Three Essays on Fiscal Policy and Global Finance

This dissertation comprises three chapters. The first two chapters examine the twin deficits relationship under different macroeconomic conditions. Specifically, the first chapter examines the impact of a fiscal policy shock on external balances in a sample of up to 67 emerging and developing economies during the 1980-2015 period and whether the impact differs in country-year observations with fiscal rules. We consider possible asymmetries by examining the impacts of both fiscal contractions and expansions, which we define in the baseline as large changes in the cyclically adjusted primary balance of at least 1.5% of GDP between any two consecutive years, and address possible endogeneity issues and the problem of the counterfactual by applying the entropy balancing technique to identify a control group that is similar in many ways to our treated units. While our analysis supports the twin deficits hypothesis, fiscal contractions and expansions of similar magnitudes appear to have asymmetric effects, though this is found to be sensitive to the choice of methodology, covariates, and sample. Our subsequent analysis reveals that even though these baseline effects do not generally differ significantly in country-year observations with fiscal rules, there is some evidence that the impacts of both fiscal contractions and expansions are significantly reduced under certain types of fiscal rules and/or design features. More specifically, while the positive impact of fiscal contraction on the current account is significantly reduced under fiscal rules with revenue targets, the negative effect of fiscal expansion on the current account is reduced under rules that seek to achieve a balanced budget or higher revenues or designed with enforcement mechanisms or escape clauses in place. The second chapter re-examines the twin deficits hypothesis through the lens of trilemma policy choices in a sample of 94 advanced and non-advanced economies. We begin by investigating how different configurations of exchange rate regimes and capital account openness affect a country’s ability to attain monetary policy independence before taking the analysis a step further to examine how the current account adjusts to changes in fiscal policy (expansions and contractions) under different policy configurations of the trilemma. Our goal in the latter step is to determine whether the current account response to changes in fiscal policy differs between policy configurations that restrict monetary autonomy and those that do not. Our findings confirm the original framing of the trilemma, which suggests a loss of monetary autonomy under a policy mix of a purely fixed exchange rate regime and full capital mobility. However, we find that countries can still achieve monetary autonomy by adopting a combination of intermediate exchange regime and capital account policy choices. On the link between fiscal and external balances, we confirm the existence of the twin deficits relationship with asymmetries in the impacts of fiscal contractions and expansions of similar magnitudes with the impact of the former being larger, contrary to the result in chapter one. This highlights the sensitivity of the result to the choice of empirical methodology, covariates, and samples used in the analysis. A subsequent analysis, however, reveals variations in the relationship under different trilemma policy configurations. For the extreme policy choices (as framed in the textbook version of the trilemma), the negative effect of an expansionary fiscal policy is exacerbated under the configuration that constrain monetary autonomy with no statistically significant difference in the effect from the baseline in configurations that do not constrain monetary autonomy. While the effect of a fiscal consolidation, on the other hand, does not differ from the baseline effect under any extreme policy configuration, there is some evidence that its impact on external balances is significantly reduced in country-year observations with intermediate policy configurations. We offer some theoretical explanations for these results. In the final essay, we examine the role of global factors, particularly global risk aversion (VIX) and regional contagion, in predicting the likelihood of extreme gross capital flow events and whether there has been a change in the role of these factors over time by utilizing quarterly data from 1990 to 2019 in a sample of 55 advanced and emerging and developing economies. We then take the analysis a step further to examine whether domestic monetary tightening can mitigate or aggravate the impacts of these factors on the likelihood of sudden stops in capital inflows. We find that gross capital flows are generally procyclical as rising global risk aversion and lower economic growth both increase the probability of sudden stops in inflows and reduce the probability of outflow surges in both advanced countries and EMDEs. The analysis further reveals the contagious nature of extreme capital flow events, especially in EMDEs, as a country has a higher probability of experiencing an extreme capital flow episode if other countries in the same region are experiencing similar episodes. Contrary to some previous findings that suggest a decline in the role of global risk aversion in influencing capital flows, our analysis shows that this is only true for EMDEs as it continues to be influential in advanced economies in the aftermath of the global financial and eurozone debt crises. On the role of domestic monetary policy, we find that while monetary tightening in EMDEs partially offsets the impact of regional contagion on the likelihood of sudden stops in capital inflows, such a policy response to rising global risk aversion only aggravates the impact of the latter on the probability of sudden stops in inflows in advanced countries. Our analysis also suggests that a rise in global risk aversion does not necessarily create a ‘flight to safety’ situation whereby capital flows out of vulnerable economies to safer global economies. Evidence from the East Asian financial crisis of the 1990s and the 2008 global financial bears this out.