Institutional quality and cyclicality of monetary and fiscal policies in SAARC countries

Muhammad Nawaz,Amana Ali,Muhammad Mazhar Iqbal

doi:10.24193/tras.55e.3

Abstract

Theoretically, government intervention in an economy should be counter-cyclical; however, practically, it has not been so in many countries, particularly in developing ones. To explain this gap between theory and practice, recent researchers have identified institutional quality as an influential factor, though their results might be susceptible to certain econometric biases. In this study, taking care of possible reasons for econometric biases, the impact of institutional quality on the cyclicality of macroeconomic policies in selected SAARC countries has been scrutinized by utilizing annual data for 1984-2015 and applying four different estimation methods. The findings of this research confirm previous results that institutional quality does matter for the cyclicality or counter-cyclicality of policy interventions. Its impact is more vivid in the case of monetary policy as the threshold level for monetary policy is less than that for fiscal policy. This result implies that the reform agenda to make policy intervention strictly counter-cyclical should include institutional factors as well.

Highlights

According to classical economists, the price mechanism is self-correcting; it takes care of external and behavioral shocks to economic equilibrium in an economy
The sign, size and significance across the different econometric technique such as Generated Method of Moments (GMM)-IV Pooled OLS, Fixed Effect[4] and Generalized Least Square (GLS) have been similar, strongly arguing that estimated models present the better prediction of cyclicality of monetary and fiscal policies in the selected SAARC countries
Rate but has been insignificant in GMM, Pooled OLS and the Fixed Effect model while significant for the generalized least square (GLS) technique; the exchange rate has been robust across different techniques and clearly shows that central banks of all these SAARC countries are relying on managing the exchange rate polices/shocks (Calderon, Duncan and Schmidt-Hebbel, 2010)

Summary

Introduction

The price mechanism is self-correcting; it takes care of external and behavioral shocks to economic equilibrium in an economy. Keynes (1936) took up the challenge and endorsed the classical view that the market mechanism works well but drew attention on its rather slow working; after a shock, the restoration of equilibrium may take a long time during which people suffer economic hardships. To accelerate adjustment processes Keynes (1936) suggested that the best mechanism would be the counter-cyclical government intervention in the private economy (Morgan, 1978). Over time, the stance of policy intervention changed from counter-cyclical to pro-cyclical in many countries due to political and economic reasons. Policy makers usually follow the policy of benign neglect in favor of expansionary policy; they keep on postponing contractionary policies unless they are badly needed (Branson, 1997; Gordon, 2006)

Objectives

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Conclusion