The Relationship between Fiscal and Monetary Policies in Colombia: An Empirical Exploration of the Credit Channel

Abstract

This paper provides evidence of the relationship between fiscal and monetary policy in Colombia through an empirical exploration of the credit risk channel. Under this empirical approach, fiscal policy serves as an important explanatory role in the sovereign risk premium which, in turn, could affect the exchange rate and inflation expectations. The colombian central bank reacts to inflation expectations by using the policy interest rate; consequently, such reaction could be indirectly influenced by fiscal policy behavior. Using monthly data from January 2003 to December 2019, we estimate a reduced-form system of equations that describes the credit risk channel in a small open economy. Our findings are in line with the theoretical predictions. Fiscal policy affected the country’s sovereign risk during this period, although its incidence was not particularly large. Thus, we infer that there could be insufficient evidence of fiscal dominance in Colombia during the period analyzed.