Macroeconomic policy interaction: State dependency and implications for financial stability in UK: A systemic review

Nasir, Muhammad Ali; Wu, Junjie; Yago, Milton; Soliman, Alaa M. Article Macroeconomic policy interaction: State dependency and implications for financial stability in UK: A systemic review Cogent Business & Management Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Nasir, Muhammad Ali; Wu, Junjie; Yago, Milton; Soliman, Alaa M. (2016) : Macroeconomic policy interaction: State dependency and implications for financial stability in UK: A systemic review, Cogent Business & Management, ISSN 2331-1975, Taylor & Francis, Abingdon, Vol. 3, https://doi.org/10.1080/23311975.2016.1154283 This Version is available at: https://hdl.handle.net/10419/205863 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 BANKING & FINANCE | RESEARCH ARTICLE Macroeconomic policy interaction: State dependency and implications for financial stability in UK: A systemic review Muhammad Ali Nasir 1 *, Junjie Wu 1 , Milton Yago 1 and Alaa M. Soliman 1 Abstract:The association between economic and financial stabilities and influence of macroeconomic policies on the financial sector creates scope of active policy role in financial stability. As a contribution to the existing body of knowledge, this study has analysed the implications of macroeconomic policy interaction/coordination for financial stability, proxied by financial assets, i.e. equity and bonds price oscillation. The critical review and analysis of the existing literature on the subject suggests that there is also ample evidence of interdependence between monetary and fiscal policies and this interrelation necessitates coordination between them for the sake of financial stability. There is also a case for analysing the symmetry of financial markets responses to macroeconomic policy interaction. On methodological and empirical grounds, it is vital to test the robustness of policy recommendations to overcome the limitation of a single empirical approach (Jeffrey–Lindley’s paradox). Hence, the Frequentist and Bayesian approaches should be used in commentary manner. The policy interaction and optimal policy combination should also be analysed in the context of institutional design and major financial events to gain insight into the implications of policy interaction in the periods of stable economic and financial environments as well as period of financial and economic distress. *Corresponding author: Muhammad Ali Nasir, Faculty of Business & Law, Leeds Beckett University, Leeds, UK E-mail: [email protected] Reviewing editor: David McMillan, University of Stirling, UK Additional information is available at the end of the article ABOUT THE AUTHORS Muhammad Ali Nasir is a senior lecturer in Leeds Beckett University, UK. His main areas of research interest are macroeconomics, financial economics, labour markets, international trade and macroeconomic modelling. Nasir also has a great interest in the history of economic thought, European integration and more recently, European financial crises, with which the article was inspired from. He is the corresponding author of this paper. Milton Yago is a senior lecturer in Leeds Beckett University, UK. His main areas of research interest are macroeconomics, international trade, microeconomics and DSGE modelling. Junjie Wu is a senior lecturer in Leeds Beckett University, UK. Her wide research interests include accounting, finance and economics. She is particularly interested in SME and CSR-related issues. Alaa M. Soliman is a senior lecturer in Leeds Beckett University, UK. His main areas of research interest are macroeconomics, financial economics, econometrics and macroeconomic modelling. PUBLIC INTEREST STATEMENT The stability of the financial sector is very important for both the economy and society. This importance creates scope of active policy role in financial stability. However, relying on a single policy measure is not the best scheme to achieve neither economic nor financial stability. This study has analysed the implications of macroeconomic policy coordination for financial stability and is particularly focused on stock and bond markets. The critical review and analysis of the existing literature on the subject suggest that there is also ample evidence of interdependence between monetary and fiscal policies and this interrelation necessitates coordination between them for the sake of financial stability. There is also a case for analysing the symmetry of financial markets’ responses to macroeconomic policy interaction. This study also suggests that it is vital to test the robustness of policy recommendations using alternative empirical approaches. Furthermore, the institutional design and major financial events are important factors in coordination of policies. Received: 09 December 2015 Accepted: 10 February 2016 Published: 03 March 2016 © 2016 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. Page 1 of 36 Page 2 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 Subjects: Banking; Investment & Securities; Macroeconomics; Monetary Economics Keywords: macroeconomic policy interaction/coordination; symmetry of financial markets responses; financial stability; Bayesian estimation; Jeffrey–Lindley’s paradox; institutional design JEL Classifications: C11; E02; E44; E52; E58; E61; E63; G12; G18 1. Introduction/background and contemporary research issues’ role of economic policies Fiscal and monetary policies are the most prominent and widely used macroeconomic policies in addressing many economic issues by policy-makers. The basic function of macroeconomic policy is to contribute towards the achievement of economic objectives, e.g. price stability and economic growth (Bank of England, 1997). Hence, as defined by the US Federal Reserve (2011), monetary policy is referred to the actions taken by monetary authority (Central Bank) to control the availability and cost of monetary instruments for national economic goals. Correspondingly, fiscal policy can be described as government’s policies of, e.g., revenue collection and spending to accomplish its financial obligations. Particular to the UK economy, Her Majesty’s Treasury (HMT) is responsible for the formulation and implementation of fiscal policy, whereas monetary policy is autonomously formulated by the Bank of England (hereafter BoE; official abbreviation1). The stance of a macroeconomic policy can be either categorized as contractionary or expansionary, depending upon its effects on the supply of money in the economy. Macroeconomic policy which leads to the expansion of money supply, for instance, through tax or interest rate cuts would be called expansionary macroeconomic policy and vice versa (Sullivan & Sheffrin, 2003). The effects of macroeconomic policies are not limited to the real economy2 as various studies, for instance Bredin, Hyde, and Reilly (2005), Ardagna (2009) and Arnold and Vrugt (2010), reported significant impacts of macroeconomic policies on the financial sector. In practise, the responses of stock and bond markets to monetary policy are acknowledged by the Bank of England (2011), stating that bonds and equities are inversely related to interest rates due to the high rates on which future income is discounted. 1.1. State dependency The associations between macroeconomic policies, the real economy as well as the financial sector are not consistent and have shown some dynamics with respect to the state of the economy. Putting it simply, the impact of a macroeconomic policy may vary under different circumstances. In support of this, Lippi and Trachter (2012) and Chen (2012) showed that monetary policy effects on output and US stock market vary according to the state of economy. It implies that the scope of monetary or fiscal policy for achievement of any objective could be influenced by other factors, often prevailing macroeconomic conditions. This dynamic behaviour of macroeconomic policy impact is called State Dependency. It also raises the question about the implications which business cycles or any other macroeconomic factors could have for effectiveness of a single or both macroeconomic policies. In addition to business cycles, the impacts of monetary policy could be influenced by the institutional framework for policy-making and major macroeconomic events impacting the economy. The macroeconomic events and or institutional changes in policy frameworks could result in paradigm shifts which in turn influence the impacts of monetary policy (see Kontonikas, MacDonald, & Saggu, 2012; Wong, Khan, & Du, 2006). Similarly, an important aspect of macroeconomic policies is the structure and design of their parental institutions. Any change in the framework of policy-making intuitions could affect the effectiveness of monetary policy (see Lu & In, 2006; Osborn & Sensier, 2009; Semiromi & Reza, 2010). Specific to institutional framework in the UK, some major changes in the past few decades can be noted, particularly the independence of the Bank of England (1997) which resulted in a big shift in institutional design. Certain responsibilities related to financial stability, e.g. banking sector supervision and management of sovereign debt were transferred to the Page 3 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 Financial Services Authority (FSA) and Debt Management Office (DMO). We will have a detailed discussion on intuitional framework in the later sections. However, the point to be made here is that state dependency and institutional design are important aspects to be considered in a study on the subject of macroeconomic policies. Most studies on this subject have been either focused on the Econometric or General Equilibrium approaches to gauge the impacts of macroeconomic policies on the economy. In this regard, Bhattarai (2011) strongly emphasized that DSGE and Econometric models should be considered complementary techniques rather than competitive. Apart from separate empirical frameworks, we also have separate approaches to estimations in this study, i.e. Traditional or Frequentist approach and Bayesian techniques. These are based on different theorems (Gauss–Markov theorem and Bayes theorem), and both approaches are fundamentally different in various contexts. The Frequentist approach is deterministic in approach, whereas the Bayesian approach is stochastic in nature. Nevertheless, these differences in empirical approaches may show different impacts of macroeconomic policies. In this aspect, Robert (2013) cautioned that each estimation approach may lead to a different conclusion and we could end up with a situation called Jeffreys–Lindley’s paradox. Thus, an analysis of the role of macroeconomic policies and resulting policy decisions might be influenced by the choice of empirical approach employed to perform the policy analysis. 1.2. Significance of the financial sector Despite their influences on the financial sector, it could be legitimately questioned why macroeconomic policies should consider financial market dynamics when financial stability has not been the mandate of macroeconomic policy-makers and institutions so far. Minsky (1974) reported the significance of the financial sector for the real economy quite a while ago, yet the behaviour of financial markets has not been incorporated into macroeconomic policy formulation hitherto. On this issue, by criticizing monetary policy stance in the real world, Mishkin (2011) argued that “although central bankers were aware that the financial sector has an important effect on economic activity, financial frictions were not an element of the pre-crisis monetary policy”.3 Hence, the defence of our intention to consider the financial sector within the macroeconomic policy mix is due to its importance for the real economy. In a recent post-financial crisis study, Borio (2011, p. 33) argued that “financial and macroeconomic stabilities are two sides of the same coin and monetary policy plays a critical role in both”. Similarly, Tsouma (2009), Funke, Paetz, and Pytlarczyk (2010) and most recently Airaudo, Cardani, and Lansing (2015) declared that financial market performance itself is important for economic stability. It was also suggested that monetary policy by incorporating stock market prices in its formulation (Taylor type rules) could help reduce economic fluctuations, which could not be done solely focusing on the real economy only. 1.3. Scope of macroeconomic policies in financial stability The frequent argument in favour of monetary policy role in financial stability documented in previous paragraphs does not imply that there is consensus among academics and economists and policy-makers on this subject. For instance, by rejecting the aspect of monetary policy role in financial stability, Nakov and Thomas (2011) argued that the optimal monetary policy should only be strict inflation targeting. This rejection was also revealed by Albulescu (2011) that monetary policy role in financial stability has not been appreciated by the Austrian school of thought. In a rather recent study, Williams (2012) showed that optimal monetary policy should be able to react to financial crises. Similarly, Blanchard, Dell’Ariccia, and Mauro (2010) argued that in the post-crises scenario, despite the fact that there is no change in ultimate goals of output and inflation stability, asset prices and leverage of agents should also be in the sight of macroeconomic policy makers. Mishkin (2011) argued that as price and output stability do not ensure financial stability, therefore, macroeconomic policy solely based on these objectives may not be enough to produce good economic outcomes. It is therefore unambiguous that there is an important role for macroeconomic policies in financial stability worth serious consideration. This is one of the considerations we are taking in this study. Page 4 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 1.4. Macro-prudential policies Financial stability4 and growth have been the remit of macro-prudential policies formulated by different regulatory bodies, for instance, by the FSA in the case of the UK. In addition, there is also an unconventional instrument of asset purchases called Quantitative Easing (Q.E) which has been used by the BoE and could be considered a policy tool for achieving financial stability. Some studies, for instance Benigno, Chen, Otrok, Rebucci, and Young (2013), argued that macro-prudential policies are welfare reducing and should not be used to avoid financial crises. In addition, Agenor and Silva (2012) and Borio (2011) claimed that prudential policies are insufficient for financial stability and urged monetary actions instead. Whereas accepting the limitations of prudential policies, Svensson (2012) and Collard, Dellas, Diba, and Loisel (2012) cautioned that monetary policy (interest rates cut) should only be used as a “Last Line of Defence” in financial crises when prudential polices are insufficient. Their caution also raises concerns as monetary policy can only take us so far due to the limitation of the liquidity trap (zero bound or nominal interest rates cannot be cut further below zero). This limitation was acknowledged by Mishkin (2011) and could be witnessed in the present economic scenario.5 Cúrdia and Woodford (2011) assert that QEs are not very effective in addressing financial crisis since they depress the returns (yield) on financial assets. Coupling the macro-prudential policies with monetary policy has been suggested as a solution to financial and economic crises. Angelini, Neri, and Panetta (2010) found that active macro-prudential policies coupled with macroeconomic policies have the potential to reduce economic volatility, though the benefits might be trivial. There is also the risk of failure of policy coordination which could bring adverse outcomes for the economy. Looking at the functioning of macro-prudential policies and macroeconomic policies, macro-prudential policies could be considered preventative, whereas macroeconomic policies work as preventative as well as reactive measures. These features of monetary and fiscal policies (macroeconomic policy) make them stand apart. A recent study on the role of fiscal policy by Benigno, Chen, Otrok, Rebucci, and Young (2012) showed that fiscal policy was an affective preas well as post-financial crises policy instrument. Similarly, Mishkin (2011) argued that “Leaning against financial instability is better than cleaning up after the crises”. It has been widely acknowledged that the current global financial and economic crises were so severe that they overwhelmed the ability of conventional monetary policy to counteract it. This sentiment also indicates the limitation of monetary policy and potential scope of fiscal policy as a complimentary tool for more effective macroeconomic policy interventions. 1.5. Fiscal–monetary policy combination In comparison with monetary policy, lesser attention has been paid to analyse the association between fiscal policy and the financial sector (Ardagna, 2009). The phenomenon behind this discrimination against fiscal policy for its potential role in economic and financial stabilities was explained by Blanchard et al. (2010). These authors argued that in the past two decades, fiscal policy took a backseat to monetary policy in the practise of macroeconomic policy implementations. The reason for this seemed to be the wide scepticism about the effects of fiscal policy, largely based on the Ricardian Equivalence.6 Hence, if monetary policy could maintain stable output and price, there was then little reason to use another instrument. A distinctive aspect of this study is the use of macroeconomic policy combinations for financial stability as there is evidence of a consensus emerging in recent studies that considers it preferable to use both policies simultaneously (see Gomis-Porqueras & Peralta-Alva, 2010; Sims, 2011). The notion of using more than one policy instrument is half a century old due to what is called Tinbergen’s Principle. This principle itself is not a policy guideline. Agenor and Silva (2012, p. 6) argued that “Tinbergen’s does not assert that any given set of policy responses will, in fact, lead to that solution. To assert this, it is necessary to investigate the stability properties of a dynamic system”. In simple words, one policy combination does not fit all and Tinbergen does not suggest any policy combination either. Most importantly, in the context of financial (government debt) stability, Hughes Hallett, Libich, and Stehlík (2011, p. 2) argued that “let us note that there will be no additional policy Page 5 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 instrument to achieve the financial stability goal (in the spirit of Tinbergen, 1952) and it is never socially optimal for monetary policy to do the job on its own”. Despite the acknowledged importance of joint policy analysis, most studies in the existing literature have only focused on a single policy. Even the studies which incorporated policy combinations into their analyses mainly focused on the EU and the real economy (see Jansen, Li, Wang, & Yang, 2008; Semmler & Zhang, 2003). A point to note here which is interesting and which will also be relevant in this study is Auerbach and Gorodnichenko (2012) who found heterogeneity in impacts of fiscal policy on different sectors of the economy. In relation to this finding and due to country-wise heterogeneity, Baum, Poplawski-Ribeiro, and Weber (2012) called for a tailored use of fiscal policy and a country-by-country assessment of their effects. Thus, sectoral and country-wise heterogeneity in impacts of monetary and fiscal policies imply that we may have a very unique optimal macroeconomic policy combination for a specific context of the financial sector’s stability. Hence, it may not be appropriate to generalize the existing evidence of policy combinations on the real economy to the financial sector’s stability everywhere. On top of this, UK financial markets have several unique features which make them stand apart (see Yang, Zhou, & Wang, 2009). In other words, the policy guidelines drawn on the basis of a particular sector of the real economy of any country should not be generalized to the financial sector’s stability in the UK, unless and until a comprehensive analysis is performed. 1.6. Indistinct key concepts It is essential that a few indistinct and elusive yet quite important concepts are defined and explained for the convenience of the reader. First is Financial Stability which has no single generally agreed definition, and therefore it is not as explicit as price stability, for example, which could be quantified as 2% inflation target by the BoE. On this same subject, according to Foot (2003) there is “no particular definition of financial stability”. However, it could be defined in the context of financial assets price volatility and generality of financial markets and institutions. An interesting and rather bold argument was made by Goodhart (2004, p. 2) that “Indeed there is currently no good way to define, nor certainly to give a quantitative measurement of financial stability”. Fortunately, the answer to the question about how financial stability could be defined in an appropriate way came out in a recent study by Khorasgani (2010, pp. 20–21). Taking a line, somewhat similar to Foot (2003, p. 3), it was argued that “There is no consensus on a definition of financial instability. However oscillation of some variables is often considered. House and stock prices, exchange rate and the prices of some other financial assets, on the one hand, and household debt growth and debt accumulation, on the other hand, are some of the main variables which are used to investigate the financial imbalances issue.” Hence, considering these arguments, our definition of financial stability is simply about the price behaviour of financial assets, i.e. stock (equities) and government bonds. Now, a legitimate question could be posed about why the particular segments of the financial market on which this study is focused are only the stock and bond markets? A simple answer and reason for this choice could be to a small extent the limited scope of this research as we are unable to consider all segments of the financial market. However, it is particularly because of the “wealth effects of stock and bond markets on the real economy” (see Airaudo et al., 2015; Funke et al., 2010; Malikane & Semmler, 2008). In addition to those authors, Broome and Morley (2004) also found that stock prices are a significant indicator of financial crises. Similarly, Campbell (1995) and David Gulley and Sultan (2003) gave a comprehensive account of the importance of bond market for governments as well as for private sector investors. Third and final reason for this choice is our definition of financial stability. Following the footsteps of Foot (2003) and Khorasgani (2010), it can be defined as financial assets price oscillation and financial market generality of financial markets and institutions. 1.7. Optimality The second term on which there is some consensus, yet requires some explanation, is our definition of Optimal Policy. In this context, we refer to Mishkin’s (2011) argument that the theory of optimal Page 6 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 monetary policy starts by specifying an objective function that represents economic welfare, and then maximizes this objective function subject to a set of constraints. The existing evidence on the definitions of Optimal Policies shows that various studies use this term in a range of contexts. For instance, Bénassy (2003) declared the optimal combination of monetary and fiscal policies as the one which leads to maximization of household utility and firm profits, whereas Nakov and Thomas (2011) categorized a monetary policy as optimal which curtails inflation. A fascinating point to note here is that apart from the different contexts in which optimality of a policy has been seen by various studies, it is also interesting to recognize that for the same context, the parameter of optimality has been different. Ferrero (2009) showed that optimal monetary policy should be flexible inflation targeting, while taking an opposite line, Nakov and Thomas (2011) argued that optimal monetary policy should only be strict inflation targeting. Hence, in these two examples, there is a difference of opinion on the optimality of monetary policy for achieving the same objective, i.e. price stability. One reason for this difference could be the constraints which should also be satisfied. In this study, we are analysing the optimality of macroeconomic policies in the context of financial stability. There is very few, yet sufficient evidence to support the importance of analysing optimality of policy combination for financial stability. For example, a recent study by Benigno et al. (2012) showed that optimal fiscal policy (taxes) is effective in restoring financial stability. This study used capital flows as the measure of financial stability. However, this study measures financial stability using stock and bond markets. In this regard, this is associated with Kontonikas and Montagnoli (2006) who argued that optimal monetary policy should positively affect stock market and house prices due to the wealth effects of these assets. In other words, this study considers a macroeconomic policy combination as optimal which positively influences our objective function, e.g. stock prices without negatively affecting the bond market (constraint) and vice versa. The optimal policy combination for financial stability is to some degree unique as mostly optimal policy has been seen as a single policy in context of the real economy. The difference of this study from any other is to take it further by taking fiscal policy and bond markets on board. Furthermore, this study also tests the optimality of our policy mix in various contexts (discussion on policy combinations and state dependencies in separate section) as a robustness measure. 1.8. Estimation of optimal policy At this point, a methodological question may arise about how this study would measure the impact of optimal macroeconomic policies on financial stability. More specifically, how long the positive effects of macroeconomic policies on stock and bond markets should persist to make a contribution to financial stability? To provide an adequately satisfying answer, this study looks into the theoretical as well as philosophical backgrounds of these questions and the answers appropriate to them. “The stock and bond markets are used as proxies for financial markets and we specifically consider the wealth effects of these markets.” In other words, the increase in value of assets leads to increase in wealth of their holders, resulting in increased consumption and economic growth (see Airaudo et al., 2015; Caporale & Soliman, 2013; Case, Quigley, & Shiller, 2012). At this point, it’s worth mentioning that Altissimo et al. (2005) comparing various European economies argued that the wealth effects are rather more important for the British economy due to the high degree of financialization than in other European countries. Figure 1 best illustrates their argument, clearly depicting the relatively gigantic size of the British financial sector in comparison to its national income relative to other countries. The wealth affects are instantaneously created with the increase in value of financial assets. A study by Carroll, Otsuka, and Slacalek (2011) found that the wealth effects are immediate and persist for several quarters before completely being defused. Similarly, an earlier study by Carroll (2004) compared various studies and argued that although there is mixed evidence, mostly the wealth effects persist into the medium term (3years). “The full effect happens asymptotically as time reaches infinity.” Despite the fact that the wealth effects are instant, instead of looking at the short term (news effects), this study will consider the Page 7 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 long-term behaviour of financial markets in response to macroeconomic policies combinations. The rationale is that a positive response from financial markets which persists over several periods may result in enduring wealth affects. The philosophical foundation of this study is derived from positivism, which suggests this study will urge on adopting the scientific approach, objective measures and systematic statistical analysis to better understand how an interaction of monetary and fiscal policies could influence financial stability. Hence, this study intends to provide a comprehensive theoretical framework which provides theoretical rationale to include the most appropriate data. Having access to two policies means there could be four possible policy combinations.7 As explained earlier, a policy combination which maximizes the objective function (Bliss Point) while satisfying the constraints would be the most appropriate or Pareto Optimal8 policy combination. Putting it more simply, an optimal policy combination would lead to relatively long-lasting positive impacts on stock and bond markets, which also significantly contributes to financial stability through the wealth effects/real economy dynamics. Considering the pragmatic aspect of this study, an insight into the current outlook of the financial sector in the UK is essential. It would shed some light on the scope of macroeconomic policies in the light of theories as well as contemporary macroeconomic and institutional environments in which financial markets exist. 2. Current financial outlook and policy measures The current state of affairs in the financial sector shows a gloomy picture. Exceptional and to a degree unprecedented events in the last few years, specifically the aftermath of Lehman Brothers collapse, led to both monetary and fiscal authorities to adopt unconventional and aggressive approaches to address the effects of the financial and economic repercussions of the crises. The BoE launched an asset purchase programme referred to as quantitative easing (QE) and the HM Treasury bailed out financial institutions including notably the Royal Bank of Scotland (RBS) and Northern Rock building society. Money was pumped into the financial sector through QE to try to solve the liquidity problems. The BoE introduced the so-called Special Liquidity Scheme*9 in 2008 to improve the liquidity position in the UK economic system. Similar practices were implemented by other countries like the USA, China and Euro zone countries, etc. However, the focus of this study is on the British economy and its relatively large financial sector. Figure 2 represents the stance of the Bank of England in response to the financial and economic crises and post-Lehman Brother’s bankruptcy episode. It is evident from the diagram that in addition to the very active expansionary stance by dropping interest rates, the BoE has also used the unconventional instrument of Quantitative Easing by purchasing financial assets on a large scale. There is some evidence in the macroeconomic literature on the intensity of the response by the BoE to the crises. Study by Landolfo (2004) showed that among Figure 1. Market capitalization in comparison with national income (% of GDP). Source: World Bank’s World Development Indicators (2013). 0 20 40 60 80 100 120 140 160 180 2003 2004 2005 2006 2007 2008 20092010 2011 UK USA EU World Page 8 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 the world major central banks, i.e. the US Fed, European Central Bank (ECB) and the Bank of England (BoE), the latter showed the most aggressive behaviour in response to adverse economic conditions. The current state of affairs represented in the above diagram clearly has two implications. Firstly, it indicates the severity of the financial and economic crises and their implications for the real economy which led the BoE to adopt an additional unconventional instrument of QE. Secondly, it also indicates the limitation of interest rates as an instrument in this particular case because of the so-called liquidity trap when rates are so low that they cannot drop much further. There is lack of sufficient evidence on the success of the Quantitative Easing measures in the existing literature due to the unprecedented nature of these strategies. However, there is some evidence in a recent contribution by Cúrdia and Woodford (2011), showing that QE may not be very useful, and it may even depress the returns (yield) on financial assets, even though asset purchases could be fruitful when there is turmoil in the financial markets. Hence, despite the fact that these measures of low interest rates and asset purchases were important to support the financial sector by providing liquidity, there may be some downsides of these measures reflected in depressed yield on assets, specifically government bonds or gilts. Figure 3 represents these effects on the most current outlook in this study of real yield curves of gilts. The outlook is very discouraging in real terms, as it is evident that in real terms, the yield curve indicates a negative return in the short term as well as falling returns in the long term (negative risk premium), i.e. between 10 and 25years to maturity. In such a situation, the government and financial institutions might be beneficiaries of low cost borrowing and high prices of asset holdings. However, the household constituting pensioners and Figure 2. Bank of England, monetary policy (rates) and balance sheet. Note: Assets in Billions GBP. Source: Bank of England Quarterly Bulletin (2012, p. 1). Figure 3. Real yield curve for UK government bonds (Gilts). Source: Bank of England (2013, February). Page 15 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 the fiscal and monetary authorities should coordinate with each other as the fiscal policy often puts some constraints on monetary policy. Moreover, the central bank inflation targeting should be coupled with fiscal constraints. In recent cases of reporting inter-dependence between macroeconomic policies, Zubairy (2009) and rather later Davig and Leeper (2011) also showed that the strong action of monetary policy can restrain the effects of fiscal policy. Consequently, policies influence the role of each other; therefore, their interaction cannot be overlooked. 7.2. Coordinating macroeconomic policies’ “symbiosis” In their study, Dixit and Lambertini (2001) argued that the interaction of the both fiscal and monetary is a recent phenomenon and it has gained importance in the field of economic policy formulation as several studies have considered the interaction of monetary and fiscal policies. They emphasized the coordination between monetary and fiscal policies and cautioned that the non-cooperative behaviour can cause low output growth and high rate of inflation, but if the authorities’ preferences coincide, the ideal growth and inflation is attainable. In case of disagreement, the outcome can be influenced by institution design; therefore, it was recommended that giving a leadership role to either monetary of fiscal authority can be fruitful. Latter investigation by Dixit and Lambertini (2003) showed almost similar findings that the optimal results are achieved by consensus of fiscal and monetary authorities on the desirable level of output and inflation, for which they coined the, later became famous, term “Symbiosis”. Similar and recent study on European Monetary Union (EMU) where monetary policy is formulated at union level (European Central Bank) but fiscal policy is formulated at country level, Ferré (2008) also emphasized that EMU should adopt coordination and exchange of information in fiscal policies as it affects economies in EMU. In the context of “Symbiosis” discussed in previous paragraphs, a recent study by Di Bartolomeo and Giuli (2011) on macroeconomic policy interaction showed that the symbiosis suggested by Dixit and Lambertini (2003) does not hold under uncertainty effects on monetary policy. They argued that macroeconomic policy uncertainties are not symmetric and could affect economy. Moreover, the role of monetary policy under uncertainty could be affected by fiscal stance. However, in the context of coordination, they unanimously supported the theme; they cautioned on viewing monetary and fiscal institutions as separate entities and urged for coordination in uncertain economic scenario. For the achievement of economic objectives, Bénassy (2003) emphasized that the optimal combination (household utility and firm profit maximized) of monetary and fiscal policies leads to better outcomes, even when information available to the policy-makers is constrained. In a recent study on dimension of information, the coordination among macroeconomic policies was investigated by Nasir, Ahmad, Ali, and Rehman (2010). Although they reported that there had been very week coordination between macroeconomic policies, yet they emphasized on more coordination and exchange of information among policy-makers for economic stabilization. Similarly, seeing coordination in the light of openness and integration of financial markets, empirical results by Pierdzioch (2004) showed that the higher capital mobility does not reduce the effectiveness of fiscal policy and it is important to consider the interaction of fiscal and monetary policies while considering the integration of financial markets as the fiscal policy shocks propagate through an open economy. Macroeconomic policy coordination is also important due to the inter-dependence between macroeconomic policies as reported in a recent study by Andrew, Libich, and Stehlik (2011). They found that the macroeconomic policies have spill-over effects on each other, and therefore even formulated independently, they are interdependent. In the medium term, coordination is more important in the context of ambition than conservatism. The coordination is important even when the policies have different objectives, as in non-coordination (Nash Equilibrium) they fall in “tug-of-war”. They suggested that the coordination should not be limited to exchange of information but extended to details of each policy. However, they did not provide empirical support to their arguments nor any framework on policy coordination. Page 16 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 7.3. Absence of policy coordination and consequence Macroeconomic policy interaction is also important for the reason that the conflicting and coordinating policies could have different implications for economy. In this context, Hughes Hallett and Libich (2007) showed that the absence of coordination is damaging for policies’ credibility; moreover, it leads towards economic instability. They also declared it necessary to take fiscal and monetary policies’ intentions into account to get a realistic picture of the effectiveness of the policies and policy institutions. Similarly, Chadha and Nolan (2007) investigated monetary and fiscal interaction and found that the design of optimal stabilization policy requires consideration of both monetary and fiscal plans. Moreover, “passive” fiscal policy necessitates large long run responses to inflation from monetary policy and aggressive monetary policy may result in an aggressive set of fiscal plans. Similarly, analysing the macroeconomic policy interaction in Romania, Talvan and Lupu (2010) argued that for economic and price stabilities, the monetary policy needs to be supplemented by fiscal policy. However, they went further and also cautioned that the non-coordination between policies could not only lead to economic instability but also social unrest. A major factor leading to popularity of coordination between fiscal and monetary policies was adverse outcome in the case of conflict between policies, supported by the work of Leitemo (2004), as they cautioned that the Nash game between an inflation-targeting central bank and the fiscal policy authorities may lead to strong interest rate and exchange rate fluctuations due to a conflict over the output gap. Economic fluctuations can be harmful to the financial stability of an open economy; therefore, fiscal policy should support the monetary policy objective to a greater extent. Similarly, the study by Lombardo and Sutherland (2004) also supported the view that the fiscal and monetary policies should be coordinated for welfare gains in monetary union. Passive fiscal policy would be better than non-cooperative fiscal policy; however, non-cooperative fiscal policy can be a better choice if monetary policy is non-cooperative. Most of these studies had been on European Union economy which has its idiosyncratic policy framework, whereas in the UK, both monetary and fiscal policies are formulated at country level. Analysing macroeconomic policy interaction in Croatian economy in an Econometric framework (Structural VECM model) empirical analysis by Rukelj (2009) showed that the fiscal policy and monetary policy showed negative impacts on each other, which showed that they moved in opposite directions; therefore, they were categorized as substitutes. However, they did not incorporate the outcome of conflicting stance, which might be due to the limited empirical framework. Specific to an aspect of the financial sector (Forex markets), study by Giorgio and Nistico (2008) showed that in the case of counter cyclical fiscal policy, fiscal discipline plays an important role in the movement of exchange rates and Net Foreign Assets. “Most importantly, they cautioned that monetary authority’s solo efforts to stabilize the financial sector (Net foreign Assets) fluctuation may results in high volatility of Forex.” Similarly, appreciating the macroeconomic policy coordination, Hanif and Arby (2009) argued that the monetary and fiscal measures may conflict with each other; poor coordination could lead to financial instability (interest rates and Forex volatility) high inflation and instable growth. In their economy analysis of Pakistan, the Monetary and Fiscal Policy Coordination Board had been established for the purpose. However, in their later study, Arby and Hanif (2010) showed that the monetary policy stance has shown a poor coordination with fiscal policy in Pakistan. The institutional arrangements, i.e. establishment of Monetary and Fiscal Policies Coordination Board, could not contribute towards coordination. This finding would be interesting in the UK context as the Monetary Policy Committee (MPC) of the BoE responsible for formulation of monetary policy has representation of fiscal authority (HM Treasury); our empirical findings in this study would give us further insight if this arrangement had been successful for policy coordination. 7.4. Fiscal coordination for monetary policy objectives The prime objective of a monetary authority is price stability; however, it may not be achievable by monetary policy on its own as a study by Beetsma and Jensen (2005) found that a negative supply shock raises the inflation and requires fiscal contraction. They also urged that there is more fiscal Page 17 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 coordination needed in Europe as the fiscal policies are formulated in national interest. Similar study by Eichengreen (2005) criticized monetary and fiscal policy framework and SGP poor performance as the European Commission cannot fully enforce fiscal policy matters. They also urged for cooperation from fiscal authorities. Analysing the influence of fiscal policy on monetary policy role, Doughty (1991) argued that the fiscal policy stance influences the role of monetary policy and inflation at two levels: (a) in the short term, fiscal policy affects the transmission of monetary policy (b) while in the long term, it affects the sustainability of monetary policy. The channels through which it influences monetary policy are domestic demand, interest rates, capital market effects and inflation effects. In practice, fiscal policy affects the monetary policy inflation-targeting strategy. Moreover, the sustainability of fiscal policy (debt stabilization) also affects monetary policy objective achievements in the long term. Therefore, it was urged that the fiscal stance should be considered for monetary policy price stability objective and overall policy framework. In a later study, investigating importance of fiscal cooperation for monetary policy, Forlati (2006) argued that in an open economy scenario, there is incentive for fiscal policy to use the tax instrument. Therefore, it was argued the fiscal policy cooperation is important for monetary policy. Later study with similar outcome by Schabert (2006) showed that the monetary policy objective of price stability relies on fiscal policy stance. The monetary policy should not behave aggressively towards achievement of its object, yet fiscal policy should also support (balanced budget) monetary policy objective. In recent evidence, analysing the effects of monetary and fiscal policies’ interaction in the context of fiscal policy effect on monetary role in price stability, investigation by Libich et al. (2011) showed that the effects of undisciplined fiscal policy can spill over to monetary policy role in price stability. It was suggested that the monetary policy should be made more explicit (inflation targeting) and show commitment (transparency and accountability) towards price stability. Their argument was that this mechanism would work as a partial substitute of monetary independence and coordination from the fiscal authority. However, their arguments require empirical validations as absence of coordination could bring sub-optimal results as acknowledged in a previous section. In the context of allocating leadership to a policy, analysing macroeconomic policy interaction in the EMU under three scenarios (Fiscal Lead, Monetary Lead and simultaneous policy formation), the study by Hallett (2008) concluded that the fiscal leadership along with instrument independence and central bank independence results in a better outcome for output, inflation and fiscal balances. Furthermore, it provides fiscal stability without engaging into fiscal rules. The results were robust against fiscal override, market reforms, globalization and changes in savings. However, it was cautioned that in case monetary authority gets leadership, target and instrument setting could cause adverse effects. Their suggestion to allocate leadership to fiscal policy supported its role even for price stability, a basic objective of monetary policy. As briefly discussed earlier, a prominent limitation of monetary policy is the zero-bond or so-called liquidity trap. In practice, the BoE has set interest rates at an all time low (0.5%) since March 2009, which is almost zero-bonds. This limitation of monetary policy in the light of macroeconomic policy interaction was investigated by Dhami and Al-Nowaihi (2009). They showed that a target (inflation or output) for one policy-maker that ignores the incentives and constraints faced by the other policymakers can lead to extremely poor outcomes. They argue that the fiscal policy expansion is fruitful in the liquidity trap when an independent central bank is not very effective. They also urged to avoid giving monetary and fiscal authorities high targets and suggested some dependence on costly fiscal policy in a liquidity trap. However, their arguments were based on a theoretical model without substantial empirical support. 7.5. Monetary coordination for fiscal objectives Fiscal policy is often the mandate of a political administration which also has responsibility of economic growth, perhaps a superior and politically profitable objective. Analysing the economic and political aspects of macroeconomic policy interaction, Nordhaus (1994) argued that the deficit Page 18 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 reduction can result in an electoral cycle (political effects) if monetary policy is non-cooperative and monetary authority may not offset the contractionary effects of fiscal policy. It was cautioned that the poorly timid deficit reduction can have adverse effects of real economy for a decade or longer; this deficit reduction can increase domestic and foreign investments, but if the monetary policy is non-cooperative (contractionary), there can be an adverse impact on economy. However, in case of monetary cooperation with simultaneous and sufficient monetary expansions (rate cuts), the gains are very high. In a later study, Shively (2004) empirically showed that the monetary and fiscal policies’ shocks dominate output fluctuations in the contractionary regime. It was urged that the policy-makers should focus on macroeconomic policy which minimizes the fluctuation of economy as well as policies which maximize the level of aggregate supply. Their findings supported the Keynesian view of stimulating aggregate demand by fiscal policy. Interestingly, they urged monetary policy cooperation for this purpose. Analogously, analysing effects of fiscal policy on output growth in the US economy, Zubairy (2009) showed the fiscal policy (Spending) effects economic growth. Most importantly, it was showed that the strong action of monetary policy can restrain the effects of fiscal policy. Therefore, these findings have important implications for simulation of economy and the financial sector by fiscal expansions and influence of monetary on their association. The scope of monetary policy in fiscal efforts to stabilize economy was brought into analysis by Leith and Wren-Lewis (2006). Focusing on EU, they found that if the monetary authority does not adopt active inflation-targeting policy, it helps the fiscal authority to stabilize government debt and has a strong impact on output and inflation. Otherwise, conflicting policies can cause macroeconomic instability. They further emphasized that restriction on fiscal policy requires supporting active monetary policy. In EU if a fiscal authority cannot meet fiscal requirements, monetary authority has to adopt a passive stance to stabilize debt equilibrium by reducing debt cost. Seeing this complementarity of monetary policy for fiscal policy in the context of fiscal measures in post-financial crises (2008–09), Midthjell (2011) argued that the outcome of fiscal measures is not certain as it depends on choice of instruments and monetary stance. Moreover, there is limited space for fiscal policy to manoeuver due to the limits of public debt and deficit. On the same dimensions, investigating design of optimal monetary and fiscal stabilization policies, Ferrero (2009) showed that the optimal monetary policy takes the form of a flexible inflation targeting, while the optimal fiscal rule prevents national governments from creating inflationary expectations at the union level. Strict inflation targeting by the monetary authority in a currency union level and fiscal flexibility were recommended, as flexible debt targeting improves welfare. Although findings and recommendations may vary from a non-monetary union country like Britain with particularly economic environment, most importantly, fiscal flexibility may lead to excessive sovereign debt issues, e.g. Greek and Ireland cases as mentioned earlier. The role of monetary and fiscal policies in the light of Consensus Assignment (monetary policy look after inflation and output, while fiscal does debt stabilization) was analysed by Kirsanova, Leith, and Lewis (2010). It was argued that in New Keynesian framework, monetary policy dominates fiscal policy for inflation and output stabilization, also in a situation when monetary policy cannot control inflation; therefore, it was suggested that this aspect focusing on monetary policy only should not be overstated. Moreover, they also supported the role of monetary policy in debt stabilization as it costs less than in the general perception and is effective in swift stabilization. Hence, fiscal policy does not dominate in debt stabilization. Though their analysis lacked empirical support, however, based on theoretical model, their augments established the importance of monetary policy in a fiscal role. In the context of this study, the prime focus is on the financial sector rather than real economy, although the financial sector’s stability is not a formal objective of fiscal authority; the unconventional steps (bailouts) taken by various fiscal authorities mentioned earlier could associate financial stability as an implicit object of fiscal authority. Page 19 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 7.6. Macroeconomic policy formulation: discretion vs. commitment Policy formulation can be either by discretion of policy-makers or by following predetermined policy rules. There are mix arguments on the choice of discretion or commitment. In the critical analysis of the US macroeconomic policy, Tager and Van Lear (2001) urged that the fiscal and monetary policies’ rules may not be as successful as there can be the problem of rigidity with policy rules. Policy rules do not help the people and organization left behind the market. There was no analytical model or data used in their research; therefore, their arguments were not supported by empirical evidences. More recent analysis by Adam and Billi (2011) showed that the discretionary macroeconomic policies cause high economic volatility and fiscal imbalance. To deal with this situation, they suggested a conservative monetary authority completely focused on inflation and determined after fiscal policy. However, if monetary policy is formulated before fiscal policy or simultaneously, it loses optimality, even in the case when fiscal policy overlooks its impact on a monetary policy role. Nevertheless, their assertion on non-cooperating monetary policy rules raises concerns about the adverse outcome in case of policy conflict as mentioned earlier. Contrarily, we can also acknowledge some evidence in favour of commitment of macroeconomic policies; for instance, a study by Pappa and Vassilatos (2007) claimed that in a monetary union, constrained fiscal policy with clear rules and active monetary policy for inflation control is necessary for macroeconomic stability. Strict fiscal rules are effective in price stability and are also not that much unbearable as they have been thought. However, their arguments were opposing to the idea that the aggressive policy actions could hamper economic and financial stabilities. 7.7. Popularity of policy interaction in euro zone Most of the study considering policy interaction had been focused on EMU; hence, Semmler and Zhang (2003) associated a whole aspect of literature on policy interaction to the Euro Zone. Prominent studies on the Euro zone, for instance Lombardo and Sutherland (2004), Beetsma and Jensen (2005), Leith and Wren-Lewis (2006) and Ferré (2008), have urged for coordination between macroeconomic policies as it positively affects real economy. They also cautioned that the conflicting policies can cause economic instability. Interestingly, the analysis by Muscatelli, Tirelli, and Trecroci (2004) declared that the interaction depends on the nature of the shocks hitting the economy, for the cases of output shocks, fiscal and monetary policies tend to act in harmony, whereas they are used as substitutes following inflation shocks. They also urged that the fiscal–monetary interaction depends on the model used to fit the data. The strategy of employing different methodological frameworks in this study (DSGE and Econometrics) will further elaborate any dependence of fiscal–monetary interaction on empirical framework. As in the Euro Zone, macroeconomic policies are formulated at union (monetary) as well as national (fiscal) levels. The policy formulation at different levels has created a situation where there might be chances of conflicting policies. A study on conflict of monetary and fiscal policies in currency union by Sanchez (2010) showed that in a currency union due to the free ride of fiscal policies on monetary authority a high volatility in Money markets occurs (interest rates). Therefore, it was suggested that small countries should maintain their monetary sovereignty. Although they did not provide empirical support to their theoretical inferences, yet recent Euro crises is a clear evidence on this issue. Moreover, their arguments were supported by a study analysing the strategic interaction between monetary and fiscal policies in a currency union carried out by Grimm and Ried (2007). They found that in a currency union where monetary policy is formulated union wide, fiscal policy is formulated strategically at country level (heterogeneously) for national objectives. The best outcome is, in the case, when monetary and fiscal policies are agreed on optimal output and inflation level, however, they declared it unrealistic. Therefore, the preferences may not coincide leading to worst effects. It was suggested that the monetary authority should be given a lead role. They urged to reduce heterogeneity of fiscal policies for long-term economic stability in EMU. A later study on the same issue of country size asymmetries by Machado and Ribeiro (2010) showed that in a non-cooperative scenario, small countries lead to active fiscal policy, while large countries adopt a moderate fiscal stance. Furthermore, non-cooperation leads to improved (reduced) outcome for small (large) Page 20 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 economies. However, they also supported the policy cooperation as it leads to overall better outcome on union level. Heterogeneity of agents (fiscal authorities) in EMU has also created a complex situation for macroeconomic policy responses to a shock; it would be interesting to briefly acknowledge a study by Aarle, Garretsen, and Huart (2003) as they analysed monetary and fiscal policies’ interaction in the light of spill-over effects between Euro area and non-Euro area economies. It was shown that the exchange rates’ adjustment acts as an important stabilizer in the case of external shock to the Euro zone. However, in the case of internal and asymmetric shocks, it is not the case. They associated this feature with the common monetary policy by ECB. Moreover, they also acknowledged that in the case of symmetric shock and symmetric economic structure, it is easier to implement appropriate monetary policy than in case with asymmetries. Similarly, the heterogeneity in EU and its implications for policy interaction were investigated by Asensio (2007) using a Keynesian framework. It showed that the heterogeneity has important implications for policy interaction in monetary union. Contrary to symmetric, monetary–fiscal instruments respond to almost every shock in a heterogeneous environment. The interaction could result in inefficiencies, for instance, unemployment and inflation. It was suggested that monetary policy should focus on common effects of shocks, while fiscal authorities should focus on idiosyncratic shocks. They associated it with a subsidiary principle of macroeconomic policy in the Euro zone. Particularly, in a scenario when substantial aspect of research on interaction is only focused on Euro zone (Semmler & Zhang, 2003) where monetary policy is formulated by the European Central Bank (ECB) at union level but fiscal policies are formulated at country level, it may not be appropriate to generalize the policy recommendation to an economy with monetary sovereignty. Perhaps, the role of macroeconomic policies and their interrelation in the EU has its own idiosyncratic nature and may not be appropriate to be generalized for economy like the British. In this context, on the basis of comprehensive study, Viegi (1999) concluded that in a monetary union, the default risk can be used as a tool to gain bail out, particularly by large countries, although this privilege may not be available to non-union members. It was also cautioned that ignoring the long-term consequences of fiscal indiscipline could cause high debt and inflation issues; therefore, sound fiscal policies should be adopted. Moreover, in a monetary union, fiscal policy has spill-over effects and it was cautioned that it could lead to high inflationary stance by all fiscal members. Although the independence of central bank was appreciated, however, its possible conflict with fiscal policy was considered counterproductive. The independence of central bank leads to active use of fiscal policy by the government as price becomes a less important objective and associated with monetary authority. Obviously, this could not be the case in the UK where fiscal authorities would have some concern about inflation due to country-wide scope. 7.8. Macroeconomic policy interaction and crowding out Although the crowding out aspect of fiscal policy in stock and bond markets could not be evident, a study by Stemp (2001) on investigating Australian foreign exchange markets concluded that fiscal policy can affect the exchange rate temporarily as an expansionary fiscal policy is crowded out by exchange rate appreciation, while contractionary policy is crowded out by exchange rate depreciation. There were no empirical methods used; critical analysis was based on arguments stemming from theories and current economic situation. The important point here is if we add exchange rate crowding out to consumption and investment crowding out (mentioned earlier), are there some crowding out effects of fiscal policy on bond and stock markets? If so, how does interaction with monetary policy influence fiscal policy and the financial sector relationship? In this regard, the study on foreign exchange markets and macroeconomic policies by Cook and Devereux (2006) supported flexible exchange rate as it can increase performance of fiscal policy and capital inflow and also emphasized on coordination between fiscal and monetary policies. Page 21 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 7.9. Favouring non-coordination Apart from frequent evidences in favour of macroeconomic coordination cited in previous paragraphs, there are also some studies, for instance Adam and Billi (2011), which argued that the fiscal policy could adopt a non-cooperative stance. Therefore, a conservative monetary authority should completely focus on its mandate of price stability and determine its stance after fiscal policy. Nevertheless, on this aspect, analysing interaction between monetary and fiscal policies in the EMU, a comparatively comprehensive theoretical framework (without empirical validation) by Staudinger (2003) showed that the monetary authority (ECB) is always better off if it takes a leading role (Stackelberg leader); however, for fiscal policy, it depends on the weights given to the inflation and output, which was non-cooperative (Nash) in most of the scenarios considered. Similarly, analysing the roles of optimal fiscal and monetary policies in economic stabilization, Beetsma and Jensen (2005) claimed that if the price rigidities between countries in a monetary union become equal, the stabilization is only done by monetary policy without requiring effort from fiscal policy. On the other hand, we must remember that a non-coordination scenario was discouraged in the same framework (Game Theory), prominently by Leitemo (2004) and Chadha and Nolan (2007) as they cautioned that the Nash game between monetary and fiscal authorities could be harmful to economy; therefore, fiscal policy should support the monetary policy objective. Some support to independent macroeconomic policy formulation was given by Leciejewicz (2010) while analysing the need for macroeconomic coordination vs. independence in the light of theoretical framework (Game Theory). It was shown that there is also a possibility of a different situation, where the independent decision between monetary and fiscal authorities may not lead to an adverse (Pareto non-optimal) scenario. However, it was also stated that the choice of instrument and policy mix depends on the effectiveness of that policy or instrument and background economic scenario. Most importantly, the idea of coordination could not be fully rejected in this study, as it was also acknowledged that for higher output growth, expansionary monetary policy should be coupled with tight fiscal stance. Instead of monetary–fiscal coordination, a comparative analysis between monetary–fiscal and fiscal–fiscal policies’ coordination in EMU was made by Carlberg (2004). It was argued that the cooperation between fiscal authorities (German and French) and monetary authorities leads to full employment. The monetary independence and cooperation between fiscal authorities also leads to full employment; therefore, it was urged that the cooperation is not compulsory as the required output could also achieved without cooperation. Although their assertions lacked empirical support, in a non-union country, for instance UK, there is only one fiscal authority; thus, we cannot go far on this dimension. Analysing the implications of macroeconomic policy coordination in the long and short terms in EMU, Hagen and Mundschenk (2002) argued that in the long run, the price stability can be achieved without coordination as tight fiscal policy in future would offset the expansionary (inflationary) stance of the present fiscal policy. However, this argument raises a few doubts as what if an automatic stabilizer would not work in the long term? Future taxes could not balance the books and what if inflation could not be stabilized? Nevertheless, they implicitly answered these concerns by acknowledging the need for coordination in the short term as lack of it could lead to adverse economic conditions. Therefore, it needs to have consensus on aggregate output and price level in EMU between monetary and fiscal authorities. They also declared current level and arrangements of policy coordination insufficient. An important implication of FTPL is that the “Inflation is also a Fiscal phenomena”. The validity of FTPL and monetarist doctrine was carried out by McCallum and Nelson (2006). They showed that both interest rates’ rules and money stock rules share the opinion that the inflation is also a function of fiscal policy. However, they suggested that detailed coordination between macroeconomic policies is not needed as monetary authority can achieve price stability at its own. Nevertheless, their Page 22 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 unwarranted assertion raises a major concern that if fiscal policy also has a permanent impact on economy, how could monetary policy achieve its objectives on its own in case of a policy conflict? A study in this context was performed by Buti, Roeger, and Veld (2001); their theoretical analysis and numerical simulation showed that the complementarity (coordination) and substitutability of macroeconomic policies and their preferences with respect to each other depend on shock hitting the economy. In the case of supply shocks, they move in opposite ways, while in demand shock, they move in same direction; although their comprehensive analysis favoured coordination to some extent, yet they associated coordination as dependent on shock hitting the economy which implies that the coordination is vulnerable to the exogenous factors. Regarding the issue to coordinate or not to coordinate, Niemann and Hagen’s (2008) argument is that the independent monetary authorities are reluctant to coordinate with fiscal authorities. To support their point of view, they gave the reference of European Central Bank’s (ECB) first President Duisenberg (2003); there is clearly no scope for coordination between monetary and fiscal policies, If that is really the case, the practises by the monetary authorities are not in line with the researchers. Nevertheless, supportive arguments on non-coordination were given by Nyamonga, Sichei, and Mutai (2008) while analysing the behaviour of macroeconomic policies in Kenya. It was reported that during the time horizon of study, the monetary and fiscal policies have shown coordination in a few periods while some periods lacked coordination. They found evidence of monetary policy dominance and declared it as a cause of less harmful outcome during times of non-cooperation. On the other hand, a study on providing evidence on practises of macroeconomic policy coordination in the USA, Astudillo showed that most of the time policies were complementary to each other for stability. We would see this phenomenon in the context of UK economy in the next section. They majority of studies on economic policy interaction have urged for coordination between policies. Followed by many others, a landmark study was by Dixit and Lambertini (2001, 2003) which gave the thought of “Symbiosis”; how to coincide for the financial sector’s stability is still an un-answered question. Moreover, when we compare the empirical work on macroeconomic policy coordination, there are differences of opinion. von Thadden (2004), Schabert (2006) and Ferrero (2009) urged to avoid very strict monetary policy for inflation control and emphasized on fiscal discipline. Similarly, passive monetary and expansionary fiscal policy was suggested by Traum and Yang (2011) for increased output. Contrarily, Barnett (2005), Pappa and Vassilatos (2007) and very recently Davig, Leeper, and Walker (2011) urged for constrained fiscal policy but strict monetary policy for the same objectives. Focusing on real economy (inflation and output), these studies have conflicting conclusions. Obviously, in the light of these contradictory arguments, we cannot suggest a solution for the financial sector of a particular economy unless a comprehensive empirical analysis is performed. 7.10. Interaction and institutional arrangements The significance of intuitional arrangements for an individual policy role has been acknowledged earlier; however, its implications in addition to macroeconomic events could affect the way macroeconomic policy interacts. In this context, analysing macroeconomic policy interaction in Indonesia, Mochtar (2004) found that the Asian Financial Crises (1997) lead central bank to run Quasi Fiscal Activity (QFA). They also briefly looked into the central bank independence and urged that the central bank has given independence in Indonesia, yet it demands fiscal discipline in controlling inflation. They cautioned that the fiscal indiscipline could put the inflation-targeting effort by monetary authority in vein. Moreover, it causes tight monetary policy which leads to further appreciation of exchange rates and results in further inflation. Therefore, they urged on fiscal policy cooperation in inflation control, despite monetary independence. However, briefly acknowledging the role of intuitional arrangements in macroeconomic policy interaction, Javed and Sahinoz (2005) argued that the fiscal authorities have conflicting incentives, targets and objectives. Therefore, they urged allocation of intuitional arrangement to monetary policy with regard to fiscal stance. Nevertheless, they also agreed on the idea of coordination for external and internal balances in economy. Page 23 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 There are conflicting opinions on independence of monetary authority; analysing the policy interaction in Russia, Merzlyakov (2011) argued that the independence of a central bank does not considerably influence policy impact. The macroeconomic policy interaction was most influential under fiscal policy as Stackelberg and cooperation and Cournot interaction (complete non-coordination) lead to adverse economic outcome. Contrarily, a similar study with an advantage of empirical support on the effects of setting an inflation target for monetary policy on performance of macroeconomic policies by Franta, Libich, and Stehlik (2011) showed that the fiscal indiscipline could affect monetary policy role; however, a legislative inflation target could help monetary policy control excessive fiscal spending. Moreover, the explicit inflation targeting could also lead to fiscal discipline. Analysing the macroeconomic policy interaction under various exchange rates’ regime, Claeys (2004) showed that the expansionary fiscal policies for output growth cause monetary policy to adopt a tighter stance, particularly in countries with a flexible exchange rate. However, in countries with fixed exchange rates, the results were not significant. It was also emphasized that the shifts in exchange rate policy regime are important. A similar and more recent study on macroeconomic policy exchange rates and implication of monetary independence was carried out by Park (2008). Interestingly, it was argued that often the exchange rate policy was not affected by monetary and fiscal policies; the central bank degree of independence does not affect price level. In specific to the UK economy, there have been prominent changes in exchange rate mechanism, for instance, abandoning the Exchange Rate Mechanism (ERM) in 1992 which may have important implications for policy coordination and interaction. The importance of institutional design and arrangement in the light of various studies has also been acknowledged in literature review chapters; however, we would very briefly revisit a few evidences to refresh the memory of the reader and to establish its relevance with subject study. The addition of institutional arrangements aspects is motivated by the arguments by Srinivasan, Jain, and Ramachandran (2009), that the institutions must be designed so that the central bank’s commitment to its objectives is not in doubt. In this context, the financial stability has not been a prime objective of any central bank, at least not explicitly, to the best of our knowledge; however, if intuitional design affects the outcome of macroeconomic policy, it raises the question about its implications for the financial sector. One of the major institutional arrangement been made during the time of study was independence of the Bank of England. This may sound a simple case of giving autonomy to monetary authority to achieve its prime objective for price stability; perhaps, it was the explicit good intention. Nevertheless, it was rather a more complex and vital change in the functioning of the BoE. Specifically, subject decision resulted in a big shift in intuitional design and certain responsibilities related with financial stability, e.g. banking sector supervision and management of sovereign debt were transferred to Financial Serves Authority (FSA) and DMO. The most significant are: a) the supervision of banking sector which was transferred to Financial Services Authority (FSA) and b) the responsibility of sovereign debt stabilization which was transferred to Debt Management Office (DMO). These are the major shifts in responsibilities and authorities with an intention to increase the efficiency of policy formulation; however, these changes may have important implications for the financial sector. Perhaps the recent or post-financial crises development and revival of the BoE role in financial stability is something that requires plentiful attention. The Financial Services Act (2012) leads to major reform in the form of formulation of FPC. The prime objective of the Committee is to identify, monitor and take action to reduce systemic risk for the protection and resilience of the British financial sector. In addition to that the Prudential Regulation Authority (PRA) as a part of the BoE also started to function from April 2013 with the objection of banking sector supervision. In specific to effectiveness of macroeconomic policies and financial stability, these intuitional changes raise questions whether the withdrawal of earlier cited responsibilities of financial supervision from the BoE influenced macroeconomic policy role. Page 24 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 In this context, a study by Weymark (2007) declared that a fully independent central bank is only concerned with achievement of economic objectives, whereas fiscal authority may influence monetary framework. However, we need to validate these assertions and extend them to the financial sector. We can report some evidence on this aspect in a US case; Lobo (2000) concluded that the Federal Reserve policy of immediate disclosure has resulted in change of volatility of stock market from before to after the announcement of monetary policy decisions. Later investigation by Lobo, Darrat, and Ramchander (2006) also acknowledged that the Federal Reserve disclosure policy has influenced the impact of monetary policy on foreign exchange markets. However, we need to see it in the context of Optimal Policy Combination as well as both financial market (stock and bond). In specific to our case, Bank of England has been independent since 1997 which may have important implications for macroeconomic policy interaction and the financial sector. With regard to the macroeconomic policy interaction and real economy, we can associate the remarks by Dixit and Lambertini (2001) as they argued that in the case of disagreement, the outcome can be influenced by institution design. Despite the fact that we could not evidence, many studies on policy coordination in the light of institutional design, yet there is a work done by Arby and Hanif (2010). It was showed that the monetary policy stance has shown a poor coordination with fiscal policy in Pakistan. The institutional arrangements, i.e. establishment of Monetary and Fiscal Policies Coordination Board, could not contribute towards coordination. This finding would be interesting in the UK context as MPC of the BoE responsible for formulation of monetary policy has representation of Fiscal authority (HM Treasury); our empirical findings in this study would give us further insight if this arrangement has been successful for policy coordination. In addition to the independence of the BoE, a major change in the institutional framework of the BoE was an explicit target of price stability by keeping inflation to 2% of Consumer Price Index (CPI) or Target 2.0. On this aspect, Haldane and Read (2000) investigated the role of monetary policy under the influence of inflation targeting and its effects on bond market (yield curve). They found that introduction of inflation targeting in UK has significantly decreased the effects of monetary policy surprises on yield curve. They associated it with the increased transparency of monetary policy due to inflation targeting. Yet, we are seeing this shift in association with addition of interaction with fiscal policy stock market. If we review the literature on the performance of policy framework, institutional design of monetary policy in the UK was praised by Bhundia and Donnell (2002), arguing that independence of central bank and institutional arrangements is based on the principles of credibility, flexibility and democratic legitimacy. Therefore, the independence of the BoE has not only increased the effectiveness of monetary policy, it has increased the fiscal coordination. Their arguments were logical, but there was no empirical evidence. In addition, this assertion also requires validity for the financial sector and most importantly its combination with fiscal policy. More recently, analysing institutional changes, Osborn and Sensier (2009) found that there was a strong evidence of structural break coinciding with the introduction of inflation targeting. They declared the inflation targeting as more important change than the independence of BoE. Similarly, Lildholdt and Wetherilt (2004) concluded that the ability of market participants to predict monetary policy stance by BoE has been improved. Later, analysing economic and structural changes in the UK economy (output, inflation and Forex), under different monetary regimes, Baumeister, Liu, and Mumtaz (2010) found that there had been a shift in response of monetary policy from economic growth and exchange rates’ fluctuation to inflation at present. They also acknowledged that economic fluctuation was less frequent after 1992 until recent past, though they did not associate it with any institutional aspect. The subject study urges to see their assertions in the light of comprehensive and alternative empirical frameworks and its implications for the financial sector. Page 31 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 the Collapse of Exchange Rate Mechanism (ERM), Dotcom bubble or Stock Exchange Crash of (2002) and earlier acknowledged Global Financial Crises and Lehman Brother’s bankruptcy (2008) which severely hit global as well as the British stock market. It must be acknowledged here not many studies have considered the implications of these events on macroeconomic policy role, particularly in subject economy. Nevertheless, we have some evidence on this aspect; a study by Gregoriou et al. (2009) analysed the influence of stock exchange crash on monetary policy effectiveness. A structural break was found in between contractionary monetary policy and stock market relationship which changed from negative to positive in the post-financial crisis (2008) period. “They associated it with limitation of monetary policy, i.e. further rate cuts; this situation provides rationale to bring in the fiscal policy which is the premise of this study.” They also declared their study as the first to consider the shift in monetary policy and stock relationship in the light of financial crises (2008). However, there are two major aspects we must consider: (1) as cited earlier, the monetary policy, particularly interest rate instrument in Britain, is in the Liquidity Trap since March 2009; (2) in the light of enormous arguments in favour of joint policy analysis, it is vital to consider fiscal policy as well. Therefore, in subject study, we are considering both policies and in context of major economic events, it would be helpful to understand which policy instrument is more useful and how to optimally combine them for financial stability. 15. Alternative empirical frameworks Macroeconomic policy literature shows that either GE modelling or Econometrics techniques have been used for empirical analysis. Acknowledging this fact, Bhattarai (2011) urged that the DSGE and Econometrics should be considered complementary techniques rather than competitive. In Econometrics framework, structural parameters are estimated from time series data to make forecasts about the impact of economic policies; however, the Econometric models do not focus enough on the optimization behaviour of household and firm. This deficiency can be complimented by DSGE framework which generates time series on which forecasts of Econometrics analysis can be assessed. The idea of using both frameworks in this study is also supported by comprehensive analysis of Consolo et al. (2009) as they concluded that the combination of DSGE model and FAVAR (Econometric) dominates other frameworks. Nevertheless, we are suggesting alternative frameworks as well as alternative empirical approaches, i.e. Frequentist and Bayesians, in addition to a brief account in introductory section. On the ability of empirical methods to lead to a meaningful conclusion, Chari (2010, p. 1) made very concise and remarkable comments that “the models are purposeful simplifications that serve as guides to the real world; they are not the real world”. Thus, in effort to reach to the best estimation and simulation of our optimal policy combination, subject study is considering both empirical framework and approaches. Though this element makes this study prominent from the previous research acknowledged in above lines, in particular to the UK, there is no evidence of this strategy in the subject area of research. 16. Conclusions In specific to the, under analysis, UK, the macroeconomic policy interaction has not been very popular among researchers; perhaps, much of the space being given to the EMU. The financial sector of the UK also has great significance and contribution towards the economy and national income. Since financial crises (2008–2009), the financial markets, particularly bond and stock markets, have been very volatile; perhaps, the high volatility of the financial sector was the basic factor resulting in the formulation of the FPC by the Bank of England. Hence, on the academic and research side, it requires having deep insight into the role of macroeconomic policies and their interaction for the financial sector of the UK. Moreover, there have been substantial intentional arrangements made into the macroeconomic policy framework in the last few years. The last two decades have also seen extraordinary major macroeconomic and financial events. It would also be interesting to analyse the implications of these institutional changes and events for optimal macroeconomic policy combination and their effectiveness for financial stability. Most of the studies on macroeconomic policy analysis have been focused on either Econometric or General Equilibrium framework or Bayesians or Frequentist Page 32 of 36 Ali Nasir et al., Cogent Business & Management (2016), 3: 1154283 http://dx.doi.org/10.1080/23311975.2016.1154283 approach; both approaches have their own advantages and limitations. This study has provided an exhaustive discussion in the context of existing paradigm and evidence on the subject and concomitantly suggested to consider an alternative empirical framework for the robustness and validity of empirical results. It would be appropriate to acknowledge the limitations of this study as it would also point us towards the potential venues of future research. At first, we acknowledge here that the scope of subject study has been limited to stock and bond markets due to a limited time horizon. However, the future possible extensions could be made to include other aspects of the financial sector, for instance, foreign exchange markets, money markets and even derivative markets would be interesting additions. Secondly, we can also extend this study to a scenario where monetary policy is in the liquidity trap; however, considering the limited time horizon, we abstained from going further in this direction. Thirdly, on empirical and methodological grounds, the theoretical framework we have developed and the critical reasoning we have documented require an empirical validation. Fourth and last limitation of this study is related to the particular macroeconomic policy and financial sector environment of the UK on which we have been focusing on. Considering the fact that the British macroeconomic policy intuitions and financial sector are both the most established and ancient in the world, as cited in the introduction, the market capitalization as share of national income is the highest in the world. Hence, the conclusions and recommendations may not be equally applicable and should be taken with a grain of salt when applied to any other economy, particularly to developing economies. This aspect also provides the rationale for the future research. Funding The authors received no direct funding for this research. Author details Muhammad Ali Nasir 1 E-mail: [email protected] Junjie Wu 1 E-mail: j.[email protected] Milton Yago 1 E-mail: m.[email protected] ORCID ID: http://orcid.org/0000-0001-6709-8522 Alaa M. Soliman 1 E-mail: [email protected] 1 Faculty of Business & Law, Leeds Beckett University, Leeds, UK. Citation information Cite this article as: Macroeconomic policy interaction: State dependency and implications for financial stability in UK: A systemic review, Muhammad Ali Nasir, Junjie Wu, Milton Yago & Alaa M. Soliman, Cogent Business & Management(2016), 3: 1154283. Notes 1. Bank stats (Monetary & Financial Statistics) are official symbols and abbreviations http://www.bankofengland.co.uk/statistics/ms/symbols.htm. 2. The part of the economy that is concerned with actual production of goods and services. 3. This refers to the period before the current financial and economic crises that started in 2008. 4. According to Foot (2003), there is no particular definition of financial stability; however, it could be defined in the context of financial assets price volatility (details in next sections). 5. In the current economic scenario, interest rates in many major economies cannot be cut any much further, e.g. in the UK, the current interest rate is 0.5, in the US 0 -0.25 and in the Euro zone 0.25%. 6. The Ricardian Equivalence refers to idea that any effort by the government to stimulate economy by debtfinanced spending would be counter by the increased household savings to pay the higher taxes in future. 7. (a) Expansionary Fiscal– Expansionary Monetary, (b) Expansionary Fiscal–Contractionary Monetary, (c) Contractionary Fiscal–Contractionary Monetary and (d) Contractionary Fiscal–Expansionary Monetary. 8. An economic state where resources are allocated in the most efficient manner. 9. Banks and building societies were allowed to swap their high-quality mortgage-backed and other securities for UK Treasury Bills for up to three years. 10. Headed by Governor of the Bank of England, this committee would monitor the UK financial sector and its effects on the economy. http://www.bankofengland.co.uk/publications/ news/2011/041.htm 11. Mishkin (2011) and Niemann and Pichler (2011) the optimal combination can be defined as “stance of Monetary & Fiscal policy which leads to simultaneous positive response from Stock & Bond markets”. 12. In the light of the Fiscal theory of price level (FTPL), a non-Ricardian scenario exists where fiscal policy has deterministic effects on price stability (Moreira, Soares, Sachsida, & Loureiro, 2011). 13. Fiscal policy’s golden rule (borrow to invest) and sustainable investment rule (Debt-to-GDP 40%) were violated. References Aarle, B. V., Garretsen, H., & Huart, F. (2003, September). 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