Fiscal Dominance and Monetary Policy Transmission in a Debt-Distressed Small Open Economy: Evidence from The Gambia (1983–2022)

Abstract

The fast build-up of the sovereign debt in low-income economies has brought up yet again the issue of fiscal sustainability and monetary policy autonomy. This paper focuses on the question of whether the increasing foreign government debt results in the dynamics of fiscal dominance that may affect the transmission of monetary policy in The Gambia during the timeframe 1983-2022. With annual time-series data and a multivariate econometric model, such as the Johansen cointegration, Vector Error Correction Modelling (VECM), impulse response functions, and forecast error variance decomposition, the analysis reflects both the long-run equilibrium relations and short-run adjustment relationships between foreign debt and important monetary variables (money supply, interest rates, inflation and exchange rate). The findings show that there is indeed a long run stable relationship between monetary variables and foreign public debt which proves structural fiscal-monetary interdependence. The exchange rate portrays the most and quickest adjustment response and it puts right about 42% of disequilibrium in a year. Foreign debt shocks are estimated to be 42% of the exchange rate volatility at a five-year horizon, which is lower than interest rates (31%), and inflation (23%). The reaction of inflation to exchange rate pass-through is lagging whereas the reaction of money supply is on the smaller side. These results imply that the external sector is the main means of transmitting fiscal pressures in The Gambia, which is in line with the tendencies of fiscal dominance in the small open economies that are exposed to foreign-currency borrowing. The fact that monetary policy has the ability to operate does not mean that the increment in the level of external debt is not influential in the macro economic environment in which the stabilization policies are to be implemented. The paper adds to the fiscal dominance body of literature by offering infrequent system-specific evidence of time-series using a debt-distressed economy in Africa and policy implications of fiscal-monetary coordination in structurally fragile contexts.

Keywords: Fiscal dominance; Foreign public debt; Monetary policy transmission; Exchange rate dynamics; Small open economy; The Gambia