Fiscal and Monetary Policy Interactions Under Inflation Targeting in ASEAN-4

This study examines the interactions between fiscal and monetary policies and how they – jointly or individually – promote macroeconomic stabilization under inflation targeting in Indonesia and Thailand and under interest rate targeting in Malaysia. Using a non-recursive small open-economy structural vector autoregression model, this study investigates specifically the separate dynamic impacts – in terms of direction, size and duration – of monetary and fiscal policies on inflation, private consumption and debt sustainability. The model consists of two exogenous variables (world commodity price and foreign interest rate) and eight endogenous variables (tax ratio, government spending, output gap, inflation rate, debt ratio, policy interest rate, exchange rate, and private consumption) from 2002:Q1 to 2022:Q4.
The results of the study provide evidence of inflation-responsive monetary policy and fiscal policy in Indonesia. However, monetary policy tightening amid fiscal expansion may lead to inefficient outcomes given that central government spending shock is found to generate persistent inflation in Indonesia. Thailand monetary authority also responds to inflation shock albeit marginally. This marginal response might be attributed to monetary policy accommodating fiscal stimulus measures, including potential increases in debt levels. Auspiciously, the effect of central government spending shock on inflation remains subdued and short-lived in Malaysia and Thailand. Nonetheless, during periods of high inflation volatility, the Malaysian monetary authority keeps the policy interest rate steady, possibly to promote sustainable economic growth. In sum, there is a need for monetary and fiscal authorities to further strengthen their coordination in order to achieve their respective policy objectives. In particular, Indonesia and Thailand which have inflation-targeting central banks should continue to engage in forward- looking monetary policy rule in order to curb the impact of delayed and weakened monetary policy transmission.
The results suggest a potential of tax-related policies as tool for inflation management in Malaysia and Thailand. However, the fiscal authorities might hesitate to implement tax hikes for fear of dampening private spending. Surprisingly, private consumption increases only slightly in response to central government spending shocks in each of the ASEAN-3 economies. This puzzling result can be explained by the permanent income hypothesis and life cycle hypothesis which state that households respond only to changes in permanent income but largely ignore changes in transitory income. Thus, the fiscal authorities should assess carefully the composition of changes in public spending, including
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the timing and duration, when adjusting their countercyclical policy settings. This is to ensure the optimum use of government resources and encourage welfare- enhancing growth.
This study also attempts to fill the gap in the empirical literature on the effects of the changes in disaggregated government spending in Indonesia, namely government consumption (public sector wages and purchases of goods and services), energy and other subsidies, and social protection (transfers to households). While fiscal expansions in Indonesia may not affect inflation as much as often feared, the fiscal authorities should still keep in mind the persistent effects of subsidies – and to some extent, the immediate effects of higher transfers to households – on inflation. In addition, the fiscal authorities should take heed of a possible deterioration in public finances as a result of fiscal expansions despite the use of fiscal rules. The impulse responses show that there is evidence of higher inflation with rising debt levels in Indonesia but none in Malaysia and Thailand.
Keywords: fiscal policy, monetary policy, inflation targeting, structural VAR, ASEAN