Fiscal and monetary policies and the cost of sudden stops

Abstract

This article investigates the effects of macroeconomic policy (monetary and fiscal) on output growth during financial crises characterized by a "sudden stop" in net capital inflows in developing and emerging market economies. We investigate 83 sudden stop crises in 77 countries over 1982-2003 using a baseline empirical model to control for the various determinants of output losses during sudden stop crises. Extending the baseline model to account for policies--contractionary as well as expansionary--we measure the marginal effects of policy on output losses. Simple descriptive statistics indicate no apparent correlation between the costs of financial crises and the economic policies pursed at the time. Once controlling for various pre-conditions and other factors, however, we find that monetary and fiscal tightening at the time of a sudden stop crisis significantly worsens output losses. JEL: E52, E62, F32, F43, O16

Monetary and Fiscal Responses during the Financial Crisis in the Developing and Emerging Economies

“…I follow the methodology by Jie (2013) and Hutchison at al., (2010), who investigates the effect of monetary and fiscal policy on output cost. The benchmark model of output cost or output-loss includes important control variables in the regression in order to measure marginal effect of macroeconomics variables and avoiding omitted-variables bias.…”

“…As the budget-balance can move with the same path with rate of economic growth, I have to decompose budget-balance into their structural and cyclical component in order to assess discretionary fiscal measure during financial crisis. I employ standard method used by Blanchard, (1990), Jie (2013) and Hutchison at al., (2010), in order to take out both trend and cyclical component from budget-balance. The discretionary fiscal policy I calculate from the residual of each country based on the following equation.…”

“…The last 28 observation represents contractionary fiscal policy and I denote in the same manner country/year with 1 fiscal contraction and 0 otherwise. This is standard measure of fiscal policy stance see more Blanchard, (1990), Jie (2013) and Hutchison at al., (2010).…”

Macroeconomic adjustment and the history of crises in open economies

“…15 Most research on banking crises focuses on event indicators, either taken from earlier versions of the Laeven and Valencia dataset we use or its earlier incarnations collected at the International Monetary Fund. 16 For discussion of various alternative measures of output loss associated in the context of financial crises see Hutchison et al (2010).…”

“…The average peak amount of non-performing loans is 28.6 (% of loans in banking sector balance sheets) while the crisis with the highest NPL was estimated at 90% - For our control variables, we rely on Hutchison et al (2010) that investigated the depth of other types of financial crises (in particular sudden stops in capital inflows), and Angkinand (2009) that focused on banking distress. Since the number of observations is limited to those banking crisis for which data is available, we only include variables for which we could find sufficient coverage.…”