On fiscal dominance in Malawi

Abstract

Keynesian economics postulates that increased government spending can stimulate growth and national economic transformation under conditions of deficient aggregate demand. This theoretical position is contrary to the orthodox neoclassical view which prioritises austerity. By this mainstream view, if government spending persistently exceeds government revenue, the resultant deficit may compromise the monetary policy objective of price stability by creating a regime of fiscal dominance, hence triggering inflation. In this paper, these contrasting positions are empirically verified for the case of Malawi. Inflation is modelled as an autoregressive distributed lag process, and the twostage least squares estimation method is employed alongside ordinary least squares estimation. The study finds no clear evidence to support the importance
of fiscal deficits nor that of money growth in Malawi’s inflation process. On the other hand, external effects on domestic prices persist regardless of whether they are captured using the exchange rate or trade openness, suggesting the need for pragmatic solutions to external imbalances. These results also suggest the need to revisit the roles that orthodox economic theory and the International Monetary Fund (IMF) place on demand-side monetary policy in addressing inflation in economies like that of Malawi.