Relative Effectiveness of Monetary And Fiscal Policies In Macroecomic Stabilization In A Developing And Post Conflict Economy: The Case Of Rwanda

Abstract

This study set out to determine the relative effectiveness of monetary and fiscal policies in macroeconomic stabilization with a focus on output and inflation in Rwanda as a developing and post-conflict economy. It aimed at identifying the relative effectiveness of both monetary and fiscal policy by comparing their effects in explaining changes in output; and the channels of transmission in a correctly specified VAR. This was motivated by the fact that variables like rainfall, aid, and war have an impact on economic activity in developing countries and should hence be included in models that explain the effects of monetary and fiscal policies on economic activity. Disregarding such factors, as has been the case in several studies would imply incorrect specification. This study contributes to the body of knowledge by including domestic exogenous variables (rainfall, foreign aid, war, and UN payments) when examining monetary and fiscal policies’ effect on economic activity. The sample data covers the period from the 1stquarter of 1996 to the 4th quarter of 2014. The findings show that unexpected changes in monetary policy affect domestic output growth and the price level. Money stock and bank credit to the private sector are the best channels of monetary policy transmission in Rwanda. The study also examined the channels of fiscal policy transmission, and test for the presence of the crowding out/in effect of government spending on private investment. The study findings are mixed. The structural VAR approach reveals that government spending negatively affects prices but does not affect real output. The recursive approach shows that both prices and output do not respond to shocks in government spending. In a different specification, where output is divided into its components, government spending is shown to affect private investment through a crowding in effect, but raises inflation. The study further investigates the relative contribution of monetary and fiscal policies to changes in nominal output, and possible interaction between these policies. The findings suggest that monetary policy is more effective than fiscal policy, and that there is interaction between both economic policies in Rwanda. Finally, two other specifications are examined, where foreign shocks are first controlled for, then both domestic and foreign shocks are ignored. The findings indicate an improvement in the results as monetary policy only influences output in the benchmark model. While the study suggests that policy makers should rely more on monetary than fiscal policy, the use of both policies has the potential to achieving higher levels of output within an environment of stable prices. This study has therefore made a significant contribution in the field of the monetary and fiscal policy transmission mechanism. The domestic exogenous variables are therefore relevant in the specification of the monetary and fiscal policy transmission mechanism. Given the Rwanda government objective of achieving an average growth rate of 11.5 percent up to 2020, it is suggested that more emphasis be placed on monetary policy than fiscal policy. However, given that government spending helps to explain private investment in the cost of rising inflation, careful coordination is required between monetary and fiscal policy in order to boost growth and control inflation. This would also help to avoid the joint inflationary effect of monetary and fiscal policies. Future studies on monetary/fiscal policy transmission mechanisms should include all relevant domestic variables within a Bayesian VAR, or panel framework in order to circumvent the issue of data limitations.