How Much Does Monetary Policy Affect the Fiscal Multipliers in a Small and Open Economy? The Peruvian Case

This paper examines the influence of monetary policy and the zero lower bound (ZLB) context on government consumption and investment multipliers in Peru from 1996Q1 to 2023Q3. Utilizing a hybrid Time-Varying Parameter Vector Autoregression with Stochastic Volatility (TVP-VAR-SV) model, the study derives impulse response functions, fiscal multipliers, forecast error variance decompositions, and historical decompositions for every quarter of the sample. The results reveal that contractionary monetary policies, particularly post-2003Q4 when the Central Reserve Bank of Peru (BCRP) began setting the reference rate, have adversely impacted both types of fiscal multipliers. Furthermore, during the COVID-19 crisis, the Peruvian economy encountered a scenario closely resembling the ZLB. This occurred as the BCRP reduced the reference interest rate to a historic low of 0.25%. Under these conditions, the findings indicate a positive and substantial enhancement in the effectiveness of the government investment multiplier. This study contributes to the broader understanding of interaction of monetary and fiscal policy in emerging market economies, particularly under a context of inflation targeting regime and dirty float exchange rate regime.