 3). If economic agents have rational expectations, a tight monetary policy today may lead almost immediately to a step-up in inflation. Thus, a combination of tight monetary policy with an expansionary fiscal policy will be ineffective. In other words, central bank independence, per se, is not a panacea for fiscal irresponsibility. In the alternative scenario whereby high fiscal deficits are financed by recourse to external borrowings denominated in foreign currency, this will result in a build-up of external debt leading eventually to a balance of payments crisis. This outcome is more likely for EMEs since they do not have the benefit of borrowing in their own currencies. Thus, external borrowings are a substitute neither for a well-developed domestic government securities market nor for fiscal discipline. As a result, in consonance with the increasing emphasis on price stability as an objective of monetary policy, most countries have put in place fiscal rules. These rules, inter alia, place limits on the deficit and debt of the government and prohibit primary subscriptions by the central banks to the governments' borrowing programmes.

Fiscal deficits are not only inflationary, but also put pressure on real interest rates and crowd out private investment. There is a vicious circle between inflation and budget deficits: higher deficits cause higher inflation through excessive money financing and then, the higher inflation feeds back into higher deficits by reducing the real value of tax collections. An attempt by Latin American governments to fund themselves through an inflation tax in the 1980s, for instance, sent inflation soaring to three-digit levels in many cases. Budget deficits turn out to be especially inflationary when the central bank is not independent and the financial markets are not developed enough to contain inflationary expectations. The very existence of large fiscal deficits puts continuous pressure on inflationary expectations. While the conventional view is that fiscal deficits lead to excessive monetary expansion and hence inflation, a more recent view -the fiscal theory of the price level - argues that fiscal imbalances lead to an increase in inflation and it is the money supply which adjusts subsequently to higher prices (see Module: 3).

The inflationary consequences of the fiscal dominance of monetary policy brought into sharp focus the need to reduce fiscal imbalances, per se, as well as the draft of resources by the fisc on the central bank. This need for monetary and fiscal coordination naturally raises the issue of its nature. A key issue in this context is whether this coordination should be rule-based or discretionary. Frameworks based on clear mandates and rules are usually considered preferable to ad hoc discretionary coordination, which could be clouded by problems of implementation and incentive distortions caused by electoral cycles. Furthermore, uncertainty and imperfect information about the current state of the economy as well as future outlook make it difficult to agree and implement a case-by-case discretionary approach to coordination. On all these grounds, there is a explicit preference for frameworks based on clear mandates/rules. In most countries, these take two forms: central bank independence and fiscal responsibility legislation.

An ideal fiscal rule should be well-defined, transparent, simple, flexible, adequate relative to the final goal, enforceable, consistent and supported by structural reforms if needed. Cross-country evidence shows that the form of fiscal responsibility legislation has varied from country to country, depending upon factors such as the historical background, social set-up, nature of financial market evolution and objectives of macro-economic policies. Some countries have set transparency requirements for their governments while others follow expenditure rules and deficit and debt rules(Table 2).

The efficacy of the fiscal rules remains a matter of debate. First, the frameworks may be circumvented by creative accounting (for example, modifying accounting practices and changing the nominal timing or other classification of taxes and expenditure). A second issue of contention is that fiscal rules might increase business cycle fluctuations. Two opposing factors are at work here. On the one hand, fiscal rules restrict unbridled government spending and this checks the excessive build-up of deficits and public debt which imparts stability to the economy. On the other hand, fiscal rules may restrict the government's ability to take countercyclical policy measures and hence, contribute to increased business cycle volatility. Ultimately, it is, therefore, an empirical exercise as to which of these two effects dominates. Levinson (1998), Poterba (1994) and Alt and Lowry (1994) find that fiscal rules are inflexible and inhibit counter-cyclical fiscal policy and thus lead to more volatile business cycles. In contrast, Alesina and Bayoumi (1996) find that such rules do not have any affect on output volatility as fiscal rules may limit destabilising politically motivated and biased policies. Fatas and Mihov (2004) find that the first factor dominates the second and, fiscal rules are, therefore, stabilising. Overall, fiscal policy rules are likely to be effective if they are accompanied by strong commitments and increased transparency.

To conclude, the inflationary consequences of the monetisation of fiscal deficits are now well-recognised. Alternatives such as recourse to external borrowings in foreign currency to finance high fiscal deficits are more likely to engender unsustainable current account deficits, high external debt and an eventual balance of payments crisis. In this context, well-developed domestic debt markets can help governments to raise their borrowing requirements locally. This will avoid automatic monetisation and the pitfalls associated with external borrowings. However, if the government borrowing requirements are high, this could exert upward pressure on domestic interest rates. Thus, the development of domestic government securities markets needs to be supported by fiscal discipline so as to provide a more enduring solution. As a result, there is a widespread consensus in favour of central bank independence, backed by some form of fiscal discipline. Such clear-cut rules are an essential pre-requisite to contain inflation and stabilise inflation expectations.