Do monetary policy outcomes promote stability in fragile settings?

ABSTRACT

This paper assesses how monetary policy outcomes affect fragility. Diving into the universe of the most prominent combinations of pursued monetary policy objectives across fragile settings, we examine the relationships between monetary policy and fragility, and find the combination of reduction of inflation and lower unemployment to be the one that delivers the highest payoff in terms of promoting peace and cohesion. Setting aside the challenges of monetary policy transmission, results from our analysis broadly confirm the above ‘winning’ combination, with low inflation as a primary desired outcome and low unemployment rate as a secondary one. We also carry out a series of robustness tests, which confirm our findings. Overall, our results lend credence to the importance of paying attention – in the context of reducing fragility – to monetary policy outcomes.

KEYWORDS:

• Fragile states
• monetary policy
• objectives
• inflation
• employment

JEL CLASSIFICATION:

• E52
• F51
• F63

Acknowledgment

We would like to thank, without implicating, Bas Bakker, Aliona Cebotari, Pedro Conceicao, Miniva Chibuye, Jose Gijon, Kangni Kpodar, Amine Mati, Montfort Mlachila, Abdoulaye Seck, Raju Singh, Katrien Smuts, Filiz Unsal, Harold Zavarcefor and four anonymous referees for their useful comments on earlier versions of the paper. This research is part of a Macroeconomic Research in Low-Income Countries project (Project id: 60925) supported by the UK’s Foreign, Commonwealth and Development Office (FCDO). The views expressed in this paper are those of the authors and do not necessarily represent those of the United Nations, World Bank and the IMF.

Supplemental data

Supplemental data for this article can be accessed online at https://doi.org/10.1080/00036846.2023.2168612.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ Practitioners have emphasized the importance of fiscal discipline as a precondition to restore macroeconomic stability.

² One option, which we will not look into because it is so recent, is for a country to adopt virtual (crypto-) currencies as a legal tender, like El Salvador did recently, which may affect the monetary policy of the country (See also Náñez Alonso et al. 2021 for some of the risks of adopting crypto currencies, such as their huge energy consumption).

³ (Echarte-Fernández and Martínez-Hernández 2018; Edy-Ewoh and Binuyo 2019), and (Padilla 2022) for interesting simulations on how adoption of dollarization in the Latin American or African context could play out).

⁴ A look at history suggests that having an independent central bank focused on containing inflation is a recent phenomenon (e.Epstein 2005). In the past, they supported growth through direct intervention and often financed the state.

⁵ Financial stability is another important objective in the fragile environment (see Addison et al. 2001).

⁶ How does monetary transmission mechanism work in practice in fragile settings? The standard economic literature distinguishes between interest rate, exchange rate and asset price channels when analysing the impact of monetary policy (Mishkin, 1996). Let’s look at each in turn. The interest rate channel is less effective in fragile countries, due to the weakness of the elasticity of investment and consumption to interest rates. The wealth effect channel is also constrained, as ownership of capital is typically concentrated on a small share of the population, who do not necessarily change their consumption levels when their wealth changes (see Poterba, 2000). Even if individuals can buy stocks and properties, the high transaction costs often preclude the purchase/sale of assets to take advantage of the wealth effect. The exchange rate channel, which operates through aggregate demand and aggregate supply effects, is typically weak in fragile settings. In theory, reducing domestic interest rate causes an outflow of capital. This, under floating exchange rate regime, cutting interest rates causes a depreciation of domestic currency and a rise in net exports and output. In a country with a fully flexible exchange rate, this transmission of monetary impulses to the real economy is highest. However, in fragile environments, one has some form of fixed exchange rate regime (dollarized, currency board or fixed peg), negating the benefits of the effect. A look at the production mix of most fragile settings – specialization in some agricultural production or mining – suggests exports are inelastic. Related to that, exports are typically priced in Euros or dollars, even in countries with floating exchange rates, implying limited path-through of exchange rate fluctuations on growth. On the import side, in most fragile environments, one obtains basic commodities, from food to fuel, from abroad, and hence are unable to reduce consumption by much in case of devaluation (see Imam, 2008). Aggregate supply tends to be inelastic in fragile countries. To summarize, the monetary transmission mechanism is typically weak in fragile settings.

⁷ This is a way to recognize that monetary policy outcomes alone do not explain the state or ability to reduce fragility.

⁸ It is possible that governance and institutional quality indicators or structural reforms directly drives fragility. However, this paper takes the stance of an indirect impact of these categories of variables on real sector variables that are used in the analyses.

⁹ Drazanova, Lenka, 2019, ‘Historical Index of Ethnic Fractionalization Dataset (HIEF)’, https://doi.org/10.7910/DVN/4JQRCL, Harvard Database (Accessed on December 18, 2020)..

¹⁰ Due to data coverage, we do not include an economic inequality variable that could have been proxied by the GINI index. Collier and Hoeffler (2004a) suggest, however, that low income could also be considered as an economic grievance.

¹¹ Unemployment estimation is based on the following definition: ‘The standard definition of unemployed persons is those individuals without work, seeking work in a recent past period, and currently available for work, including people who have lost their jobs or who have voluntarily left work. Persons who did not look for work but have an arrangement for a future job are also counted as unemployed. Some unemployment is unavoidable. At any time, some workers are temporarily unemployed between jobs as employers look for the right workers and workers search for better jobs. It is the labour force or the economically active portion of the population that serves as the base for this indicator, not the total population’. – Source: World Bank WDI database.

¹² In addition, exchange rate volatility is based on the volatility of average monthly exchange rate data of the local currencies against the US Dollar, instead of daily values.

¹³ We report results for the ‘best’ performing IV estimation of each model. Results from fixed-effects and random effects models are considered.

¹⁴ Building on the empirical work of Hansen (1999), we wanted to check if there is inflation threshold level beyond which the nature of correlation between price stability and fragility changes but could because of data limitations.

¹⁵ This is confirmed by the time series of global average of MEV, which we computed. This series clearly shows a change in the trend in 1992.

¹⁶ The introduction of grievance variables decreases significantly the number observations for the period 1980–1992, thus making robust statistical inference – based on grievance and merged models – impossible.

¹⁷ Following Angrist and Krueger (2001), the use of lagged variables as instrumental variables could be problematic if the omitted variables or residual are serially correlated because it would yield biased estimated coefficient. It could be an avenue to improve our current findings.

Additional information

Funding

The work was supported by the Foreign, Commonwealth and Development Office (FCDO) [60925].