Academic journal article Journal of Economics and Economic Education Research

Interaction between Monetary and Fiscal Policy in Jordan

Academic journal article Journal of Economics and Economic Education Research

Interaction between Monetary and Fiscal Policy in Jordan

Article excerpt

INTRODUCTION

A large body of literature suggests that the discretionary regime of monetary and fiscal policy produces on average an inefficiently high amount of inflation and budget deficit. This suggests that optimal monetary and fiscal policy may be dynamically inconsistent.

Three approaches have been introduced in the literature to address the inconsistency problem. First is establishing an independent monetary policy with its main mandate centered on price stabilization (Rogoff 1985). Second is conducting monetary and fiscal policy by a technique centered on inflation and deficit targeting (Bernank and Mishkin (1996) and Sevensson (1997). Third is applying pre-set monetary and fiscal rules when responding to the state of the economy (Taylor, 1993, 2000), and McCallum (1997). Enhancing the credibility of both monetary and fiscal policy is a common theme of the three approaches.

Generally speaking, many studies have found an inverse relationship between monetary policy independence and average level/variability of inflation. Furthermore, a number of studies have found that targeting techniques and pre-set policy rules could improve welfare by lowering inflation and deficit. For other studies, however, the gains from monetary policy independence have been examined in isolation from the actions of the fiscal policy. And, it is argued that once the fiscal policy actions are taken into account, the goal of stabilizing prices of monetary policy may cause some welfare loss--in the form of lower output and increased fluctuations in the state of the economy. However, beginning with Sims (1980), a parallel line of empirical research on the effect of monetary and fiscal policy within the context of macroeconometric models has been accumulated in the literature. Applying the different forms of Vector Autoregression (VAR) models has been the dominant methodology.

In fact, an enormous amount of work has been done on the macroeconomic effect of monetary policy within the context of VAR models. On the other hand, the work on fiscal policy has received relatively less consideration in the context of VAR empirical analysis. Even less attention has been devoted to estimating the dynamic interaction between monetary and fiscal policy.

This paper empirically examines the dynamic interaction between monetary and fiscal policy in Jordan, and thus fills a void in the literature particularly for emerging countries. The main focus of this paper is how and to what extent both monetary and fiscal policy responds over time to each other and to the movements in the state of the economy. The empirical analysis undertaken in our work was based on VAR analysis where Vector Error Correction Model (VECM) is suggested by the data. Generalized impulse response functions (GIRF) developed by Koop, Pesaran, and Potter (1996) and Persaran and Shin (1998) constituted the primary tools of analysis in this paper.

These tools of analysis were chosen to overcome the identification problem incorporated in the VAR model. It is important to note that solving the identification problem in modeling the interaction between monetary and fiscal policy amounts to imposing a number of restrictions on the effects of monetary and fiscal policy. In fact, there is a well-known common pattern in identifying the restrictions on the effects of monetary policy, but there is a critical lack of consensus about identifying restrictions on the effects of fiscal policy. Therefore, by using our techniques, we attempted to avoid imposing restrictions on the effects of monetary and fiscal policy. Likewise, the GIRF was chosen not only to detect the direction and the duration of the impacts and/or responses between monetary and fiscal policy (Enders (1995), but also to overcome the ordering problem for the selected endogenous variables.

The rest of this paper is organized as follows: in the next section, the selected variables used to study the mutual interaction between monetary and fiscal policy were introduced. …

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