It takes two: Fiscal and monetary policy in Mexico

Summary

Focus

The intertwined channels of fiscal and monetary policy are a challenge for policymakers. By design, the fiscal authority and the central bank decide and implement each form of policy independently. But taking policy decisions without considering the other side can lead to policies that are in conflict with one another. It is thus important to understand how fiscal and monetary policy interact and the nature of the feedback between them.

Contribution

We propose a model of the Mexican economy to analyse the response of fiscal and monetary policy to shocks and qualify their effects through estimation. In our model, authorities set their policy instruments according to rules tied to specific targets. The central bank targets inflation while the fiscal authority targets debt or the deficit. Fiscal and monetary decisions each influence the other's target through regular channels, such as economic slack and the exchange rate. But one key difference from other models is that we explore the sovereign risk premium channel. The risk premium transmits global shocks and affects domestic financial conditions.

Findings

The sovereign risk premium plays an important role in how fiscal and monetary policy interact with each other. A rise in risk premium lowers output, raises inflation, depreciates the exchange rate and tightens domestic financial conditions. Monetary and fiscal policy can work together to offset these effects. The government scales back spending to reduce its borrowing requirements while the central bank raises the interest rate to curve currency depreciation and cap the growth in foreign debt. If both authorities respond forcefully enough, together they can reduce public debt and lower the risk premium.

Abstract

We model the interaction between fiscal and monetary policy and qualify their effects in a semi-structural small open economy model calibrated for Mexico. In our model, fiscal and monetary policy follow rules tied to specific targets. We estimate how fiscal policy, through deficits and public debt accumulation, and monetary policy, through the interest rate, directly affect the economy. We study the nature of the feedback between policy decisions and examine their indirect effects through the sovereign risk channel. We find that the response of monetary policy to stabilise the economy after a shock depends on how strict is the fiscal rule. A loose fiscal stance pushes a tighter monetary policy stance. Instead, the economy recovers faster when monetary and fiscal policy complement each other.

JEL classification: E52, E58, H5, H63.

Keywords: monetary policy, fiscal policy, sovereign risk premium, policy rules.