Abstract
This Selected Issues paper on Zambia reports that the authorities have outlined a range of alternative policy scenarios to achieve greater pro-poor growth. The thrust of these policies is to support higher growth in rural areas, where the incidence of poverty is particularly high, by investing more in infrastructure development, while also stepping up delivery of public services, notably in health and education. Implementing these alternative policies would require significantly more financial assistance from the donor community.
II. Fiscal Dominance and Inflation in Zambia1
A. Introduction
1. Governments running persistent fiscal deficits tend, over time, to resort to money creation to finance their deficits, thus causing inflation.2 During the last two to three decades, Zambia experienced persistently high inflation and large budget deficits. In this context, this paper analyses how fiscal policy affected monetary outcomes and inflation in Zambia during the period 1981–2004. It provides evidence on the relationship between money, inflation, and budget deficits and tests for “fiscal dominance” using Vector Autoregression Analysis (VAR).3 These tests seek to identify the prevailing type of fiscal and monetary policy regimes.
2. In a so called “fiscally dominant” regime, the fiscal authorities—because of inefficiencies in their taxation system or for other reasons—set the primary budget balance independently of public sector liabilities. As a result, persistent budget deficits may, over time, force the monetary authorities to monetize the debt, creating inflation. Under such a regime, monetary policy works mainly through seigniorage and the government’s budget constraint to determine inflation.
3. Conversely, in a “monetary dominant” regime, monetary policy determines inflation through more ‘orthodox’ channels such as monetary targets or Taylor rules. Under this regime, the fiscal authorities set or adjust the primary budget balance to ensure the sustainability of public sector liabilities4.
4. The evidence suggests that fiscal policy in Zambia has relied on seigniorage as an important source of government revenue, while monetary policy monetized the debt, creating inflation. This type of ‘fiscally dominant’ regime, which is observed frequently in developing countries, appears to have prevailed in Zambia especially during periods of severe fiscal stress. The VAR analysis, however, can not discriminate clearly between fiscal and monetary dominant regimes. Indeed, there is some evidence that fiscal policy tried to increase the primary budget balance in the presence of a current or expected increase in government liabilities, suggesting that a “monetary dominant” regime also operated in Zambia.
5. The plan of the paper is as follows: section B provides an overview of budget deficits and inflation in Zambia and in a large group of sub-Saharan African countries; section C, summarizes how monetary theories have paid attention to underlying fiscal constraints; section D applies VAR analysis to test for fiscal dominance in Zambia, following the methodology suggested by Canzoneri et al. (2001). Section E concludes.
B. Trends in Budget Deficits and Inflation
6. Fiscal outcomes in Zambia over the past three decades were not strong enough to support a program of disinflation. Shortcomings in budget policy and execution resulted in extensive recourse to domestic financing. Persistent shortfalls in external budget support also contributed to higher domestic borrowing by the government. Moreover, monetary expansion typically exceeded targeted rates. As a result, during the period 1972–2004, annual CPI inflation averaged 41.5 percent, with a peak of 183 percent in 1993, while overall central government budget deficits averaged 9.3 percent of GDP
Seigniorage and Inflation, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.Seigniorage and Inflation, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.Seigniorage and Inflation, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.7. Seigniorage served as an implicit form of taxation to finance the budget deficits. As shown in Figure II.1, seigniorage—measured as the annual change in base money in percent of GDP—averaged, 5.8 percent of GDP during 1972–2004.5, 6 Moreover, the stock of base money was negatively correlated with primary budget balances, suggesting the monetization of debt. Figure II.2 shows the stock of base money and primary budget balances during the period 1980–2004 (both in percent of GDP). These two aggregates were negatively correlated throughout the period, with a coefficient of -0.3; however, during periods of severe fiscal stress, such as the 1980s and early 1990s, when the debt-to-GDP ratio and inflation were rising rapidly, the negative correlation was even higher (-0.5) and the stock of base money relative to GDP was double that in other periods, while primary surpluses were either negative or close to balance.
Money and Primary Surplus, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.Money and Primary Surplus, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.Money and Primary Surplus, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Sources: IFS, and staff calculations.8. Figure II.3 plots the average budget balance (revenue-expenditure) against inflation in the period 1980 and 2004 for a large group of Sub-Saharan countries in Africa, including Zambia. A regression of the annual average of inflation in the period 1980–2004 on the annual average of the central government budget balance (including grants) in percent of GDP for 34 SSA countries finds a significantly negative correlation between budget surpluses and inflation, with a one percentage point of GDP increase in the budget surplus decreasing inflation by almost 2 percentage points. Budget balances alone, however, explain only a relatively small proportion (14 percent of the cross-country variation in inflation.
Inflation = 8.4-1.98*budget balance (T-G)
R2 = 0.14; t-statistic on (T-G) = -2.04
Budget Balance and Inflation in Selected Sub-Saharan African Countries, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Budget Balance and Inflation in Selected Sub-Saharan African Countries, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Budget Balance and Inflation in Selected Sub-Saharan African Countries, 1980–2004
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
C. Fiscal and Monetary Dominance: Theory and Evidence
9. The evidence above on the persistently high inflation and the large extraction of seigniorage revenues, suggests that decisions about the supply of base money were ‘dominated’ by the fiscal authorities rather than by the central bank. Moreover, the existence of a large and unsustainable nominal debt whose real value could be reduced by unanticipated inflation, provided an incentive to inflate away the debt, particularly in an environment of limited central bank independence.
10. The literature on “time-inconsistency” illustrates that governments facing a trade-off between inflation and unemployment are tempted to choose higher-than-optimal inflation rates. To reduce a government’s ‘inflationary bias’, the suggested solution is to delegate monetary policy to an independent and conservative central bank.7 That is, the key to guaranteeing a firm commitment to price stability is to have a central bank that is independent of the fiscal authorities and able to resist pressures to inflate away or monetize the debt.
11. A more recent theoretical literature on how fiscal policy affects monetary policy, the so called “fiscal theory of the price level” (FTPL),8 stresses the role of fiscal policy in price determination and also provides a theoretical rationale on whether a monetary policy set by an independent and conservative central bank is sufficient to guarantee price stability, as standard monetarist theory would predict.9 The FTPL argues that an inappropriate fiscal policy could jeopardize the objective of price stability, irrespective of how committed to low inflation the central bank may be.
12. The difference between the standard view of a monetary dominant regime and the FTPL lies in their different interpretation of the government’s intertemporal budget equation. The former states that the value of government debt is equal to the present discounted value of future government tax revenues net of expenditures, where both debt and surpluses are denominated in units of goods. This equation may be expressed as
B/P = present value of future surpluses,
where B is the outstanding nominal debt of the government, and P is the price level. The standard view interprets this equation as a solvency constraint on the government’s fiscal policy, and independent of the price level P. According to this view, when this equation is disturbed, the government must take revenue and/or expenditure measures to restore equality and satisfy the solvency condition.
13. However, advocates of the FTPL argue that the intertemporal budget equation should be viewed as an equilibrium condition: whenever the solvency condition is disturbed, the market-clearing mechanism moves the price level, P, to restore equality. This implies that if the market anticipates a fall in future primary surpluses, the real value of government debt would fall, through an increase in the price level, and no adjustments to fiscal and monetary policy would be required to restore the fiscal solvency condition. A monetary dominant (MD) regime would emerge if primary surpluses adjust automatically to limit the growth of public liabilities and ensure fiscal solvency for any determined price level. As a result, monetary policy is conducted independently of government financing requirements and becomes the nominal anchor for macroeconomic stability. A fiscally dominant (FD) regime would instead prevail if primary surpluses tend to be uncorrelated with public liabilities and follow an arbitrary process, with prices adjusting to ensure fiscal solvency. As a result, in FD regimes fiscal policy becomes the nominal anchor.
14. From a policy perspective, it is important, therefore, to know whether a country has either a fiscal or monetary dominant regime. In a FD regime, to control the price level, monetary policy will work mostly through seigniorage and the government’s budget constraint, while in a MD regime monetary policy will work through more standard channels (e.g. interest rates).10
D. Fiscal or Monetary Dominance? An Impulse Response Analysis
15. To help determine which of these regimes prevailed in Zambia, the tests devised by Canzoneri, et. al (2001) to discriminate between a monetary dominant and a fiscally dominant regime were carried out. These tests employ impulse response functions from an unstructured VAR model to determine how future primary budget surpluses and public sector liabilities, both normalized on GDP, respond to shocks to the primary budget surplus and to shocks to government liabilities. The evolution of the primary budget surplus, central government debt, and central government liabilities, all as ratios to GDP, are shown in Figure 4.
Budget Balances and Public Sector Liabilities, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Budget Balances and Public Sector Liabilities, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Budget Balances and Public Sector Liabilities, 1980–2004
(In percent of GDP)
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
16. Consider first a shock to the primary surplus. In a MD regime, an increase in the current primary budget surplus helps reduce future liabilities. Thus, under this regime, a negative relationship between current innovations to the primary budget surplus and future liabilities should be observed.11 In a FD regime, the primary budget surplus is assumed to be exogenous, and therefore future liabilities should not respond to a current increase in the primary budget surplus.
17. Consider next a shock to government liabilities. In a MD regime, a current increase in government liabilities helps increase future primary budget surpluses. Under this regime, a positive relationship between current innovations to liabilities in the first period and future primary budget surpluses should be observed. A similar positive relationship would also be consistent with a FD regime, however, where nominal GDP (or the price level) has to fall to make the value of the existing debt equal to the expected present value of primary budget surpluses. A negative relationship or no relationship between current innovations to government liabilities and future primary surpluses are also consistent with a FD regime.
18. The impulse response functions of the VAR computed for both orderings of the variables are shown in Figures 5 and 6.12 The lack of response of future budget primary surpluses to a current shock in liabilities for several periods after the shock (from period 1 to 4), suggests a fiscally dominant regime (Figure 5, top left panel). The positive lagged response (from period 5) is consistent with both a fiscally dominant regime and a monetary dominant regime, as the fiscal authorities would adjust the primary budget surplus to limit debt accumulation, and thus cannot discriminate between the two regimes.
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Primary Budget Surplus/GDP, Liabilities/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Primary Budget Surplus/GDP, Liabilities/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Primary Budget Surplus/GDP, Liabilities/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Liabilities/GDP, Primary Budget Surplus/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Liabilities/GDP, Primary Budget Surplus/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
Impulse Response Analysis
(to Cholesky One S.D. Innovations ± 2 S.E.)
Ordering: Liabilities/GDP, Primary Budget Surplus/GDP
Citation: IMF Staff Country Reports 2006, 118; 10.5089/9781451841282.002.A002
19. Government liabilities respond positively to a shock in the primary budget surplus, thereby excluding a fiscally dominant regime (Figure 5, top right panel). However, a monetary dominant regime cannot be excluded, since government could run a larger primary budget surplus in anticipation of future higher obligations. The positive autocorrelations of the primary budget surplus process (see bottom panel in Figures 5 and 6) suggest that the authorities may wish to run surpluses over a long period of time, perhaps to cope with external shocks which are likely to be persistent. When the ordering is inverted and liabilities are entered first in the VAR estimation, the results are similar (Figure 6).
E. Concluding Remarks
20. Fiscal considerations and commitment drive the choice of monetary policy regime. In this context, this paper analyzed the effects of fiscal outcomes on inflation in Zambia for the period 1980–2004. The empirical results suggest that inflation in Zambia was mainly driven by the government’s need to maximize seigniorage to finance persistently large budget deficits. The characteristics of such a “fiscally dominant” regime were especially evident in times of severe fiscal stress, such as the period of fast debt accumulation and rapidly rising inflation during (1980–1993). The impulse response analysis, however, suggests that future liabilities tend to grow despite a positive shock in the current primary surplus. This could be consistent with a monetary dominant regime, if governments were willing to create surpluses (or reduce deficits) in anticipation of mounting future liabilities.
F. References
Barro, Robert, and David, Gordon, 1983, “Rules, Discretion, and Reputation in a Model of Monetary Policy”. Journal of Monetary Economics, 17, pp.3 –20.
Canzoneri, Matthew, Cumby, Robert, and Diba, Behzad, 2001, “Is the Price Level Determined by the Needs of Fiscal Solvency?”, American Economic Review, 91, pp.1221 –38.
Catão, Luis and Marco Terrones, 2003, “Fiscal deficits and Inflation”, IMF Working Paper, WP/03/65.
Christiano, Lawrence J., and Terry J. Fitzgerald, 2000, “Understanding the Fiscal Theory of the Price Level”, Cleveland Federal Reserve Bank.
Cochrane, John, 1998, “A Frictionless View of US Inflation”, in Ben Bernanke, and Julio Rotemberg (eds), NBER Macroeconomics Annual, pp. 323 –84.
Cukiermann, Alan, 1992, Central Bank Strategy, Credibility and Independence: Theory and Evidence, MIT Press.
Grilli, Vittorio, Masciandaro, Donato, and Guido Tabellini, 1991 “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries”, Economic Policy, 13, pp. 341 –392.
Kydland, Finn, and Edward Prescott, 1977, “Rules Rater than Discretion: the Inconsistency of Optimal Plans”, Journal of Political Economy, 85, pp.473 –492
Nachega, Jean-Claude, 2005, “Fiscal Dominance and Inflation in the Democratic Republic of the Congo”, IMF Working Paper, WP/05/221.
Rogoff, Kenneth, 1985, “The Optimal Degree of Commitment to an Intermediate Monetary Target”, Quarterly Journal of Economics, 100, pp.1169 –1190
Sargent, Thomas and Neil Wallace, 1981, “Some Unpleasant Monetarist Arithmetics”, Federal Reserve Bank of Minneapolis Quarterly Review.
Sims, Christopher, 1994, “A Simple Model for Study of the Price Level and the Interaction of Monetary and Fiscal Policy”, Economic Theory, 4, pp. 381 –99.
Tanner, Evan and Alberto Ramos, 2002, “Fiscal Sustainability and Monetary versus Fiscal Dominance: Evidence from Brazil, 1991–2000”, IMF Working Paper, WP/02/5.
Woodford, Michael, 1994, “Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy”, Economic Theory, 4, pp.345 –80.
Zoli, Edda, 2005, “How Does Fiscal Policy Affect Monetary Policy in Emerging Market Countries?”, BIS Working Papers, No. 174.
Prepared by Alfredo Baldini.
The econometric tests are based on Canzoneri et al. (2001) who use VAR analysis to discriminate between monetary and fiscally dominant regimes. In turn, these tests are based on the fiscal theory of price determination developed by Sims, (1994), Woodford (1994) and Cochrane (1998).
In 2001–04 the average annual seigniorage was still high at 4 percent of GDP. Countries with thin capital markets, relatively inefficient tax systems, and unsustainable debt paths tend to rely most on seigniorage revenues. See Grilli, Masciandaro, and Tabellini, (1991).
Seigniorage is closely related to (next-period) inflation with a correlation coefficient of 0.64.
Econometric testing of the FTPL was inaugurated by Cochrane (2001) and Canzoneri, et. al. (2001) who run tests for fiscal dominance using U.S. post-war data. More recently, Tanner and Ramos (2002), and Zoli (2005) have tested FTPL on, respectively Brazil, and a number of selected emerging market economies, Nachega (2005) tested FTPL for the Democratic Republic of Congo.
A positive relationship between current innovations to the primary surplus and future liabilities would also be consistent with a MD regime. This interpretation assumes that the government is generating a larger primary surplus in anticipation of higher future obligations (Tanner and Ramos, 2002).
The Hodrick-Prescott filter was used to transform the variables into trend stationary series. The Akaike information criterion indicated two lags. Granger-causality tests rejected the null hypothesis of no causality for each variable.
