MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA

JOURNAL OF ECONOMIC DEVELOPMENT 81 Volume 28, Number 1, June 2003 MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA The Universiy of The Wes Indies A vecor error-correcion model (VECM) is esimaed o examine he relaionship among ineres raes, moneary base, credi claims o he privae secor, real income, prices, governmen spending, budge deficis and exchange rae in Jamaica. Coinegraion is used o idenify he VECM. The empirical resuls show ha fiscal deficis are moneized in he long-run; he roles of financial services are weak, and inverse price-real oupu relaionship exiss in boh he shor-run and he long-run. Moneary disciplines, reducion in fiscal spending and sound regulaory acions are crucial o reduce he naional deb, he inflaion and ineres raes, crowd in privae invesmens, aver financial crisis and promoe economic growh. Keywords: Vecor Error-correcion Model, Fiscal Spending, Financial Services, Defici Finance, and Jamaica. JEL classificaion: E6 1. INTRODUCTION Privaizaion, divesmen, deregulaion and liberalizaion are policies ha have been followed in he pos Breon Woods era in Jamaica. In he 1989 elecion, he People Naional Pary came o power following almos a decade of Jamaica Labour Pary reign and was mandaed o pursue more comprehensive, coordinaed and decenralized divesmen programmes. However, he sequencing of he privaizaion and liberalizaion policies was no well ordered. 1 The Naional Commercial Bank (NCB) was privaized in 1989 whereas he foreign exchange raes, prices and he nominal ineres raes were liberalized in 1991. These developmens led o massive depreciaion of he Jamaican dollar relaive o he US dollar by more han 68% in 1991, while nominal ineres raes 1 Shaw (1973) and McKinnon (1973) had argued earlier ha financial liberalizaion promoes economic growh, however, Dornbusch and Reynoso (1993) have cauioned ha financial liberalizaion in he absence of a fiscal discipline environmen will lead o higher inflaion and ineres raes, capial fligh under a fixed exchange rae regime, bankrupcies and hamper economic growh. Similar senimens are also shared by Sargen (1993) and McKinnon (1993).

82 and inflaion raes rose by more han 76% and 51%, respecively, alhough he M2/GNP raios which measure financial deepening, a financial process which Shaw (1973) describes as accumulaion of financial asses a a pace faser han non-financial wealh 2 fell from 51.4% in 1985 o 44.5% in 1991. The governmen expendiure per gross domesic produc (GDP) dropped in 1991 o abou 21%, and a budge surplus was recorded for he firs ime in abou wo decades, because of he sale of Sae-own enerprises. The relaive imporance of privaizaion as a share of GDP was 5.8% in Jamaica, second only o he 12% recorded in Chile where privaizaion and liberalizaion policies sared in he 1970 s. See Table 1, McKinnon (1993), Edwards (1985) and Corbo (1985). Table 1. Moneary and Budgeary Indicaors in Percenages, 1970-1994 1) 1970 1977 1980 1985 1990 1991 1992 1993 1994 p 14.6 10.8 27.1 25.9 21.8 51.1 77.2 22.1 35.7 er 0 0 0.7 40.8 25.7 68.7 89.7 8.7 32.6 mb 19.7 16.7 47.9 34.8 15.8 28.2 88.6 44.8 31.3 ge 23.7 9.0 25.8 29.8 9.4 1.3 46.2 53.2 61.1 rr ep 10.6 3.6 17.2 6.9 4.4 25.5 42.8 6.8 7.3 ERR 8.8 10.6 17.2 29.7 32.7 24.8 29.8 32.3 30.7 CU/MB 61.1 66.7 50.8 28.7 37.8 38.8 29.8 28.1 28.5 CU/GDP 3.9 6.1 5.4 4.8 7.4 5.8 4.9 5.0 5.8 M2/GNP 33.8 36.5 38.4 51.4 44.4 44.5 45.0 41.8 44.2 GE/GDP 20.2 35.8 41.7 40.1 31.3 20.8 22.7 25.8 30.8 BD/GDP 2.8 16.8 15.2 8.6 4.1 1.1 3.8 5.6 6.4 CUCMB 0.9 1.5 0.9 1.0 1.0 2.5 1.6 1.5 1.4 RRCMB 0.3 0.2 2.4 3.9 1.7 1.3 7.7 4.2 3.4 TRMB 1.1 1.4 3.3 4.9 2.6 3.7 8.7 5.7 4.9 GGDP 7.8 2.3 5.7 4.6 5.4 0.7 1.6 1.4 0.9 RY(J$b) 1.30 1.41 1.01 1.14 1.70 1.72 1.64 1.88 1.87 Noes: 1) The sources of he compued figures are various years issues of IMF s Inernaional Financial Saisics, and PIOJ s Economic and Social Survey of Jamaica. CU/MB is a currency-moneary base raio, CU/GDP is currency-gdp raio, M2/GNP is M2-GNP raio, GE/GDP is GE-GDP raio, BD/GDP is Budge deficis-gdp raio, TRMB is seigniorage, RRCMB is seigniorage due o he reserve componen of moneary base, CUCMB is seigniorage due o currency componen of moneary base, and rr ep is ex-pos real ineres raes. GGDP is he average annual growh rae, RY is he real income (GDP/CPI) where CPI is he period average consumer price index (1995 = 100). 2 McKinnon (1993) used M3/GNP raios o define financial deepening, bu because Bank of Jamaica does no repor daa on M3, we have defined he financial process by M2/GNP raios.

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 83 From 1990 o 1994, he money supply as a share of GDP averaged more han 42%, he ex-pos real ineres raes averaged abou negaive 10%, he effecive reserve raio (ERR) defined as legal reserves as proporion of oal deposis (boh ime and sigh deposis) and he currency-moneary base (CUMB) raios, respecively, averaged more han 30% confirming ha he Jamaican economy remained financially repressed 3 wih currency and coins consiuing only a small fracion of he base money in he counry. During hese periods he average seigniorage as a share of gross naional producs (GNP) was more han 5% as compared wih abou 1% in mos developed counries and 4.5% in Lain America. Addiionally, abou an average of 73% of he seigniorage accrued from he required reserve componen of he moneary base over hose periods as shown in Table 1. The relaively low ineres raes which he governmen pays on public deb including he zero ineres rae on reserve requiremens on bank deposis imply ha he seigniorage derived by he governmen o finance fiscal deficis in he counry, as high as i is, is sill under-esimaed. The high spread beween savings and loans averaged more han 14% from 1991-1996 which mean ha privae individuals, and no commercial banks, generally ended up paying mos of he seigniorage in he counry. Fiscal deficis as a share of GDP increased successively o an average of more han 5% from 1992 o 1994. Bank reserve requiremen raios were increased o 25% in he budge of 1994 causing he Treasury bill raes and he lending raes o rise o 42.98% and 49.46%, respecively. As a resul, boh he public and governmen resored o overseas borrowing, hus aggravaing he exernal and inernal debs. Alhough he banking and financial insiuions recorded massive profis in he early years of he sabilizaion programmes due o drasic increases in inflaion raes, ineres raes, and devaluaion, by 1995, he associaed adverse selecion and moral hazard problems had reversed mos of heir profis o losses, and mos of he insiuions had become insolven due o non-performing and bad loans. This necessiaed he closing down of some banks 4 and he esablishmen of he Financial Secor Adjusmen Company (FINSAC) in February 1997 by he governmen o serve as a bridge bank o channel funds o 3 I is he financial process whereby he flow of money o profiable invesmens in he sysem is resriced by non-marke forces such as governmen and oligopolisic insiuions, and allocaion of loanable funds are carried on by adminisraive means raher han by marke forces. See John Black (1997) and McKinnon (1993). 4 Among he financial insiuions ha failed and were eiher closed down or aken over by FINSAC in he mid 1990s are: Blaise Trus and Merchan Bank, Cenury Naional Bank, Terarch Invesmens, Universal Invesmens, Island Life Merchan Bank, Voche Capial Invesmens, Caldon Finance Group, Fideliy Finance and Merchan Bank, Island Vicoria Bank, Workers Bank, and Eagle Group which consised of Commercial Bank, Merchan Bank and Building Sociey. In 1998, non-performing loans in boh Ciizens Bank and NCB amouning o abou $15 billion were acquired by FINSAC wih he governmen owning close o 85 percen of he shares of Ciizens Bank, and mos of he financial insiuions in he counry were disressed.

84 disressed banks and resrucure heir operaions. In 1998, he assessmens of he financial losses were esimaed o cos he counry abou 30% of he GDP, making he governmen he principal share holder of mos of he financial and banking insiuions in he counry. A he close of 2001, he dus of he FINSAC s deb seled a he cos of J$120b o ax payers, while he naional deb rose o J$495b which formed 134% of he GDP in 2002. Inflaion rose from abou 15% in 1970 o he heigh of abou 77% in 1992, during ha period he economy recorded negaive average real growh. In view of he above overview of he economy, he moivaion for his paper is o esimae a vecor error correcion model (VECM) o examine he effec of fiscal and moneary policies on he naional deb, he abysmal economic growh, and he dynamics of inflaion financing in he counry following he adopion of he sabilizaion programme in 1989. We have esed for he effec of hese policies on he price-real oupu relaionship, and examined he characerisic of financial deepening or repression, and oher macroeconomic issues for (a) he long run by using he -raios and zero resricion ess on he disribued lags of he relevan coefficiens of he coinegraion esimaes of he VECM; (b) a medium erm and shor run by using he sylized raios in Table 1, and he resuls of impulse response funcions and innovaion accouns, and finally (c) by conducing sensiiviy analysis o es he robusness of he findings. Hopefully, he findings will provide us wih a beer undersanding of he dynamic characerisics of he economy o assis in prescribing appropriae policy recommendaions o deepen he financial markes, reduce he growing deb and promoe economic growh. The model is developed and he sources of daa are discussed in Secion 2. The empirical resuls and sensiiviy analysis are repored and evaluaed in Secion 3, and he sudy is concluded wih a summary and policy recommendaions in Secion 4. 2. THE MODEL A vecor auo-regressive (VAR) model is referred o as aheoreical because curren variables are regressed on heir lags wihou relying on any deail heoreical basis. This sudy, however, used macroeconomic heory o develop he included variables in he VAR model. Based on he objecives of he sudy, we have included ineres rae in he model because i was found o be significan in Jamaica by Gharey (1998). Addiionally, i is ofen used by he bank of Jamaica o offse undesirable speculaion in he exchange rae. The pure vecor auo-regressive model is expressed as * A ( L) X = u (1)

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 85 * 2 3 where A ( L) = I A L A L A L K, E ( ) = 0, E( u u ) = Ω s, E( u u ) = 0 1 2 3 u s = s, E( y u s ) = 0 < s, and X = [ r mb p y pcr g bd er] is an 8 1 vecor of observable endogenous variables. The lower case leers in X denoe he logarihmic form of he variables and subscrip denoes ime period. Thus he logarihmic form of moneary base is mb, credi claim o he privae secor is pcr, real oupu is y, price is p, governmen spending is g, a budge defici is bd, an ineres rae is r, and he exchange rae is er. The reduced form of Equaion (1) is s X ( + u (2) = A L) X 1 * 1 2 where A ( L) = ( I A ( L)) L = A1 + A2 L + A3 L + K. The VAR represenaion of he sochasic vecor of variables exiss only if he process is inverible, meaning ha he elemens of he coefficien marices A i 0 as i. The reduced form Equaion (2) can be consisenly esimaed by using he ordinary leas squares (OLS) mehod wihou experiencing a simulaneous equaion bias problem. The Cholesky decomposiion of he conemporaneous covariance posiive definie marix Ω is Ω = 1 1 P P or P Ω P = I where P and ( ). The 1 P are lower riangular marix, and E Pu up = P Ω P = I corresponding dynamic vecor moving average (VMA) represenaion of he reduced form of X is wrien in he form of Wold decomposiion as follows: PX ( + Pu, (3) = PA L) X 1 P ( I A( L) L) X = Pu. Thus X follows: 1 1 = ( I A( L) L) P v, where v = Pu, and he Wold VMA becomes as X = B( L) (4) v 1 1 1 2 where B ( L) = ( I A( L) L) P ; ( ) = j B L P + B L + B L +K ; L v = v, E v ) = E ( v v s ) = 0, s, and E( v v ) s = I, = s ; v is a column vecor of unobservable exogenous orhogonal innovaions which are serially and muually uncorrelaed a leads and lags wih a dimension of 8 1, and B (L) is an 8 8 marix of polynomials in he lag operaor L. The coefficien marix of B (L) represens he response of he sysem o a one 1 2 j (

86 sandard error innovaion in v. A represenaive elemen of B (L) is b ij (L), and i shows he response of all fuure values of x i o a one sandard error s one-ime curren innovaions in x j. Thus, b ij (L) is he impulse response funcion of x i wih respec o a shock in x j. From Equaion (4), he ih elemen of X a ime + h is x i + h = j = 1 s = 0 ij, s j, + h s b v. Thus, he percenage of he expeced h-period-ahead squared predicion error of x i produced by an innovaion in x j is zero if x i is exogenous. This is he necessary and sufficien condiion for x i o be exogenous wih respec o he remaining variables in he sysem. The srucural vecor auo-regression (VAR) of he reduced form model of Equaion (4) is recovered in he form of VECM in he radiion of Johansen and Beveridge- Nelson decomposiion as follows: * * = C ( L) X + C(1) LX = C ( L) X + C(1) X 1 C ( L) X = v, (5) where ( ) 1 * 1 C L = B ( L) and C ( L) = C( L) C(1) which means C (1) = B (1). Thus, Equaion (5) is he simulaneous-equaions sysem which capures he VMA represenaion of he srucural Equaion (4), and is corresponding reduced-form sysem is D α x ϕ =. (6) * 1 + ( L) x v The reduced rank (0 < q < 8) implies ha C (1) can be facorized as C ( 1) = Dα. Thus, C (1) is a singular marix and is expressed as a produc of wo recangular marices wih full column rank, where D measures he adjusmen speed o close deviaions of he errors from equilibrium and α capures he marix of coinegraing vecors. The common rend s represenaion of Equaion (5) was ransformed by Johansen s VECM ino Equaion (6), and is long-run coinegraion of he variables were used o resric and idenify he non fundamenal represenaions of he VAR model in he sudy o give a reasonable or economically accepable impulse-response funcions and vecor decomposiion. See Blanchard and Quah (1987, 1993), Lippi and Reichlin (1993), Crowder (1995), and Gharey (2001) for an applicaion o a developing counry. Addiionally, he model was also riangularized ino orhogonal form by ordering he included variables in accordance wih he pair-wise correlaions beween heir innovaions, and he bi-variae causal relaionship beween hem using he Granger (1969) causaliy echnique. The resuling level form of he ordered variables included in he VECM were esimaed, and he long-run esimaes from he VECM were hen used o idenify and obain a more robus impulse response funcions and innovaion accouns ha wihsood sensiiviy analysis.

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 87 2.1. Daa Daa were colleced primarily from various issues of he IMF Inernaional Financial Saisics. However, he missing fiscal accouns and GDP annual daa were updaed from various issues of Economic and Social Survey published by he Planning Insiue of Jamaica (PIOJ), and heir respecive quarerly series were generaed by using he mehod oulined in Goldsein and Khan (1976), and employed for Jamaica by Gharey (1998). P is he price level and is measured by he consumer price index (CPI); Y is real GDP (GDP; GNP); G is governmen spending; BD is a budge defici; R is a reasury bill rae; ER is period average of an exchange rae; MB is moneary base; M1 is he money supply and PCR is he credi claim o privae secors. The daa covered he period 1961.1-1998.4, bu because of lack of adequae daa for GDP, G and BD, and some los end-poin daa due o lag adjusmens, he esimaed period is 1962.2-1993.4, a sample of size 122. 3. THE EMPIRICAL RESULTS Tess of augmened Dickey and Fuller (1979) and Phillips and Perron (1988) showed ha he variables employed in he sudy were inegraed of order one. 5 The opimum lag lengh of he variables included in he VECM was chosen based on minimum informaion resuls obained from Akaike informaion crierion (AIC), Schwarz 2 Bayesian informaion crierion (SBIC), and Sims (1980) asympoic χ saisics o be one, afer saring from eigh lags o preserve he degrees of freedom. Noe ha he VECM approach did no require he use of economic heory o impose zero resricions. See Gharey (2001, p. 421). We have herefore ordered he variables in he model according o he resuls of he pair-wise correlaion, Granger causaliy ess and coinegraion. I was found ha moneary base and money muliplier, real income and prices, and governmen spending and budge deficis have residual correlaions wih absolue values ha exceeded 80 percen, and heir causal relaionships were saisically significan. See Table 2. The Johansen s coinegraion ess were esimaed using an augmenaion lag inerval of one, over he 1962.2-1993.4 sample periods, under he assumpion of a consan erm wihou a deerminisic rend in daa. A he 0.05 significan levels, he more robus maximal eigenvalues es showed ha here were a leas wo coinegraion vecors while he race es showed a leas hree coinegraed vecors. 6 See Table 3. 5 These are rouine resuls which are no repored for breviy. They can be requesed from he auhor. 6 Exended criical values abulaed in Oserwald-Lenum (1992) were used for boh race and maximal eigenvalues ess. Johansen and Juselius (1990) recommended he maximal eigenvalues es for having

88 Table 2. Bi-variae Granger Causaliy Tes Resuls, 1962.2-1993.4 y m1 7.2 y mb 4.6 y p 19.0;4.1 g m1 5.5 g p 8.4;5.2 g bd 6.8;5.5 g mb 4.7;5.9 g y 4.4 g er 4.2 mm g 3.0 *** cudd r 2.8 *** er y 12.4 er p 12.0;3.10 *** er r 4.0 er cudd 5.0 m1 er 5.5 bd p 5.9 bd y 3.4 p m1 20.5 p mb 9.8 p cudd 4.8 mb pcr 4.1 g pcr 4.5 mb cudd 3.1 mb bd 3.0 *** mb er 4.4 Noes: All of he repored causaliy es resuls as judged by heir respecive F-saisics are significan a leas a 0.05 levels. The hree aserisks denoe significance a 0.10 levels. In he case of bi-direcion causaliy ess, he firs F-saisics refer o he lef-hand side variables causing he righ-hand side variables, while he second F-saisics refer o he significance of reverse causaion. Ordering does no require he use of ri-variae causaliy echnique o resolve he causal direcion in an even of bi-direcional causaion. Noe ha he definiion of Granger causaliy is used here, alhough he erm causaliy is no an accepable philosophical concep because i is based on informaion. The logarihmic form of a money muliplier is mm, and a currency demand deposi raio is cudd. The res of he variables mainain heir definiions. Table 3. Resuls of Johansen s Coinegraion Tes of [r mb p y pcr g bd er], 1962.2-1993.4 H 1 λmax C.V. H 1 λrace C.V. r = 1 85.75 51.99 * r 1 260.37 165.58 * r = 2 52.71 46.45 * r 2 174.62 131.70 * r = 3 39.69 40.30 * r 3 121.91 102.14 * r = 4 29.11 34.40 * r 4 82.22 76.07 * r = 5 22.21 28.14 * r 5 53.10 53.12 * r = 6 14.51 22.02 * r 6 30.89 34.91 * r = 7 10.43 15.67 * r 7 16.38 19.96 * r = 8 5.94 9.24 * r 8 5.94 9.24 * Noes: The * denoes significance a 0.05 level, λ max is likelihood raio (LR) based on maximal eigenvalue of he sochasic marix, and λ race is LR based on race of he sochasic marix. The esimaed VECM showed ha ineres rae and budge deficis were wo endogenous variables in he sysem. The AIC and SBIC were 210.97 and 210.74, respecively, for ineres rae, 177.54 and 177.77, respecively, for he budge defici, and 285.13 and 285.36, respecively, for real income. The error correcion (EC) erm was power. See also Dickey and Rossana (1994, p. 348).

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 89 0.82[10.88] for ineres rae equaion and was significan a 0.05 levels; while he budge deficis equaion has an EC erm of 3[1.66] which was significan a 0.10 levels. The real income has EC erm of 9[0.85] and was insignifican. The -raios were repored in he square bracke. The leading VECM employed in he sudy has ineres rae as endogenous variable. The long-run esimaes of VECM: [r mb p y pcr g bd er] which included an inercep erm were esimaed by OLS, dynamic OLS (DOLS) which used he Newey-Wes adjused sandard errors wih Parzen s weighs and runcaion lags of welve o correc heeroscedasiciy and serial correlaion problems, maximum likelihood procedure (MLP) which used Newon-Raphson ieraive mehod for convergence using a second order auo-regressive process, and Johansen coinegraion esimaes. See Table 5. The long-run resuls in Table 5 showed ha ineres raes were increased significanly a 0.01 levels by changes in prices, real income, budge deficis and exchange raes, while growh in moneary base, privae secor claims o credi and governmen spending reduced ineres raes, alhough only he governmen spending was significan a 0.05 levels. This laer evidence followed from he fac ha he base money caused governmen spending as shown in Table 2, or ha seigniorage derived from an increase in he base money was passed on o he governmen o finance is expendiure. The long-run ineres rae equaion also indicaed ha governmen spending encompassed he base money. These resuls were suppored by he idenifying resricions in Table 4, and he impulse response funcions in Figure 1. Table 4. Tess of Resriced Normalize Coinegraed Johansen Esimaion of [r mb p y pcr g bd er], 1962.2-1993.4 Resricions: (i) (ii) (iii) A B C D A B C A B 1 1 1 1 1 1 1 1 1 1 0 1 1 0 1 1 1 0 0 0 1 1 1 0 0 1 0 0 0 1 0 1 1 0 1 0 1 0 1 1 1 1 1 1 0 1 1 0 1 1 1 1 0 1 1 1 0 1 1 1 1 0 1 1 1 1 1 1 0 0 0 1 1 1 1 1 1 1 1 0 1 Likelihood raios for validaing he resricions χ 2 (20) = 144.4 * χ 2 (15) = 92.3 * χ 2 (10) = 46.7 * Noes: The log likelihood raios saisics are calculaed by Johansen s maximum likelihood procedure (MLP), and are used o es wheher he hypohesized resriced coinegraed vecors lie in he space spanned by he coinegraed esimaes. See also Table 5.

90 Response o One S.D. Innovaions 1.5 1.5 1.5 1.5 1.0 1.0 1.0 1.0 0.5 0.5 0.5 0.5 0.0 0.0 0.0 0.0-0.5-0.5-0.5-0.5-1.0-1.0-1.0-1.0 0.10 1.5 0.3 0.10 1.0 0.5 0.0 0.2 0.1-0.5 0.0 - - -1.0-0.1 0.01 0.01 0.01 0.01-0.01-0.01-0.01-0.01 - - - - -0.03-0.03-0.03-0.03 0.10 0.10 0.01 0.01-0.01 - -0.03-0.01 - -0.03 - - 0.10 0.10 - - - - 0.20 0.20 0.15 0.15 0.10 0.10 0.05 0.05 - - -0.05-0.05 Noes: Response of: (1) r o mb, (2) r o p, (3) r o pcr, (4) r o bd, (5) r o er, (6) mb o y, (7) p o y, (8) p o g, (9) y o r, (10) y o mb, (11) y o p, (12) y o g, (13) y o bd, (14) y o er, (15) pcr o r, (16) pcr o g, (17) pcr o bd, (18) g o y, (19) bd o r, (20) bd o mb, (21) bd o pcr, (22) bd o g, (23) er o p, and (24) er o g Figure 1. Impulse Response Funcions of Seleced Variables due o one s.d. shock in ohers

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 91 Table 5. Long-run Esimaes of [r mb p y pcr g bd er] using r as a Dependen Variable, 1962.2-1993.4 Regression OLS DOLS MLP Johansen mb 0.777 0.777 0.189 0.170 [1.448] [1.609] [0.543] [0.306] p 14.306 14.306 7.358 13.899 [3.671] [6.687] [2.154] [4.633] y 14.165 14.165 8.106 8.806 [5.170] [6.614] [3.563] [2.867] pcr 1.848 1.848 0.470 0.339 [1.381] [1.941] [0.514] [0.302] g 6.450 6.450 4.846 7.600 [1.793] [3.029] [1.581] [4.093] bd 0.200 0.200 0.576 0.746 [0.206] [0.228] [0.647] [0.313] er 4.376 4.376 4.908 2.087 [2.967] [6.196] [3.969] [1.716] inercep 44.165 44.165 24.194 22.588 [4.396] [5.389] [3.105] Noes: The noaions mainain heir definiions. The figures in square brackes are he -raios. OLS are ordinary leas squares esimaors, DOLS is dynamic OLS, MLP is maximum likelihood procedure which uses Newon-Raphson s ieraive mehod for convergence using second order auo-regressive processes, and Johansen is Johansen s coinegraing esimae. The generalized mehod of momens (GMM) esimaes of budge deficis equaion no repored in he ex showed ha growh in governmen spending, ineres rae and depreciaion augmened budge deficis, alhough only he former was significan a 0.01 levels. Innovaions in economic growh, privae secor claims o credi and moneary base reduced he budge deficis. Thus, increased sale of reasury bonds immediaely reduced curren ineres raes and generaed seigniorage revenues which were used o finance he budge deficis. See Champ and Freeman (2001). The -raios of he esimaed VECM in Table 5 and zero resricion ess on he disribued lags of he individual coefficiens in Table 4 yielded similar resuls, wih he laer reinforcing he former in siuaions where he significan levels were marginal. In he main, he resuls confirmed he exisence of he long-run price-real oupu inverse relaionship, inflaionary financing, he ineffeciveness of financial inermediaion o promoe economic growh, and he fac ha exchange raes were influenced by boh moneary and fiscal policies. See Table 2.

92 3.1. Impulse Response Funcions and Innovaion Accouning Resuls The VECM obained by ordering he included variables and imposing a long-run resricion wihou any arbirary imposiions is [r mb p y pcr g bd er]. I is esimaed o discuss he shor-run and medium-erm dynamic policy implicaions of he model by examining he impulse response funcions and innovaions accouning esimaes which are repored for up o fory-sep-ahead, our assumed medium erm, in Table 6 and Figure 1. The response of mb, p and g o one sandard deviaion (s.d.) shock in y was posiive. See panels 6, 7 and 18 of Figure 1. The response of p, pcr, bd and er o one s.d. shock in g was posiive as shown in panels 8, 16, 22 and 24, respecively. Similar posiive response was obained for r and er due o one s.d. shock in p as shown in panels 2 and 23, and he response of he variance of y o one s.d. shock in mb was also posiive as depiced in panel 10. The response of y o one s.d. shock in boh p and g were significanly negaive, and so was he response of bd o one s.d. shock in mb. See panels 11, 12 and 20. This mean ha inflaion shock in he economy was immediae alhough i did no reach is peak ill five years. However, conrary o Friedman s (1968) observaion, he duraion was much longer han five years. See also Gharey (2001, p. 426). Addiionally, increases in he base money yielded seigniorage which was used o finance he budge defici. There was, however, a mild negaive response of y o one s.d. shock in r, bd and er as depiced in panels 9, 13 and 14 of Figure 1. Similar mild negaive response was obained for pcr due o one s.d. shock in r and bd as shown in panels 15 and 17, and he response of bd due o one s.d. shock in pcr was depiced in panel 21. Thus, increases in ineres raes, budge deficis, and depreciaion rearded economic growh and foser financial disiner mediaion, while reducion in budge deficis slighly improved he process of financial inermediaion. The response of r o one s.d. shock in mb and pcr were no discernible. See panels 1 and 3. However, he response of r o one s.d. shock in bd and er flucuaed posiively in he firs hree quarers ahead and coninued hereon posiively a a much lower rae as shown in panels 4 and 5. This mean ha inflaion was moneized as moneary policy was fed ino governmen spending which hen caused inflaion, and he availabiliy of credi claims o he privae secor inched up real economic growh and reduced prices. Governmen spending, ineres raes, and own shocks augmened he budge deficis, while shocks due o credi claims o he privae secor slighly reduced he budge deficis. Increases in he base or inside money resuled in economic growh, alhough he laer caused increase in prices, governmen spending and fed back ino he base money. In Table 6, innovaions accouning esimaes indicaed ha 100% of he r variance was explained by own innovaions. A he fory-sep-ahead abou 11% of he variance in r coninued o be explained by own shocks, while abou 28% and 54% of he shocks were explained by p and y, respecively. The high ineres raes in he counry were driven in par by rising inflaion and ransacions. Abou 97% of he variance in mb was

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 93 explained by own shocks in he firs-sep-ahead. A he fory-sep-ahead, he explanaion of he mb variance by own innovaions dropped o abou 43%, while innovaions in y, p and r explained 20%, 17% and 7%, respecively. The variance of y was due o abou 41% of is own innovaions and abou 53% of he shocks in p a he firs-sep-ahead. By he fory-sep-ahead, he shocks in p explained abou 71%, while shocks in g and mb explained abou 16% and 18%, respecively. The variance of p was explained by abou 91% of is own shocks a he firs-sep-ahead. A he fory-sep-ahead, explanaion from own shocks dropped o abou 38%, while shocks in y and g explained abou 45 and 14%, respecively. The variance of g was explained by nearly 94% of is own shocks in he firs-sep-ahead. A 10-year ahead, he variance of g was explained by abou 54% of is own shocks and abou 29% by shocks in y; while shocks in p and mb explained abou 7% and 5%, respecively. The variance of bd was explained by abou 41% of is own shocks, and abou 53% by shocks in g a he firs-sep-ahead. A 10-year ahead, abou 75% of he bd variance coninued o be explained by shocks in g, more han 12% by is own shocks, and abou 4% by shocks in mb. Of he remaining variance of bd, shocks in r and er explained abou 3%, respecively. The forecas error of er a he firs quarer ahead was explained by abou 70% of is own shocks, 17% by shocks in p, abou 8% by shocks in r and 3% by shocks in y. A he fory-sep-ahead, own shocks explained abou 10%, while shocks in p, y and g explained 24%, 52%, and 11%, respecively. Thus, in he medium erm increased in governmen spending, prices and ransacions were he primary facors ha caused depreciaion in he counry. See Table 6. Table 6. Innovaion Accouning of [r mb p y pcr g bd er], 1962.2-1993.4 r: Innovaions in: h r mb p Y pcr g bd er 1 100.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2 89.5 0.0 4.1 2.4 0.0 2.1 1.7 0.1 4 51.9 0.1 18.1 15.4 0.1 6.0 4.4 3.9 8 45.5 0.2 18.0 24.3 0.1 4.2 3.1 4.4 40 11.5 0.1 28.0 54.3 0.0 1.1 1.7 3.2 mb: 1 3.4 96.6 0.0 0.0 0.0 0.0 0.0 0.0 2 5.0 93.1 1.0 0.0 0.1 0.5 0.0 0.2 4 7.6 86.4 3.4 0.3 0.1 1.5 0.4 0.2 8 7.5 75.8 7.8 3.5 0.2 3.5 1.5 0.2 40 6.6 43.2 16.6 20.4 0.2 7.6 4.8 0.4

94 Table 6. (Coninued) r: Innovaions in: r mb p y pcr g bd er p: 1 2.7 6.6 90.7 0.0 0.0 0.0 0.0 0.0 2 2.7 5.6 85.4 3.4 0.0 1.3 0.4 1.1 4 1.1 3.9 72.7 15.1 0.1 5.3 0.6 1.3 8 1.1 3.1 55.3 29.3 0.1 10.4 0.2 0.5 40 0.7 2.3 37.7 45.5 0.1 13.6 0.0 0.0 y: 1 0.4 4.7 53.5 41.3 0.0 0.0 0.0 0.0 2 0.2 6.5 57.0 33.7 0.0 0.7 0.3 1.5 4 0.2 6.6 61.6 24.5 0.1 3.3 0.7 3.0 8 0.4 7.6 65.3 15.1 0.2 8.3 0.5 2.5 40 0.3 8.0 70.9 2.5 0.3 16.4 0.3 1.3 pcr: 1 0.5 0.4 0.3 0.9 97.9 0.0 0.0 0.0 2 3.4 1.6 0.7 2.9 89.0 1.0 0.7 0.0 4 7.2 0.9 1.0 4.8 80.3 3.1 2.0 0.6 8 5.7 0.5 0.9 8.6 74.2 5.7 3.0 1.4 40 4.5 0.2 0.2 21.5 57.4 10.7 3.4 2.0 g: 1 0.0 0.2 0.1 0.0 5.5 94.4 0.0 0.0 2 0.0 3.6 0.2 0.5 3.9 90.1 0.4 0.2 4 0.2 5.4 0.6 3.3 3.0 83.7 1.1 0.2 8 0.2 5.8 2.9 11.8 2.2 73.1 1.1 0.2 40 0.2 4.7 7.4 28.9 1.3 54.4 0.8 0.4 bd: 1 2.7 0.0 0.0 0.4 2.3 53.4 41.0 0.0 2 1.3 1.3 0.3 0.9 2.2 63.2 30.5 0.3 4 2.5 2.5 0.9 1.2 2.1 69.3 19.9 1.5 8 3.6 3.6 0.6 0.7 2.1 70.9 16.3 2.2 40 3.2 4.4 0.1 0.4 2.0 75.0 12.1 2.6 er: 1 8.1 0.2 17.2 2.8 0.2 0.1 1.5 69.8 2 4.4 2.1 19.7 10.2 0.3 0.3 3.6 59.3 4 1.6 1.8 21.9 21.5 0.3 2.3 3.4 46.9 8 2.3 0.9 23.1 34.5 0.3 6.2 2.3 30.3 40 1.2 0.1 24.1 52.3 0.3 10.8 0.8 10.5 Noes: The number of seps ahead is lised under h, and he figures are percenages of he expeced squared predicion error produced by innovaions.

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 95 3.2. Sensiiviy Analysis The more robus λ Max es from Johansen coinegraion showed ha here were wo endogenous variables which were ineres raes and budge deficis. 7 Following he superior diagnosics and dynamics of VECM wih ineres raes as endogenous, coinegraion was used as he idenifying resricion for he sensiiviy analysis. The variance decomposiions of he models a he fory-sep-ahead were pre-ordered by pair-wise correlaion and causaion ess in Table 2 o obain he following VECM: A = [r mb p y pcr g bd er], B = [r mb p g pcr bd y er], C = [r mb g bd pcr p y er] and D = [r pcr mb p y g bd er]. The resuls in Table 7 were very robus and consisen hroughou he differen models, and len credibiliy and affirmaion o he main findings. Unlike Gharey (2001, p. 429), correlaion and Granger causaliy were no required o pre-order he included variables o idenify he VECM in Jamaica. Table 7. Sensiiviy Analysis Using Innovaion Accouning a Fory-Sep-Ahead, 1962.2-1993.4 Innovaions in: Var. r mb p y pcr g bd er r: A 11.5 0.1 28.0 54.3 0.0 1.1 1.7 3.2 B 11.5 0.1 28.1 54.8 0.6 1.1 0.6 3.2 C 11.5 0.1 28.7 54.8 0.3 1.0 0.4 3.2 D 11.5 0.1 28.4 53.7 0.3 1.1 1.7 3.2 mb: A 6.6 43.2 16.6 20.4 0.2 12.4 0.0 0.4 B 6.6 43.2 16.6 20.2 0.6 12.2 0.1 0.4 C 6.6 43.2 15.8 20.2 0.4 13.1 0.2 0.4 D 6.6 42.8 16.5 20.6 0.5 12.4 0.0 0.4 p: A 0.7 2.3 37.7 45.5 0.1 13.6 0.0 0.0 B 0.7 2.4 37.7 44.7 1.4 12.8 0.3 0.0 C 0.7 2.4 36.3 44.7 0.8 14.2 0.7 0.0 D 0.7 2.4 37.8 45.5 0.0 13.6 0.0 0.0 y: A 0.3 8.0 70.9 2.5 0.3 16.4 0.3 1.3 B 0.3 8.0 70.9 2.4 0.2 16.6 0.4 1.3 C 0.3 8.0 69.1 2.4 0.1 18.8 0.0 1.3 D 0.3 8.3 70.1 2.4 0.7 16.4 0.3 1.3 7 Johansen and Juselius (1990) sugges ha he maximal eigenvalue es has greaer power han he race es... See Dickey and Rossana (1994, p.348).

96 Table 7. (Coninued) Innovaions in: Var. r mb p y pcr g bd er pcr: A 4.5 0.2 0.2 21.5 57.4 10.7 3.4 2.0 B 4.5 0.2 0.2 13.6 72.4 2.2 4.7 2.0 C 4.5 0.2 0.2 13.6 73.3 2.2 3.8 2.0 D 4.5 0.1 0.4 15.3 63.6 10.7 3.4 2.0 g: A 0.2 4.7 7.4 28.9 1.3 54.4 0.8 2.3 B 0.2 4.7 7.4 27.8 1.4 54.3 2.0 2.3 C 0.2 4.7 6.0 27.8 1.2 55.5 2.3 2.3 D 0.2 4.8 7.2 29.8 0.4 54.4 0.8 2.3 bd: A 3.2 4.4 0.1 0.4 2.0 75.0 12.1 2.6 B 3.2 4.4 0.1 0.8 0.5 76.5 11.8 2.6 C 3.2 4.4 0.1 0.8 0.4 76.4 12.1 2.6 D 3.2 4.8 0.1 0.5 1.5 75.0 12.1 2.6 er: A 1.2 0.1 24.1 52.3 0.3 10.8 0.8 10.5 B 1.2 0.1 24.1 52.7 0.9 10.4 0.1 10.5 C 1.2 0.1 23.4 52.7 0.5 11.4 0.1 10.5 D 1.2 0.1 24.1 52.5 0.0 10.8 0.8 10.5 Noes: A = [r mb p y g pcr bd y er], B = [r mb p g pcr bd y er], C = [r mb g bd pcr p y er], and D = [r pcr mb p y g bd er]. Thus, governmen spending exacerbaes he growing budge deficis, and was inflaionary; ineres raes were highly sensiive and were driven by inflaion and real oupu; depreciaion was conracionary and was caused by rising inflaion, governmen spending and ransacions; moneary expansion was influenced mosly by increase in ransacion, prices and governmen spending. Credi claims o privae secors were largely self-financed and modesly driven by economic ransacions and governmen spending; were affeced negaively by increase in ineres raes, budge deficis and depreciaion; were insensiive o increase in moneary base, and were largely exogenous. 4. CONCLUSION A VECM was esimaed o examine he relaionship among ineres raes, moneary base, credi claims o he privae secor, real oupu, prices, governmen spending, budge deficis and exchange raes, wih coinegraing regression as he idenifying resricion. The variables were saionarized a degree uniy by boh ADF and PP ess. The uni lag

MONETARY POLICY AND DEFICITS FINANCING IN JAMAICA 97 was chosen from differen informaion crieria o be opimum, and was adoped for he sudy because is esimaed coefficiens conform o economic heory. The sysem was riangularized o orhogonal form by ordering he variables according o he resuls of he residual correlaion of innovaion marix and bi-variae Granger causaliy ess. The VECM indicaed ha ineres rae and budge deficis were he only wo endogenous variables in he lis of variables included in he model, and he former was used as he leading equaion because is EC erm was highly significan and yielded beer dynamics han he laer. Coinegraion was adequae means of idenifying he VAR model. Sensiiviy analysis shows ha here was no need o use correlaion or Granger causaliy o pre-order he included variables o obain robus resuls. In he long-run, price-real oupu relaionship was inverse in he counry and he fiscal deficis were moneized. However, in he shor-run, whereas he inverse price-real oupu relaionship sill exiss, money was non neural which can be explained by Lucas informaion mis-percepion, and more so by Taylor s relaive-price heory because of he myriads of milian unions in he counry. The use of seigniorage revenues o finance governmen expendiures worsened he budge deficis. Addiionally, ineres raes in he counry were insensiive o increase in he base money and credi claims o he privae secor, bu were largely driven by rising ransacions and inflaion. Growh in he credi claims o privae secors reduced he budge deficis, bu is effec on economic growh was minimal. An expansion in governmen spending was conracionary, bu inflaionary. I also resuled in depreciaion and exacerbaed he budge deficis. Therefore, we recommend ha he counry follows moneary discipline, cus fiscal expendiure and employs sound regulaory acions o reduce boh he presen value of he naional deb and growing fiscal deficis o crowd in privae businesses, reduce he incidence of high inflaion, preven furher bankrupcies and bank failures, and promoe economic growh. REFERENCES Black, J. (1997), A Dicionary of Economics, New York: Oxford Universiy Press. Blanchard, O.J., and D. Quah (1989), The Dynamic Effecs of Aggregae Supply and Demand Disurbances, American Economic Review, 79, 655-73. (1993), The Dynamic Effecs of Aggregaes Demand and Supply Disurbances: Reply, American Economic Review, 83(3), 653-658. Champ, B., and S. Freeman (2001), Modeling Moneary Economies, Cambridge Universiy Press: Cambridge, U.K. Corbo, V. (1985), Reforms wih Macroeconomics Adjusmen in Chile during 1974-84, World Developmen, 13, 893-916. Crowder, W.J. (1995), The Dynamic Effecs of Aggregae Demand and Supply Disurbances: Anoher Look, Economic Leers, 49, 231-237. Dickey, D.A., and W.A. Fuller (1979), Disribuion of he Esimaors for Auoregressive Time Series wih a Uni Roo, Journal of he American Saisical

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