A standard inflation targeting framework assumes the absence of fiscal dominance, and abstracts from the effects of unbalanced fiscal positions and public debt financing. This assumption is relaxed by adding the notion of a fiscal gap into the standard inflation targeting model. The financing of fiscal gaps is assumed to be largely implemented through the creation or retirement of public debt, which then affects the premium levied on Philippine interest and exchange rates in the international and domestic capital markets.
A structural model of an inflation targeting framework is specified under the presence of a fiscal gap and public debt. The model is empirically tested for Philippine data using a three-stage least squares estimation procedure, and taking note of the impact of the fiscal gap on the output gap, inflation and interest rates. The existence of interest rate rule regimes in the presence of a fiscal gap variable is examined separately through Markov Switching Vector Autoregressive Models.
We find that the fiscal gap significantly impacts on the target variables in the inflation targeting system and directly affects the short term interest rate contrary to the standard assumption of zero fiscal dominance. Furthermore, there is evidence of the existence of interest rate regimes, such that activist fiscal policies in the low output regimes are only effective in the short term, as their impact on interest rates are larger and tend to lead to interest rate increases beyond those intended by the monetary authorities.