daniel chigunwe
Economy Uncensored with Tapiwanashe Mangwiro
When a Government indulges in expansionary fiscal policy, increasing public spending or cutting taxes to stimulate the economy, it can lead to short-term gains.
Simultaneously, when the central bank adopts a contractionary monetary policy to tame inflation by raising interest rates or reducing the money supply, the goals of the two policies can be at odds.
In Zimbabwe, the collision between these two approaches has proven to be a critical factor in the devaluation of the Zimbabwean dollar (ZiG), and the Reserve Bank of Zimbabwe (RBZ) has had to intervene multiple times to defend the currency.
The outcome? A staggering 43 percent depreciation over just two months, with the exchange rate moving from 14 to the US dollar to 25.
A tale of two policies: Fiscal expansion and monetary contraction
Expansionary fiscal policy aims to boost aggregate demand. By increasing government spending on infrastructure, social services, or subsidies, or by cutting taxes, governments can stimulate consumption and investment, ideally driving up economic growth.
While this sounds beneficial in theory, the reality is far more complex, especially when a country is grappling with inflation and rising debt levels.
Monetary policy, on the other hand, is used to control inflation. A contractionary approach typically involves raising interest rates, making borrowing more expensive, and curbing the money supply to reduce inflationary pressures.
In Zimbabwe, where inflation has historically been rampant, the RBZ has been tightening monetary policy to anchor expectations and control price stability.
The problem arises when these two policies, fiscal expansion and monetary contraction, are implemented simultaneously.
The government has been injecting money into the economy through public expenditure, adding liquidity, while the RBZ has been trying to remove liquidity through high interest rates. This “push-pull” creates significant strain on the economy and, crucially, on the exchange rate.
Exchange rate mechanics: The impact of fiscal expansion
An increase in government spending or reduced taxes typically leads to higher aggregate demand, but if the economy is already running close to its capacity, this can push up inflation. The higher demand for imports, in particular, can strain the current account.
Zimbabwe, like many other developing countries, relies heavily on imports of goods and services. Expansionary fiscal policy boosts demand for foreign goods, which increases demand for US dollars or other foreign currencies.
This heightened demand for foreign currency puts downward pressure on the local currency, weakening its exchange rate.
As more Zimbabwean dollars are used to buy foreign currency, the value of the ZiG drops relative to currencies like the US dollar.
The RBZ has found itself in a difficult position, intervening to prop up the ZiG by dipping into its foreign currency reserves. But as seen recently, these efforts have limits, and the currency was devalued by 43 percent, a stark signal that market forces were overpowering the central bank’s interventions.
Monetary policy: The contractionary backlash
On the other side, a contractionary monetary policy, characterised by higher interest rates, is intended to reduce inflation by discouraging borrowing and cooling down economic activity. The RBZ’s move to tighten the money supply should, in theory, support the local currency.
By reducing the amount of money circulating in the economy, it is expected that demand pressures ease, leading to price stability and a stronger exchange rate.
However, in practice, this tightening of monetary policy creates its own set of problems. For businesses and consumers, borrowing becomes more expensive, which can stifle investment and slow down economic growth.
The very policies intended to control inflation can lead to reduced confidence in the economy if not balanced correctly with fiscal measures.
The fundamental issue is that while the RBZ tightens monetary policy, the government continues to increase fiscal spending.
This results in what economists refer to as “policy incoherence.” The expansionary fiscal policy essentially floods the economy with liquidity, while the central bank attempts to drain that liquidity through higher interest rates.
The result is confusion in the currency market and a lack of trust among investors, further weakening the ZiG.
The role of expectations
In foreign exchange markets, expectations play a significant role in determining currency value.
Investors and currency traders constantly assess the credibility of a country’s economic policies.
When there is a perception of inconsistency between fiscal and monetary policies, as seen in Zimbabwe, it increases uncertainty.
Investors, fearing continued devaluation or instability, may move their funds to safer, more stable currencies. This capital flight further erodes the value of the local currency, creating a vicious cycle.
Additionally, high inflation rates, driven by fiscal stimulus, can erode consumer and investor confidence in the currency.
As people lose faith in the ZiG’s ability to hold value, they rush to convert their holdings into more stable currencies, like the US dollar, exacerbating the depreciation.
The inevitable devaluation
Despite the RBZ’s repeated interventions to defend the ZiG, market forces eventually prevailed. The central bank’s efforts to prop up the currency through the sale of foreign reserves and direct market intervention were unsustainable in the long term.
With dwindling foreign reserves and growing pressure from fiscal expansion, a devaluation was inevitable. In just two months, the parallel exchange rate shifted dramatically, highlighting the failure to reconcile expansionary fiscal policy with a contractionary monetary stance.
The way forward
Zimbabwe’s recent currency devaluation underscores the dangers of incoherent economic policies. For the ZiG to stabilise, fiscal and monetary policies must align. While the government seeks to boost growth, it must also address inflation and external imbalances.
This requires carefully balancing public expenditure with policies that curb inflation without over-relying on the central bank to defend the currency.
If Zimbabwe continues down the path of mismatched policy, the exchange rate may face further volatility, and the local currency could lose even more value. A coordinated policy approach is not just desirable; it is essential to ensuring long-term economic stability.
Tapiwanashe Mangwiro is a resident economist with the Business Weekly and writes this in his own capacity. @willoe_tee on twitter and Tapiwanashe Willoe Mangwiro on LinkedIn
Bongani Ndlovu