The Relative Effectiveness of Monetary and Fiscal Policies on Economic Activity in Zimbabwe (1981:4-1998:3) 'An Error Correction Approach'

This paper examines the impact of monetary and fiscal policies on economic activity in Zimbabwe by employing a modified St Louis equation for the period 1981:4 to 1998:3. The main objective is to determine the relative effectiveness of monetary and fiscal policies on the economic growth process in Zimbabwe using the new econometric techniques of time series, cointegration and error correction approach. Secondary data was collected from various publications like, Government of Zimbabwe (1987): Annual Economic Review of Zimbabwe, Central Statistical Office (1998) National Accounts 1985-97 and Reserve Bank of Zimbabwe (various issues) monthly and quarterly bulletins. Quarterly data was used to make a total of 68 observations. LIMDEP Version 6.0 and PC GIVE Version 8 packages were used for data analysis. The regression results suggest that the monetary influence is relatively stronger and more predictable than fiscal policy in determining economic activity. These results suggest that monetary policy can be relied on as a successful macroeconomic stabilization tool in Zimbabwe. Fiscal policy should be streamlined as it is found to have an insignificant impact on economic activity in Zimbabwe. The impulse dummies which are included in the model in order to reduce the impact of outliers in the scaled residuals were also found to be significant. These impulse dummies are for the period when Zimbabwe experienced severe drought and also a bumper harvest. Exports had an insignificant impact on economic activity.


INTRODUCTION
Macroeconomic policy can be divided into two broad categories, namely monetary and fiscal policies. Ubogu (1985, 30) defines monetary policy as an "attempt by monetary authorities of a country to influence the level of aggregate economic activity by controlling the quantity and direction of money supply and credit availability. Thus, monetary policy is designed to ensure that the supply of money is adequate to support desirable and sustainable economic growth". He defines fiscal policy on the other hand as the discretionary action taken by the government to vary certain fiscal aggregates such as total government expenditure on goods and services, transfer payments and tax revenues at any given level of output. Consequently, through the budgetary manipulation, fiscal policy exerts its influence on aggregate demand via its impact on output, employment, savings, investment and other fiscal variables.
The general practice of the government is to aspire towards the achievement and maintenance of full employment, balance of payments equilibrium, accelerated economic growth and development, equitable distribution of wealth and income, price stability and exchange rate stability. These broad goals can be pursued through the application of either fiscal or monetary policies or the simultaneous utilization of the two as mutually complementary economic policies. The fact that both monetary and fiscal policies, individually or jointly affect the level of economic activity has remained undisputed among economists, but the degree and relative superiority of one of these policy measures over the other in influencing economic activity has been a subject of prolonged and heated controversy among economists and policy makers alike. It is interrogate this dilemma that this study was carried.
Macroeconomics has been in existence for many centuries. During the eighteenth and nineteenth centuries some monetarists uncovered the basic quantity theory of money which is still the basic modern day theory of money. During the twentieth century macroeconomics development was due to three essential reasons which are: a) Statisticians started collecting and systematizing data; b) Careful identification of business cycles as a recurrent phenomenon; and c) The Great Depression of the 1930s The Classical economists through Say's Law could not correct the Great Depression.
The central assertion of the Classicals was that market economies fully self regulate and they guarantee low levels of unemployment and high levels of production.
Keynes' pioneering work in 1936 swept away the time long belief in the supremacy of monetary over fiscal measures. This marked the beginning of the "Keynesian Revolution" with its emphasis on fiscalism. Consequently, fiscal policy was then regarded as a relatively more potent and reliable policy instrument for economic stabilization. For the first twenty five years after the Second World War Keynes' ideas gained popularity because they gave justification to large governments. In the 1970s confidence in the Keynesian economics began wane due to stagflation that is the coexistence of high inflation, low employment and declining output. It is like Keynesian policies were causing instability. Monetarists believe that monetary impulse is the most important factor accounting for variations in output, employment and prices. Milton Friedman (1974. p.27) remarked ''I regard the description of our position as money is all that matters for changes in nominal income and for the short run changes in real income as an exaggeration but the one that gives the right flavor of our conclusions." Most of the monetarists believe that pure fiscal policies, like increasing government expenditure, financed by taxes, cannot influence real output. These findings signaled the revival and re-emergence of monetarism, professing the relative efficacy of monetary policy. Since the advent of the "Monetarist Counter Revolution", a lot of theoretical and empirical test has been shown in the monetary versus fiscal policy debate. Neo-Keynesians, on the contrary, argue that even pure fiscal measures work. According to this school, a necessary condition for the ineffectiveness of pure fiscal policies is zero elasticity of demand for money with respect to interest rates. A few economists even go to the extent of asserting that money does not matter.

ZIMBABWE'S MACROECONOMIC PERFORMANCE
At independence in 1980, Zimbabwe initiated development planning as an instrument for achieving rapid socio-economic development. The first two development plans, the Transitional National Development Plan (1981)(1982)(1983) and the First Five Year National Development Plan (1985)(1986)(1987)(1988)(1989)(1990) were formulated in an economic and social environment in which government controls were the order of the day, and overprotection of the economy as well as monopolistic practices prevailed for both monetary and fiscal policies. The ultimate goal of development planning was to raise the living standards of people. The implementation of development plans was faced by many hurdles and planned targets were not achieved. In the public sector, the government used the Public Sector Investment Programme (PSIP) as an instrument for implementing development plans, and in the private sector, economic policies and incentives were used. For the first ten years after independence, the economy experienced many set backs as well as advances (see Table 1 on macroeconomic indicators).
Since 1983, investment especially in the productive sectors of the economy has been continuously declining. Rural development and land reform, economic expansion and During the reform programme, monetary policy's major aim was to reduce inflation to less than 10% by 1995. After recognizing that direct control methods used to control credit and money supply during the 1980s need to be changed in a more market oriented economic environment, the government moved to indirect methods of control.
Despite the implementation of reforms, Zimbabwe did not perform as planned.
Throughout the ESAP period, budget deficits exceeded targets as shown in Table 1. On the revenue side, reductions in tax rates were expected to result in increased investment and growth, so that lower rates over a broader base would not result in  The restoration of macroeconomic stability was not achieved and this threatens to undermine the credibility of the government's reform programme. It is against this background that the government embarked on the second phase of the economic reforms, the Zimbabwe Programme for Economic and Social Transformation (ZIMPREST 1996(ZIMPREST -2000. ZIMPREST incorporates a far reaching programme for fiscal restructuring and public sector revitalization. The objectives of ZIMPREST as far as fiscal rationalization is concerned were to restore revenues, manage expenditure, divest assets and liabilities and manage deficit financing. Reorientation of the government was to be achieved through restructuring of government for service delivery and complete public enterprise reforms. Monetary reforms to be carried out during ZIMPREST were to put in place a modern system of supervision and prudential regulation of the banking system and to incorporate the shift of market based instruments of monetary policy. The set targets of ZIMPREST for both fiscal and monetary policies were not met as the budget deficit, inflation and interest rates were unmanageable (see Table 1). However the major concern of policy makers was to restore confidence, create macroeconomic stability and sustain long term economic growth. Page 8 of 35

RESEARCH QUESTIONS
This paper sought to provide answers to the following questions: 1) Which macroeconomic policy is relatively effective on economic activity in Zimbabwe?
2) How can macroeconomic stability be attained in Zimbabwe?

HYPOTHESES
The following hypotheses are tested in this paper: HO : Monetary and fiscal policies do not influence economic activity in Zimbabwe.

Literature Review
Policy makers have an objective function which they want to maximize or minimize depending on the nature of the objective function. There is wide agreement about the major goals of macroeconomic policy: full employment, balance of payments equilibrium, stable prices and accelerated economic growth and development. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for the other. There is least agreement about the role that various instruments of policy can and should play in achieving the several goals. Page 9 of 35

THEORETICAL LITERATURE VIEW
The Classical economists believe that it is the forces of supply and demand which are essential in determining the level of economic activity. The Classical quantity theory of money, associated with early economists such as Fischer and Say, assume that money supply is exogenously determined, so that the causation between money and price is only in one direction. This theory mainly looks at the relationship between the money in circulation, spending, output, employment and prices. Classical economists argue that, these variables do not mainly depend on the quantity of money in circulation. Therefore money does not play any role in the determination of output, employment and income which are major activities in the economy. Classical theory therefore indicates that money is neutral.
Fischer's argument considered as an improvement of the Say's Law developed an equation of exchange which can be expressed as: MV=PQ, where M is money supply, V is velocity of money, P is the price level and Q is real output. Assuming V and Q are fixed then variations in money supply are transmitted into price level. Therefore an increase in money supply causes inflation without affecting output. From the equation Fischer concludes that money is neutral because its growth affects nominal variables such as price and interest rates and not real ones. Say's and Fischer's model propose the use of alternative actions (mainly fiscal) to achieve economic growth.
The Cambridge School of Thought based its argument on the principle of cash balance approach. According to this theory, money supply is equal to the fraction of income in cash form together with the price level (P) and real output (Q). Therefore the money supply model is expressed as: M=kPQ. According to this theory, if money increases people will accumulate excess balances, spend more and consequently increase the price level because its output is fixed in the classical theory. Therefore this theory argues that money is neutral because money is used as a medium of exchange.
The Neo-Classicals examined the role of money in economic activity. The Solow's model uses a production function approach to examine the role of money. In this model output is considered as a function of capital stock, labour force and technology. The model concludes that in the long run output growth depends on capital available per worker. Therefore an increase in saving mobilization increases capital available per Page 10 of 35 worker and hence the production and output in the economy. Solow's model indicates that money is not relevant in economic growth because output does not depend on monetary growth but capital available per worker, hence money is neutral.
The Keynesians suggested that a change in money supply may change the level of output via change in interest rates. Keynes argued that the classical mechanism might fail to guarantee full employment equilibrium because of several reasons. For one thing wages and prices may not be flexible; for another, income, rather than the interest rate, may determine savings and if the (speculative) demand for money (which Keynes called the liquidity preference schedule) is infinitely elastic with respect to changes in interest rates (i.e. the liquidity trap), then no extra investment would be forth coming from a further rise in savings and the economy would end up in an unemployment equilibrium.
Keynes in the 1930s in the theory of "public finance" argued that government expenditure and revenue should be used as instruments to reduce cyclical variations in economic activity. Allocation of resources is based on the work of Adam Smith (1776) whereby it is argued that society requires some commodities which cannot be provided by the private sector. To improve on the social welfare, government through fiscal policy needs to provide these commodities. In this process economic growth is affected. The "monetarist" school, headed by Milton Friedman, contends that the Classical rather than the Keynesian theory would be valid as long as money can affect real variables in the short run, but only nominal magnitudes in the long run. Friedman stated a "modern" quantity theory which has its roots in the "ancient" quantity theory but it is broader than its predecessor. Stated in a very simple way, the 'modern" quantity theory states that a change in money supply will change the price level as long as the demand for money is stable; such a change also affects the real value of national income and economic activity but only in the short run. As long as the demand for money is stable it is possible to predict the effects of the changes of money supply on total expenditure and income.
The monetarists argue that if the economy operates less than the full employment level, then an increase in money supply will lead to a rise in output and employment because of a rise in expenditure, but in the short run only. After a time, the economy will return to a less-than-full-employment situation which must be caused by other "real" factors. The monetarists believe that changes in money supply cannot affect real variables in the long run. At near-full-employment point or beyond it, an increase in money supply will raise prices. Before full employment, income rises with a rise in money supply and expenditure. The rise in income will, then, crucially depend upon the ratio of income to money supply because at that point output can no longer be increased. People will now raise their demand for money rather than spend it and the supply of and demand for money would once again be equal to one another.
Friedman opposed fine tuning and all activist policy and advocated an outcome-blind monetary rule: just keep the money supply growing at a steady non-inflationary rate, irrespective of what is happening month by month in the economy. In this regime, he alleged, unemployment would gravitate to its "natural rate", a rate that government policy is helpless to reduce. Monetary policy that attempts to aim at unnaturally low unemployment may succeed temporarily but its main and lasting effect is simply to cause inflation. As for fiscal policy, which Keynes had stressed, Friedman dismissed it as of no macroeconomic importance.
New Classical macroeconomics is a revival of the old classical orthodoxy that Keynes challenged more than half a century ago. For about a decade from the mid 1970s, the For the New Classical economists the economy is made up of actors who consistently pursue the maximization of some clearly defined objective function. The actors trade with one another in well organized markets. Trade takes place at market clearing prices such that all who wish to trade at going prices are able to do so. This far, the framework would be recognized by a Classical economist. Novelty arises from the fact that the New Classical Economist will not locate these actors in static world, but rather in a stochastic environment. The world is one in which there are recurrent shocks to the system-bad harvests, earthquakes, sunspots, policy shifts, exogenous taste changes, wars etc. In other words, while actors are rationally trying to respond to the price signals of the market, these signals are "noisy". The fact that they are noisy has important implications. The New Classical world is often characterized as being "perfect" in the sense of full information and costless adjustment.
The rational expectations hypothesis simply amounts to the assumption that, in forming their expectations of what prices (and perhaps other variables) will be, the actors do the best they can. The rational expectation is mathematical expectation given the information available at the time the expectation is formed: P e t = E( p t |I t-l ), where E is the expectation operator, p e t is the typical actors subjective expectation of the price level in period t, formed on the basis of all information available up to and including period t-l, This means that, given the information available at the time the forecast is made, no better forecast could be made on the basis of the same information. This means that a 'rational' forecast will on average be correct and that no other forecasting technique will   , 1997). This stability in the economic environment will aid economic agents in their decision making. Therefore, it is fair to conclude that monetary policy, as approximated by changes in the M1, will have important implications for changes in Pakistan's nominal income in the long run. Based on the results they further concluded that in the short run the monetary policy is relatively effective and that the money supply is exogenous and cause a significant movement in the price level and hence GDP. The policy implications stemming from the analysis clearly suggested that monetary policy plays an active role in influencing the level of economic activity in Pakistan. In a nutshell, an increase in money supply increases economic activity in Pakistan, which in turn increases money demand to finance a higher level of economic activity.

EMPIRICAL LITERATURE REVIEW
The relationship between monetary and fiscal policy in the process of macroeconomic stabilization have been examined by Lambertini and Rovelli (2003). By analyzing the Stackelberg equilibrium, they identified three cases each assigning the initiative to treasury, government and central bank respectively in conduct of policy measures. The study concluded that the preferable and probable outcome is the one in which the fiscal authority appear as the leader in macro-economic policy game.

International Journal of Management Sciences and Business Research, 2012 Vol, 1.No 5 ISSN (2226-8235)
Page 17 of 35 In an empirical investigation of a group of emerging market countries Zoli (2005) found that there is fiscal dominance in case of Brazil and Argentina. They explored that, fiscal policy actions appeared to have contributed to movements in the exchange rates more than unanticipated monetary policy maneuvers, establishing the fact that fiscal policy does affect monetary variables. Agha and Khan (2006)   were fairly recent which means that if they were to be used, then there was going to be disjointed data especially for the 1980s when there were controls. Data on money supply was deflated using the Consumer Price Index (CPI) to get real figures.

d) Measure of External Influences on the economy
Due to openness of the economy and heavy dependence on foreign trade, with high commodity trade ratio (imports plus exports as a proportion of GDP), the foreign sector performance is captured on the model. The original growth model assumes that the domestic economy being analysed is relatively closed to the rest of the world. While this may characterize a developed economy, it is not true for countries whose foreign sector accounts for a large proportion of their GNP. In addition because monetary and fiscal actions obviously affect the foreign sector, the correlation between external and Kamau also used real exports to capture external influences on GNP). Although import figures could have been used, it is considered inefficient because substantial volume of imports is not reported in accounting. Therefore, import figures may be biased.
Availability of foreign exchange could also be used to capture availability of foreign influences but the problem is the most appropriate proxy to capture availability of foreign exchange. This is further compounded by lack of quarterly data for say foreign reserves which can be used as a proxy. Therefore real exports are considered exogenous in the model.

Stationarity Tests
The results obtained from the ADF test on each variable show that real GNP, money supply, and exports are integrated of order one ( i.e non-stationery / random walk ) at 1% level of significance and government expenditure is stationary in levels (integrated of order zero)

ST LOUIS GROWTH MODEL
The model estimated is equation Where Y, M, F and E represent real Gross National Product (real GNP), real money supply (M2), real government expenditure. c i, m i , f i and e i are the coefficients to be estimated and U t is the error term.
Based on the AIC, the optimal lag length is found to be one for real GNP, four for real government expenditure, three for money supply and five for real exports. When estimated the general model is found to suffer from the problem of normality, reset and autocorrelation. Therefore the solution is to add some impulse dummies to the model,

Co integration Test
The test used to check on co integration is the Engle- Granger (1987) test. Co integration is performed on GNP, government expenditure, money supply and exports.
Co integration results are presented in Table 2 below.

*indicates co integration at 5%
The co integrating error term obtained by regressing GNP and exports is found to b stationery at 5% level of significance using the Engle-Granger test statistic.

Short Run Dynamic (Error-Correction) Model
Since there is only one co integrating vector in this model, the short run model can be expressed as follows: ∆GNP = f(Govt. Expt, ∆MS, ∆Exports, ECM Exports )

Further Analysis of the Results
Certain propositions with respect to monetary and fiscal influences were tested in earlier studies in this field. Two most commonly tested propositions were regarding the strength and the predictability of monetary and fiscal actions. Following Keran (1970) and Darrat (1984), it was tested whether monetary and fiscal actions are 1) more predictable, and 2) stronger. The relative predictability of monetary and fiscal impacts on income can be judged by the relative size of the t-statistics of the corresponding sum coefficient. Table 4 shows that the t-statistics for the monetary policy are larger than those of the fiscal policy. This suggests that the actual and the estimated relationship between GNP and the monetary policy variable is likely to have the same sign as the relationship between GNP and the fiscal policy variable. This test confirms the evidence described in the regression results whereby monetary policy is more significant than fiscal policy.

Parameter Stability Test
The Chow test is carried out to check on the structural stability of the error correction model. The test examines the possibility that the estimated equation has undergone a single point shift. The sample period is divided into two sub-periods i. e 1981:4 -1989:4 and 1990:1 -1998:3. The model for the two sub-samples was regressed separately and the one involving the whole sample. Regressions for these different models were then compared as shown in Table 5 below.

ECONOMIC INTERPRETATION OF THE RESULTS
The results interpreted here are those contained in Table 4. With much interest in the monetary and fiscal policy variables, monetary policy is stronger and significant at 1.6%.
This suggests that monetary influence has a greater impact on changes in real income than fiscal influence in Zimbabwe. It can also be seen that monetary changes may be used to alter economic activity much easier than fiscal policy. It can be deduced that monetary expansion is transmitted to real variables such as income and not to nominal variables, and hence money is neutral in this model. The relative predictability test and relative strength test suggests that monetary policy has more impact on real income than fiscal policy.
Fiscal policy action is insignificant and has a negative impact on economic activity. The expectation is that an increase in government revenue would also boost government expenditure and the general demand in the economy and hence increase economic output. This might mean that some other factor was chewing into government revenue thus reducing the actual and real portion of the revenue contributing towards GNP.
Corruption, misappropriation and financial profligacy could be the possible identities of this chewing factor. Fiscal policy is supposed to be important in allocating resources and thereby ensuring efficient production in the economy. It is however shown that the The growth model displays parameter stability across the most significant shift of the Economic Structural Adjustment Programme (ESAP) adopted in 1991 as evidenced in Table 5. Based on this test, results of the growth model are likely to be reliable as they are based on a stable model. As regards monetary policy, its impact on economic activity is significant. The analysis has indicated that it is consistent with the literature of the monetarist economists. The relationship between fiscal policy and economic activity is insignificant possibly because of the bureaucracy and inefficiency of the government.

POLICY RECOMMENDATIONS
Money growth has a strong and permanent impact on real income growth in Zimbabwe.
Since money growth exerts a positive statistically significant influence on the growth of real income, a 1 % change in money exerts a less than 1% change in income growth.
On the basis of a stable money-GNP link, the scope of monetary policy as a stabilization tool on economic activity should be greatly recommended. This makes it easier for authorities to ascertain the liquidity needs of the economy and thereby create greater certainty in the amount of credit and money to be supplied to achieve the macroeconomic objectives. Financial intermediaries enhance development through their role in the saving-investment process.
Monetary policy should be used as a short term tool for macroeconomic stabilization in Zimbabwe because from the results of the model there is no co integration between money supply and GNP. This means that money supply will only affect economic activity in the short run not in the long run. From these findings the following recommendations are apparent. policies that enhance export performance should be encouraged for example the setting up of export process zones (EPZ), Export Credit Guarantee Companies which will act as a safeguard to financial institutions which give loans to small and medium scale entrepreneurs, value addition of export products and attractive packaging of export products in terms branding and trademarks. All this is done in order to make exports more competitive on the international market; and e) The impulse dummies are significant in explaining economic activity in Zimbabwe and since these dummies are capturing the periods when there is either a drought or a bumper harvest, Zimbabwe should have a long term plan for drought mitigation since drought is a recurrent exogenous shock affecting economic activity.