Tools Beyond Fiscal, Monetary Stance Help Improve Policy Outcome: IMF's Gita Gopinath

The use of additional tools beyond fiscal and monetary policy, such as foreign exchange intervention, capital controls, and domestic macroprudential measures, helps economies achieve macroeconomic stabilisation, affirmed a working paper by IMF deputy managing director Gita Gopinath and economist Suman Basu.

For shocks to commodity prices and global interest rates, monetary and fiscal policies may help achieve a combination of macroeconomic adjustment and stabilisation in the absence of financial frictions. These tools appear to be helpful in managing such shocks, even after the addition of some financial friction. However, when we turn to premium spikes and sudden stops that are amplified by financial frictions, the use of FX intervention, capital controls, and domestic macroprudential measures may become especially helpful to improve outcomes, according to the findings of the paper.

The Mundell-Fleming approach describes how changes in demand affect output. The Mundell-Fleming approach showed that after economic shocks, monetary policy and exchange rate flexibility could achieve macroeconomic stabilisation in this regime.

However, some practical limitations of the Mundell-Fleming approach have emerged over time. Countries have experienced new problems, the international finance literature has advanced, and the composition of the global economy has changed, forcing countries—especially emerging and developing economies—to move beyond existing frameworks towards a mix of other frameworks.

"When applying it after a shock, we typically assume that returning the economy to the pre-shock levels of home output and trade balance is the desirable outcome," the report said. But, over time, policymakers have become more sophisticated, it said. They know that it may be appropriate to make macroeconomic policy adjustments in response to some shocks while resisting others.

If there is no formal integration of these inputs, it is not clear whether the results from each framework are consistent with, or actually invalidate, each other, the authors argue.

Gopinath and Basu propose an integrated policy framework diagram to analyse the use of multiple policy tools as a function of shocks and country characteristics. The underlying model includes the use of monetary policy, FX intervention, capital controls, and domestic macroprudential measures.

The authors proceed step by step in building the IPF diagram. Specifically, they design the diagram to incorporate the following key elements: a normative structure to explain which shocks to accommodate and which to resist, and additional policy tools beyond monetary and fiscal policy.

Their second step is to add financial frictions that can generate premium spikes, sudden stops, and domestic credit crunches. The resulting diagram can be tailored to each country depending on which frictions are most relevant to that country.

These first two steps include all the tools except fiscal policy, because it is typically too slow to handle high-frequency external shocks. Bear in mind, however, that fiscal policy has sometimes swung into action to handle the largest shocks—such as during the Covid pandemic.

The authors also show how the occasional addition of fiscal policy may alter the results. A narrative on the policy mix emerges from the multiple variants of the IPF diagram. The diagram illustrates that for shocks to commodity prices and global interest rates in the absence of financial frictions, monetary and fiscal policies may help achieve a combination of macroeconomic adjustment and stabilisation.

These tools appear to be helpful in managing such shocks, even after the addition of some financial friction. When we turn to premium spikes and sudden stops that are amplified by financial frictions, the use of FX intervention, capital controls, and domestic macroprudential measures may become especially helpful to improve outcomes.