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EFFECTS OF FISCAL POLICY ON THE CONDUCT AND TRANSMISSION

MECHANISMS OF MONETARY POLICY IN ZIMBABWE

BY

WILLIAM KAVILA

DEPUTY DIRECTOR, ECONOMIC RESEARCH DIVISION

RESERVE BANK OF ZIMBABWE

ABSTRACT

This paper provides an analysis of the effects of fiscal policy on the monetary policy

transmission mechanism in Zimbabwe under a dollarised environment. The analysis was

conducted using an Unrestricted Vector Autoregression model to identify shocks to fiscal

variables and their impact on the monetary policy transmission mechanism. The variables

analysed are interest rates, budget deficit, inflation, money supply and a proxy for economic

activity over the period 2009 to 2014. The impulse response functions and variance

decompositions are used to study the effects of identified shocks. The results suggest that

nominal interest rates respond positively to a fiscal deficit shock. Furthermore, the results

suggest that the response of inflation and money supply are muted, reflecting the limited role

played by fiscal policy in influencing money supply and inflation under the dollarized

environment.

Keywords: Structural VAR, Fiscal deficit, Monetary Policy, Transmission Mechanism

JEL classification: C32, E52, E62

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Table of Contents

1. INTRODUCTION..............................................................................................................................4

2. TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE..............................................................7

Revenue Performance....................................................................................................................7

Expenditure Performance...............................................................................................................8

Fiscal and Monetary Policy Interaction in Zimbabwe.................................................................10

3. LITERATURE REVIEW.................................................................................................................11

Theoretical Literature...................................................................................................................11

Empirical Literature.....................................................................................................................14

4. METHODOLOGY...........................................................................................................................18

Data and Estimation Method........................................................................................................19

5. EMPIRICAL RESULTS...................................................................................................................20

6. CONCLUSION AND POLICY RECOMMENDATIONS..............................................................27

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1. INTRODUCTION

The efficient coordination of fiscal and monetary policies is a pre-requisite for sustainable

economic growth in the context of achieving both internal and external balance. Prudent

macroeconomic management allows for mutually reinforcing objectives of both fiscal and

monetary policies. On the contrary, inefficient coordination give rise to sub-optimal

economic outcomes. As highlighted by Balino and Enoch (1998), the necessary condition for

effective coordination between monetary and fiscal policies is that each policy should be on a

sustainable path. Even with effective coordination, unsustainability in one policy has negative

spillover effects on the other, making the entire macroeconomic framework unsustainable. In

addition, coordination also looks at the credibility of the overall policy mix. In this regard, the

effectiveness of monetary and fiscal policies is dependent upon significant coordination.

The coordination of fiscal and monetary policy is crucial since the two policies operate in

different time frames. Monetary policy can be adjusted more frequently and is normally used

in fine tuning the economy. On the other hand, it takes a long time to change the fiscal stance.

In this regard, the issue of coordination of fiscal and monetary policies had been prominent in

the context of macroeconomic stabilization programmes (Niemann, 2008). The need for

fiscal and monetary policy coordination has become pertinent especially given that most

countries have established independent central banks. As a result, central banks around the

globe have moved to primarily focus on price stability through inflation targeting (Sehovic,

2013). Central bank independence has resulted in increased disassociation between fiscal and

monetary goals, implying that economic policy management increasingly focuses on the

coordination of fiscal and monetary policies.

The importance of coordination between fiscal and monetary policy also came to the fore

during the global financial crisis of 2008. The crisis showed that financial instability and

weak fiscal policies can have a negative impact on each other. Crucially, the financial-fiscal

feedback loop negatively affects the smooth operation of the monetary policy mechanism.

The crisis highlighted that sound fiscal and monetary policies are critical for sustainable

growth (European Central Bank, 2012). The coordination of fiscal and monetary policies also

gained prominence as countries endeavoured to deal with the global financial crisis. Several

countries carried out unconventional monetary and fiscal policies. Notably, monetary

authorities turned to quantitative easing, while fiscal policies were highly expansive

4

characterised by increased government spending and reduced taxes. Against this background,

efficient coordination of monetary and fiscal policy becomes a necessity to ensure a

sustainable policy mix in the aftermath of the crisis (Liborioa, 2011).

The euro area sovereign debt crisis also showed that if fiscal and monetary policies are

operating at cross purposes, the overall policy mix would be unsustainable. In the euro area,

in particular, unsustainable fiscal policy including high debt levels, adversely impacted on the

monetary policy transmission mechanism (ECB, 2012). In this regard, fiscal and monetary

policy should be in harmony. The euro area crisis highlights that fiscal and monetary

coordination should be an integral part of countries moving towards or are in a monetary

union. In this regard, as the Common Market for Eastern and Southern Africa (COMESA)

strides towards a currency union it becomes imperative to review and examine the state of

fiscal and monetary coordination in the respective member countries.

The need for fiscal and monetary coordination increases under monetary union arrangements.

As highlighted by Suarez and Panico (2007), in a monetary union without fiscal federation,

fiscal policy is the only policy instrument which can be deployed to deal with asymmetric

shocks. Under a monetary union, the existence of only one monetary authority with several

fiscal authorities requires significant measures to ensure adequate monetary and fiscal policy

coordination. In a monetary union, coordination is required at two levels, that is, coordination

among fiscal authorities of member states and in the coordination among monetary and fiscal

policy authorities (Tirelli and Muscatelli, 2005).

It is against this heightened requirement for greater coordination of fiscal and monetary

policy for countries moving towards or in a monetary union that it becomes imperative to

assess the interaction of fiscal and monetary policy in Zimbabwe. The assessment of fiscal

and monetary coordination in Zimbabwe is, however, an interesting case since the country

adopted the multicurrency system in 2009. In the multicurrency system, the country uses an

array of foreign currencies, in which the principal currencies include the United States of

America dollar (US$), British pound, South Africa rand, Botswana Pula and the Euro. It

should be noted that while Zimbabwe is under a multicurrency system, the US$ is the unit of

account and the majority of the transactions (over 90%) are in US$. All goods and services

are priced in US$. The adoption of the multicurrency system resulted in the loss of monetary

policy autonomy. This implies that the country is unable to use traditional monetary policy

5

and exchange rate instruments to fine tune the economy. In this regard, the role of monetary

policy has become limited, implying that the interaction between monetary and fiscal policies

in Zimbabwe takes a different dimension. Fiscal policy is dominant under the multicurrency

system, therefore there is need for the Zimbabwean Authorities to ensure that there is fiscal

sustainability.

Historically, Zimbabwe faced significant fiscal challenges as exhibited by huge fiscal deficits

averaging more than 9% of GDP for the period 1980 to 2008. The country adopted the

multicurrency system in 2009 to stabilise the economy and this resulted in economic activity

rebounding, on the back of an improved business environment. In this regard, growth in gross

domestic product rebounded to an overage of 10.6% over the period 2009 to 2012, while

annual inflation was below 5%. Fiscal performance also improved since the inception of the

multicurrency system, with fiscal deficits averaging less than 3%. This was aided by the

concomitant implementation of the cash budgeting framework since 2009.

In the absence of a local currency, the impact of fiscal policy on the smooth functioning of

the monetary policy is expected to be minimal. It should, however, be noted that fiscal policy

can affect monetary policy through its impact on interest rates and financial stability. Despite

adopting a cash budgeting system in 2009, Government of Zimbabwe (GoZ) has since 2013

turned to domestic borrowing on the back of declining revenues. The increased recourse to

domestic borrowing, may have resulted in higher market lending rates and the crowding out

of private investment.

There are few studies on the interaction between fiscal and monetary policy in Zimbabwe and

these have mainly concentrated on the impact of fiscal deficits on inflation. Most of the

studies were done for the period prior to 2008. Makochekanwa (2011) examined the causality

between government deficits and inflation and observed that there exists a causal link from

the budget deficit to the inflation rate. He concluded that the monetisation of the budget

deficit impacted negatively on inflation. Kararach et al (2010) also argued that the prime

source of Zimbabwe’s hyperinflation was excessive money printing to finance huge budget

deficits.

The rest of the study is organised as follows: Section II, provides an overview of trends in

fiscal developments including institutional arrangements. Section III reviews theoretical and

6

empirical literature, while methodological issues are addressed in Section IV. Section V

analyses the results based on the empirical findings. Section VI proffers policy

recommendations.

2. TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE

This section reviews fiscal trends in Zimbabwe since independence in 1980. In addition, the

section also analyses the observed relationship between fiscal and monetary variables as a

prelude to the econometric analysis of the effects of fiscal policy on the conduct and

transmission mechanism of monetary policy in Zimbabwe.

Zimbabwe’s fiscal performance was largely poor over the last 3 decades, starting in 1980,

with fiscal deficits averaging well above 5% of GDP. The high fiscal deficits were mainly

attributed to elevated Government expenditures. Figure 1 shows developments in

Government revenues, expenditures and deficits since 1979.

Figure 1: Developments in Government revenue, expenditure and fiscal deficit as a %

of GDP from 1980 to 2014.

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

-40

-20

0

20

40

60

80

Expenditure Revenue Deficit

Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)

Revenue PerformanceGovernment revenue averaged 26% of GDP between 1980 and 2014. Value-Added Tax

(VAT) dominated the revenues, accounting for about 30% of the total revenue collected

7

between 1980 and 2014. Equally important were individual and corporate taxes which also

contributed about 28% of total revenues over the same period.

In a bid to improve revenue collection, GoZ made several institutional changes. Notably, the

GoZ established the Zimbabwe Revenue Authority (ZIMRA) in 2001 a semi-autonomous

institution, which merged the former Department of Taxes and Department of Customs and

Excise. This resulted into a leaner organisation and boosted revenue collections.

To increase the contribution of indirect taxes as well as to expand the tax base, the country

introduced value-added tax (VAT) in 2004. The introduction of VAT at a 15% standard rate

improved the performance of indirect taxes. Over the years, the GoZ has been introducing

and refining tax policy with the view to improve revenues. In light of the increasing

informalisation of the economy, government introduced presumptive tax to cater for business

that do not keep proper books of accounts such as informal and cross border traders, transport

operators, hair dressing saloon operators and small scale miners.

Government also introduced the Large Client Office in 2010 aimed at providing a one-stop-

shop service to large clients in the administration of Income Tax, Pay As You Earn (PAYE)

and Value Added Tax (VAT). In the same year, the GoZ also introduced VAT fiscalisation

process for operators with a certain threshold. This involved the configuration of fiscal

devices to enable them to record sales and other tax information on the read-only fiscal

memory at the time of sale for use by the tax authorities in Value Added Tax (VAT)

administration.

Expenditure PerformanceGovernment expenditures have been elevated, averaging about 36% of GDP between 1980

and 2014. Recurrent expenditure has dominated Government spending since 1980, with

expenditure on social spending and employee compensation accounting for an average of

80% of total expenditure. The huge recurrent expenditures crowded out productive capital

expenditures such as spending on infrastructure. Figure 2 below shows the composition of

government expenditure since 1980.

8

Figure 2: Composition of Government Expenditure: 1980-2014

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

20122014

- 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

Capital Expenditure Net Lending Recurrent Expenditure

Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)

Salaries and wages have been the largest single expenditure head since 1980. The wage bill

increased from around 39% of total expenditures in 1980 to about 70% in 2014. Figure 3

below shows the proportion of employee compensation to recurrent expenditure.

Figure 3: Employee compensation versus other Government expenses

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

20122014

-

0.20

0.40

0.60

0.80

1.00

Salaries and Wages Other Expenses

Source: Ministry of Finance and Economic Development, Zimbabwe, (Various Publications)

9

With government spending dominated by recurrent expenditures, capital expenditure received

low allocations, impacting negatively on infrastructure development over the years.

Government expenditure performance has also been affected by expenditure overruns by

respective line Ministries. With a view to control expenditure overruns, Government set up

the Implementation and Control of Expenditure Unit which validates expenditure requests

from line Ministries and also ensures that the ministries do not overshot their budgetary

allocations.

In 2009, Government adopted the cash budgeting system in a bid to foster fiscal discipline

among line Ministries. This went a long way in reigning in expenditures by line Ministries

and resulted in lower deficits. While adoption of multicurrency in 2009 improved revenue

collection, it did not alter Government’s spending pattern, as expenditure remained tilted

towards employee compensation. Wages and salaries have remained the most dominant

component of expenditure from 2009 to 2014.

Fiscal and Monetary Policy Interaction in Zimbabwe

The GoZ’s fiscal deficits reached peaks of 20% and 22%, of GDP in 1998 and 2000,

respectively. The deficits were difficult to address since the main expenditure head was in the

form of salaries and wages. During the 1980s and 1990s the budget deficit was financed

through both domestic and external sources. As a result, the country contracted huge

domestic and external debt. Government faced challenges in meeting external debt

obligations since 1999, resulting in the country accumulating external payment arrears.

Faced with huge budget deficits and limited financing options, the GoZ made recourse to the

monetisation of fiscal deficits. The excessive recourse to bank finance by the fiscus fuelled

money supply growth, which led to an upsurge in inflation. The recourse to central bank

financing impaired the smooth functioning of monetary policy, with the central bank

recording significant losses as a result of financing fiscal deficits. Kovanen (2004) and

Kramarenko (2010) found the prevalence of fiscal dominance in Zimbabwe prior to 2008.

Munoz (2007) highlighted that as a result of money printing central government losses

reached 75% of GDP in 2006. The negative impact of the fiscal deficits on monetary policy

were more evident during the period 2000 to 2008, when inflation reached a peak of 231

million per cent in July 2008.

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The GoZ’s failure to service its external debt led to the accumulation of external payment

arrears, which were estimated at 86% of public and publicly guaranteed debt in 2012. The

perceived unsustainability of fiscal policy and debt could have had a negative impact on the

credibility and confidence in monetary policy and the overall policy mix. In 2007 and 2008,

the lack of confidence in monetary policy manifested itself through unofficial dollarisation

and the emergence of a parallel market for foreign exchange which affected the efficiency of

monetary policy. The lack of confidence in monetary policy also negatively impacted on

financial stability.

The adoption of the multicurrency system in 2009 subordinated the role of monetary policy to

fiscal policy. Under the multicurrency regime GoZ can no longer seek recourse to central

bank financing. This effectively means that the government has to finance its deficits by

borrowing from other financial institutions other that the central bank and from non-bank

domestic sectors.

Since 2009, Government has been pursuing cash budgeting in a bid to nurture fiscal

discipline. Cash budgeting was critical for fiscal consolidation between 2009 and 2011, when

the economy was recovering at a fast pace. The cash budget system, however, exhibited

greater vulnerabilities as the economy slowed down in 2012. Reflecting the slowdown in the

economy, the GoZ increased borrowing to finance fiscal expenditure overruns.

The limited fiscal space that characterised the study period forced Government to seek

alternative sources of finance such as issuance of TBs to finance deficits. The issuance of

TBs impacts on monetary policy variables such as interest rates. In this regard, there is need

for close coordination between fiscal and monetary authorities to ensure that fiscal deficits

are financed on a sustainable basis.

3. LITERATURE REVIEW

Theoretical Literature Fiscal and monetary policies are the traditional tools used by governments to achieve

macroeconomic stability. Fiscal policy refers to the control of government revenue

collections and expenditures to influence economic activity. Monetary policy on the other

11

hand refers to the control of money supply or interest rates by the central bank to achieve

stated macroeconomic objectives. Monetary and fiscal policy are implemented by two

different bodies and, therefore, coordination of the policies is required.

A change in either fiscal or monetary policy will influence the effectiveness of the other,

thereby, affecting overall policy direction. Fiscal policy affects the conduct of monetary

policy through several channels, notably interest rates and exchange rates. Under fiscal

dominance, for example, fiscal policy sets the general environment in which the central bank

conducts monetary policy. Fiscal dominance implies that even when the central bank is

independent, monetary policy can be severely limited by the stance of fiscal policy.

Sargent and Wallace (1981) focused on the impact of fiscal indiscipline on monetary policy.

They argued that monetary policy and price level stop being exogenous when the fiscal

deficit is predetermined and unsustainable. In this regard, fiscal sustainability is a

precondition for monetary stability. The authors also introduced the concept of fiscal

dominance, a scenario in which an extreme case of fiscal indiscipline has significant negative

implications for monetary policy. In a broad sense, fiscal dominance occurs when it is the

fiscal authorities who determine the extent to which budget deficits are financed through

bond issuance and seignorage. In the face of fiscal dominance monetary authorities lose their

ability to control inflation, whenever the real interest rate exceeds the growth rate of the

economy (Sargent and Wallace 1981).

Leeper (1991); Sims (1994); and Woodford (1994) popularized the ‘Fiscal Theory of the

Price Level’ which emphasizes the role of fiscal policy in macroeconomic stabilisation.

According to the Fiscal Theory of the Price Level, government’s inter-temporal budget

constraint is important in the determination of the price level. The theory posits that there is a

set of unique prices that tend to equate the present value of future budget surpluses with the

current stock of government debt. Leeper (1991) categorized policies into “active” and

“passive” policies. Passive policies are also known as Ricardian fiscal policy, which ensures

the satisfaction of the government’s intertemporal budget constraint. An active monetary

policy is the one that pursues its inflation target notwithstanding the Government's financial

position, but passive monetary policy accommodates fiscal policy.

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Davig and Leeper (2009) argued that monetary and fiscal policies fluctuate between active

and passive behavior. Lack of fiscal discipline results in increases in debt and inflation.

Under such a case, even if the central bank raises interest rates aggressively, it is not able to

reduce aggregate demand and inflation.

The “perverse effect of fiscal policy” (Beetsma and Bovenberg, 1999) is another theoretical

strand on the interaction and coordination of monetary and fiscal policy. Beetsma and

Bovenberg (1999) assert that a more anti-inflationary oriented central bank has a perverse

effect on the incentive of the fiscal authorities to reduce the level of debt.

The other strand of literature on monetary and fiscal policy coordination focuses on the

distortions that may emerge on the conduct of monetary and fiscal policy based on either

rules or discretionary policy. Beetsma and Uhlig, (1999) found that a distortionary fiscal

policy causes blockage between the natural and actual output forcing the monetary authority

that would otherwise want to stabilize output around the natural level, to resort to inconsistent

policies that can be inflationary. Dixit and Lambertini (2003) tested the relation between the

monetary and fiscal policy and showed that fiscal policy authorities who have discretionary

powers can undermine monetary policy authorities by running own policy based on rules.

This, constrains the use of monetary commitment and monetary policy based on rules.

Buti et al. (2001) posited that the relationship between monetary and fiscal policy depends on

the type of shock which the economy is facing. Coordination is particularly desirable in

cases when the economy is faced with shocks on the supply side, while the opposite is true

for shocks occurring on the demand side.

Hilbers (2004), also states that there are direct and indirect channels in which fiscal policy

may influence monetary policy. For instance, if a country is running an expansionary fiscal

policy, which usually results in deficits, there are two possibilities which the government may

resort to, in order to carter for its deficits. First, government can finance the deficit through

money printing or borrowing from the market. In many instances the government may

resolve to finance the deficit through the printing of money which implies monetary policy

expansion. Expansion in monetary policy results in inflationary pressures in an economy

which may lead to a devaluation of a nation’s currency, balance of payments challenges as

well as a banking crisis.

13

Second, Government may resort to finance the deficits through the domestic banking market,

thus affecting the monetary policy’s credit transmission channel. High budget deficits are

often associated with the crowding out of the private sector in the money market, as fiscal

authorities finance budget deficits by borrowing from the banking sector. This results in an

increase in lending rates as demand for credit outstrips supply. As the cost of credit increases,

so does the cost of production and the general price level (Hilbers, 2004). In addition, fiscal

measures, such as introducing or changing a consumption tax or value added tax, have a

direct effect on inflation. A once off rise in indirect taxes may put pressure on prices and this

could lead to a price-wage spiral which could trigger adverse inflationary expectations and

eventually lead to high inflation. Furthermore, perceptions or expectations about government

activities, may have an indirect impact on monetary policy. Expectations that the government

may struggle to sustain its financial position may constrain the potency of monetary policy.

Perceptions and expectations of large and on-going budget deficits and resultant huge

borrowing requirements may also trigger a lack of confidence in the economic prospects of a

country. This may become a risk to stability in financial markets. Such lack of confidence in

the sustainability of the financial position of the government may become a potential

destabilising factor on bond and foreign exchange markets, eventually leading to the collapse

of the monetary regime, (Hilbers, 2004).

Empirical Literature

Several studies have been done on the interaction of between monetary and fiscal policy,

particularly in the aftermath of the Global Financial Crisis. Most of the studies, for example,

Sehovic (2014), Lanmann (2014), Schroth (2013), Mortensen (2013) and Galí and Monacelli

(2008), have focused mainly on the coordination of fiscal and monetary policy in the

European Monetary Union (EMU).

Tomšík (2012) ascertained that fiscal policy has an impact on the monetary policy’s interest

rate channel as noted in the case of the Czech Republic, whose government bond yields have

a significant impact on long-term interest rates. When government bond yields rise, the risk

of a sovereign debt crisis increases, leading to an escalation in long-term lending rates. This

relationship, however, was weakened by the Global Financial Crisis, especially when it came

14

to credit advances to large corporations and deposits. Dunn et al. (2011) investigated the

monetary policy transmission mechanism in Pacific Island Countries (PICs) and found that

lower fiscal deficits, coupled with lower public debt are correlated with lower average

inflation and higher output growth. Furthermore, lower inflation was related to lower interest

rates and lower costs of production.

Rukelj (2010) examined the interactions of fiscal policy, monetary policy and economic

activity in Croatia using monthly data for the period 1997 to 2008. The researcher used a

structural Vector Error Correction Model (VECM) to identify permanent and transitory

shocks on government expenditures, money aggregate M1 and the index of economic

activity. The main conclusion made was that fiscal and monetary policy move in the opposite

direction, which indicates that they can be used as substitutes.

Deskar-Škrbić and Šimović (2013), employed a structural Vector Autoregressive (VAR)

model to analyse the dynamic effects of discretionary fiscal shocks on economic activity of

the private sector in Croatia from 2000Q1-2012Q2. They showed that government spending

had a positive and statistically significant effect on private aggregate demand and private

consumption which affects inflation and therefore, the conduct of monetary policy.

There are, however, few studies on the coordination of fiscal and monetary policy in Africa

and even developing countries in general. Nyamongo et al. (2008) studied the monetary-fiscal

policy interactions in Kenya for the period 1979 to 2007 and concluded that the fiscal and

monetary policies were coordinated on a number of years but there were also several years

with no evidence of coordination between the two policies. The study also shows a greater

degree of monetary policy dominance in Kenya using a non-structural VAR analysis. The

study also estimated the output gap as a way to gauge the cyclical behaviour of both the fiscal

and monetary policies and it was observed that fiscal and monetary policy displayed both

procyclical and countercyclical behaviour.

Frankel et al. (2008) showed that South Africa’s fiscal policy had been predominantly

procyclical, while monetary policy had been mildly countercyclical. They concluded that

fiscal policy should be made more countercyclical to ensure macroeconomic stability.

Swanepoel (2004) found that monetary policy had been mainly anti-cyclical in South Africa

but highlighted the challenge of coordination between fiscal and monetary policy in the

15

country. The results were also confirmed by Du Plessis et al. (2007) using a structural vector-

autoregression approach to assess the cyclicality of fiscal and monetary policy in South

Africa since 1994. The study concluded that monetary policy had contributed markedly to the

stabilisation of the South African economy. Specifically, Du Plessis et al. (2007) concluded

that monetary policy had been largely countercyclical since 1994, while fiscal policy had

been largely pro-cyclical.

Chukwu (2010) examined the monetary and fiscal policy interactions in Nigeria using

quarterly data between 1970 and 2008. The interactions of monetary and fiscal policy was

analysed using both VAR model and State-space with Markov-switching. Using a VAR

model, Chukwu (2010) simulated generalised impulse responses and observed that

there is evidence of a non-Ricardian fiscal policy in Nigeria. As a step further, the study

applied a State-space model with Markov-switching to estimate the time-varying parameters

of the relationship between monetary and fiscal policies. The State-space model showed that

monetary and fiscal policies in Nigeria have interacted in a counteractive manner for most of

the sample period (1980-1994). The study also observed some of form of accommodativeness

of monetary policy between 1998 and 2008. Overall, Chukwu (2010) found the existence of

fiscal dominance in Nigeria, implying that inflation, predominantly results from fiscal

problems, and not from lack of monetary control.

Obinyeluaku and Viegi (2009) examined the relationship between fiscal balances and

monetary stability in ten SADC countries based on the dynamic response of inflation to

different shocks. The study showed evidence of fiscal dominance in five out of ten countries

throughout the period 1980-2006, while the remainder revealed monetary dominance.

Crucially, the study also observed that fiscal policy affects price variability through aggregate

demand. The main conclusion from the study was that fiscal policy matters for achieving and

maintaining price stability in the SADC region.

There are also few studies on the interaction of fiscal and monetary policy in Zimbabwe.

Munoz (2007) highlighted that high government fiscal deficits led to increased central bank

quasi-fiscal losses which interfered with monetary management from 2003 to 2007. Munoz

(2007) estimated the quasi-fiscal losses at about 75 percent of GDP in 2006. The deficits

were financed by money creation or the issuance of RBZ securities, resulting in high

inflation.

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Makochekanwa (2008) argued that the relatively high fiscal deficit experienced by Zimbabwe

was the root cause of the high inflationary environment in the years 2005 to 2008. The study

found a causal link running from budget deficit to the inflation rate using Johansen co-

integration technique over the period 1980 to 2005. Makochekanwa (2008) concluded that

the monetization of budget deficits led to hyperinflation.

Easterly and Schmidt-Hebbel (1993) also studied the relationship between fiscal deficits,

inflation and interest rates for developing countries including Zimbabwe for the period 1978

to 1989. For Zimbabwe, the authors concluded that a percentage point increase in the deficit

to GDP financed through money creation increased inflation by 10 percent. Despite

Zimbabwe maintaining interest rates control in the 1980s, Easterly and Schmidt-Hebbel

(1993) found that a percentage point increase in the deficit to GDP financed through domestic

financing increased interest rates by 2.7% through simulations. This implied a negative

impact on the operation of monetary policy.

Kramarenko (2010), and Kovanen (2004) found evidence of fiscal dominance in Zimbabwe,

particularly in the 2000s. They argued that the high fiscal deficits experienced by the country

since 2000 impacted negatively on the economy, including impeding the normal functioning

of monetary policy.

17

4. METHODOLOGY

4.1 Model Specification

A review of empirical literature on African countries shows that most studies used variants of

Vector Autoregression (VAR) to examine effects of fiscal policy on the conduct and

transmission mechanisms of monetary policy (Chukwu, 2010; Nyamongo et al. 2008; and

Du Plessis et al. 2007).

In light of the above, this study applies an Unrestricted Vector Autoregression model to

assess the effects of fiscal policy on the monetary policy transmission mechanism in

Zimbabwe. The VAR model is specified, following Sims (1980) and expressed as follows:

Y t=c+ A1 Y t−1+……… Ap Y t−p+μt (1)

Where Y t is a vector of endogenous variables with linear dynamics, A1 …… A p is a vector of

autoregressive coefficients and μt is an n-dimensional Gaussian white noise with covariance

matrix. E (μt1 μ t )=φ, c=(c1 ….cn) is an n– dimensional vector of constants. To keep the

model parsimonious, five variables, namely fiscal deficit, money supply, interest rates,

inflation and index of economic activity are simulated to assess their response to a fiscal

deficit shock. Precisely the model is described as follows:

[M t

Gt

Y t

Rt

I t

]=[C 1

C 2

C 3

C 4

C 5

]+[0 b11 c11 d11 e11

a21 0 c21 d21 e21

a31 b31 0 d31 e31

a41 b41 c41 0 e41

a51 b51 c51 d51 0]∗[

M t

Gt

Y t

Rt

I t

]+…+[a1 p b1 p c1 p d1 p e1 p

a2 p b2 p c2 p d2 p e2 p




]∗[Mt−p

Gt−p

Y t−p

Rt−p

I t−p

]+[ε1 ,t

ε2 ,t

ε3 ,t

ε4 , t

ε5 ,t

]where: Mt is represents money supply, Gt, budget deficit, Yt, economic activity, Rt interest

rates and It, inflation.

The VAR model isolates purely exogenous shocks and gets the responses of the endogenous

variables after the economy is hit by these shocks. Getting the structural model is also called

18

identification. According to Sims (1980), identification is the interpretation of historically

observed variation in data in a way that allows the variation to be used to predict the

consequences of an action not yet undertaken. The VAR, therefore, allows for identification

of shocks to a variable, which are then used to assess the impulse response of other variables

from the identified shock.

The impact of fiscal policy is represented by a shock to fiscal deficit, while that of monetary

policy is represented by a shock to money supply and interest rates. In the case of a dollarized

economy like Zimbabwe, where the country does not have monetary control, a significant

foreign capital inflow or outflow not related to the national output, which increases money in

the system, can be taken as a typical example of a monetary policy shock.

4.2 Data and Estimation Method

The analysis is conducted using monthly seasonally adjusted data for the fiscal deficit,

consumer price index, money supply, interest rates and a proxy for economic activity for the

period 2009 to 2012. The VAR requires all variables to be either stationary or cointegrated to

ensure unbiased coefficients. As such, the unit root tests and Johansen cointegration tests are

conducted to test for stationarity of variables as well as the cointegrating properties of the

data. The lag length also matters and is determined using both the Akaike information

criterion (AIC) and Final Prediction Error (FPE).

The variables used were obtained from Ministry of Finance and Economic Development and

Reserve Bank of Zimbabwe. To enable the interpretation of estimated coefficients as

elasticity variables were expressed in logarithms. The analysis was only limited to the multi-

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currency era to avoid bias in estimated coefficients emanating from distortions caused by the

transition from hyperinflation to the multi-currency regime.

5. EMPIRICAL RESULTS

5.1 Unit Root Tests

As a preliminary analysis, the statistical properties of the data were assessed using unit root

tests and Johansen cointegration tests. The number of lags was automatically selected by the

Akaike Information Criterion (AIC) and Final Prediction Error (FPE). The unit root test

results obtained from Augmented Dickey Fuller tests are shown in Table 1 below.

Table 1: Unit root tests

Variable Level First Difference

Economic activity -5.376***

(0.000)

-6.5496***

(0.000)

Money supply -3.1562**

(0.0267)

-9.3339***

(0.000)

Inflation -0.6489

(0.8523)

-6.4464***

(0.000)

Interest rate -3.8716***

(0.0037)

-5.4761***

(0.000)

Budget deficit -8.9793***

(0.000)

-9.9827***

(0.0001)

Source: Researcher’s own Computations

The unit root test results in Table 1 above shows that economic activity, money supply

interest rate, and budget deficit variables are stationary in their levels, while inflation,

measured by consumer price index is only stationary after first differencing. The appropriate

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lag length was determined to be 6 using both the AIC and FPE approaches. Table 2 below

shows the results from lag length tests.

Table 2: Determination of appropriate lag length

Lag LogL LR FPE AIC

1 684.5354 NA 2.80e-16 -21.624112 720.3050 59.81140 1.99e-16 -21.977213 748.2863 42.20139 1.87e-16 -22.074964 770.9199 30.42548 2.18e-16 -21.997375 813.2494 49.96269* 1.41e-16 -22.565556 845.4358 32.71406 1.37e-16* -22.80117*


Note: * indicates lag order selected by the criterion, LR: sequential modified LR test statistic (each test at 5% level), FPE: Final prediction error, AIC: Akaike information criterion, SC: Schwarz information criterion, HQ: Hannan-Quinn information criterion

5.2 Impulse Responses

The impulse response functions and variance decompositions for the length of 24 periods for

all three cases were considered and the response of individual variables to the identified fiscal

policy shocks in all three cases are presented in Figure 4 below.

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Figure 4: Impulse response functions


The results in Figure 4 above suggest that the nominal interest rates respond positively to a

fiscal deficit shock. Specifically the results indicate that a 1% fiscal deficit shock leads to a

0.02% increase in nominal interest’s rates over a period of four months, with the impact

disappearing after 10 months. In addition, output increases in the short term, following a

fiscal deficit shock. The results, therefore, suggests that a shock in government budget deficit

has a transitory positive impact on interest rates and output. The inflation rate and money

supply are, however, not responsive to a fiscal deficit shock.

The results confirm the assertion that in dollarized economies, inflation developments mainly

mirror that of a country whose currency is being used. As such, domestic policy becomes

ineffective in influencing inflation developments. Fiscal policy affects interest rates through

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the crowding out effect. The positive response of interest rates to a budget deficit shock is

expected since government has in most cases been financing the mismatches in its revenues

and expenditure through the issuance of Treasury bills. Money supply in a dollarized

economy is mainly affected by changes in capital flows, implying that fiscal policy affects

money supply in cases where government borrows externally. External borrowing by the

Government was, however, limited during the period under review due to outstanding arrears

to external creditors. As a result, the insignificant impact of fiscal policy on money supply

was expected.

5.3 Variance Decomposition Results

The forecast error variance decomposition was applied to assess the relative importance of

individual shocks in explaining forecast error variances of the observed variables.

Specifically, the variance decomposition analysed are the decomposition of interest rates,

inflation, money supply and economic activity to a fiscal deficit shock. The results are shown

in Tables 5-8 below.

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Table 3: Variance Decomposition of Interest Rates

Period S.E. Deficit Interest Inflation Money Supply Output

1 0.185674 0.050148 99.94985 0.000000 0.000000 0.000000 2 0.197201 1.733573 81.18590 4.637394 12.00760 0.435534 3 0.202708 8.883989 64.32536 7.646598 17.60983 1.534220 4 0.203312 14.10107 55.68852 8.157283 19.06936 2.983768 5 0.203724 17.93303 51.21738 7.851259 19.38546 3.612869 6 0.203766 19.84094 49.21157 7.604188 19.73783 3.605467 7 0.203835 20.68622 48.16467 7.453526 20.16426 3.531327 8 0.203858 20.95296 47.59824 7.369404 20.58465 3.494740 9 0.203879 21.00515 47.26249 7.318508 20.93946 3.474392 10 0.203893 20.98315 47.05654 7.286137 21.21397 3.460205 11 0.203904 20.94364 46.92165 7.263823 21.42128 3.449604 12 0.203912 20.90354 46.82815 7.247699 21.57893 3.441669


The variance decomposition of interest rates in the Table 5 above suggests that about 21.6

percent of the variation in interest rates is explained by money supply, while 20.9 percent is

explained by budget deficit. The interest rate variable itself explain a greater proportion of the

variation, accounting for 46.8 percent. Inflation and output explains 7.2% and 3.4% of

variation in interest rates respectively.

The variance decomposition of inflation suggests that about 93.5 percent of the variable is

explained by the inflation variable itself as shown in Table 6 below. This suggests that

inflation persistence has mainly been due to inflation expectations, with fiscal and monetary

policy playing a limited role in explaining the inflation dynamics under a multiple currency

regime.

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Table 4: Variance Decomposition of Inflation


The budget deficit only explains a paltry 1.2 percent of the variation in inflation, while

interest rates and money supply explain only 4.1 percent and 0.13 percent. The results

suggest that inflation under the multiple currency regime has predominantly been influenced

by other factors besides fiscal and monetary policy variables.

The variance decomposition of money supply suggests that the budget deficit only explained

0.37 percent of the variation in money supply, while inflation and interest rates explained

14.8 percent and 13.6 percent respectively. Money supply variable itself explain about 70.9

percent of the forecast error variation. The variance decomposition are shown in Table 7

below.

25

Table 5: Variance decomposition of money supply


Table 8 below shows the variance decomposition of output. It shows that about 22.6 percent

of the variation in economic activity is explained by fiscal variable, 17.3 percent by inflation

and 53.1 percent by the economic activity variable itself.

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Table 6: Variance decomposition of output


6. CONCLUSION AND POLICY RECOMMENDATIONS

This paper attempted to assess the effects of fiscal policy on monetary policy transmission

mechanism in Zimbabwe. Zimbabwe makes an interesting case to study, given its limited

capacity to influence policy through monetary policy following the adoption of the multi-

currency regime. The VAR model was applied to assess the response of relevant monetary

policy variables, notably, interest rates and money supply to fiscal policy shocks.

The effects of fiscal policy shocks on monetary policy variables were examined using

impulse response functions and variance decompositions. The results from the impulse

response functions suggest that the effects of fiscal policy shocks on money supply and

interest rates is positive.

The variance decomposition of monetary policy variables suggest that fiscal policy has to a

lesser extent influenced interest rates and money supply under the multicurrency regime.

27

Specifically the impact on money supply has been largely insignificant. The results are

consistent with most empirical findings which suggest that in a dollarised economy, money

supply becomes highly endogenous. The results also suggest that inflation dynamics have

largely been influenced by inflation persistence and other factors besides fiscal and monetary

policy variables. The large proportion of the variation in economic activity explained by

fiscal policy shock, suggests that fiscal policy has been instrumental in influencing economic

activity under the multiple currency environment.

The results suggest the need for Government to properly sequence its Treasury Bill issuance

to avoid volatility on monetary conditions, explained by changes in real interest rates and real

effective exchange rate, through the crowding out effect. Moreover the need for coordination

between monetary and fiscal policy remains highly critical. Given the dominance of fiscal

policy under the multicurrency regime, it is imperative that the government effectively

implements its fiscal policy to impact positively on the economy. Future work on this topic

could give a more precise definition of fiscal and monetary policy shocks. Moreover, a more

sophisticated model is needed with additional variables, including the real effective exchange

rate and government revenues to assess the implications of fiscal policy on the monetary

policy transmission mechanism.

28

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