Fiscal Policy Options and their Macroeconomic Impact Jan Gottschalk (May 2010)

Option I—Large Fiscal Expansion: 2010 Budget Amendment and MTBF

The fiscal expansion would trigger another demand-led boom, on top of already strong demand conditions:

The inflationary impact will be large, and together with current meat price inflation, will lead to high and persistent inflation:

The financing of the fiscal expansion in the MTBF is much more risky than it was during the boom- bust cycle:

The combination of high inflation and uncertain financing is risky: Persistent, double-digit inflation is costly and erodes confidence in the currency Simulations assume passive monetary policy stance that resists nominal currency appreciation and allows high inflation: even without a nominal appreciation, the currency will appreciate in real terms, which will hit the tradable sector hard If the currency is allowed to appreciate in nominal terms, the increase in inflation would be much smaller, at the cost of a more immediate negative impact on the tradable sector

If financing inflows stop, in the absence of an immediate fiscal tightening, a large currency depreciation is likely In a high inflation environment, this could lead to a depreciation-inflation spiral and ultimately to a collapse of the currency (full dollarization) This risk is less pronounced if the currency was allowed to appreciate initially, but macroeconomic volatility/turmoil will nevertheless be substantial

Monetary policy has no good options: Its best bet is to allow a nominal currency depreciation; the tradable sector will suffer, but the real appreciation is ultimately the result of the fiscal expansion and will take place either through the nominal appreciation or high inflation, or monetary policy tightens dramatically to offset the inflationary impact of the fiscal expansion

Drastic monetary tightening (increase in policy rate to at least 20% over next two years) is effective in controlling inflation, …

… but at the cost of a massive recession and crowding out of the private sector:

Option II: Combating inflationary pressures and financial risks through expenditure restraint

The output gap would close …

… and inflation would return to the low single digits:

In nominal terms, expenditures under this option would be considerably smaller, …

… but in real terms the difference is much smaller, because inflation erodes the purchasing power of expenditures under the MTBF scenario:

Bottomline The fiscal expansion planned in the MTBF carries substantial risks to macroeconomic stability, with high inflation eroding the purchasing power of these expenditures, such that in real terms, expenditures are not much higher than under an alternative scenario with expenditure restraint.