Empir Econ (2017) 53:1529–1552

DOI 10.1007/s00181-016-1177-2

Effect of credibility and reputation on discretionary

fiscal policy: empirical evidence from Colombia

Juan Camilo Galvis Ciro1 · Helder Ferreira de Mendonça2

Received: 5 March 2015 / Accepted: 20 August 2016 / Published online: 27 September 2016
© Springer-Verlag Berlin Heidelberg 2016

Abstract This paper relates to the literature on the possible effect of inflation tar-
geting on fiscal discipline in developing countries. In particular, we present empirical
evidence to address this issue based on the Colombian experience. This study relies
on two main issues. The first is to verify whether the adoption of inflation targeting in
Colombia affected the discretionary fiscal component in the period 2004–2014. The
second issue is to analyze whether the monetary credibility amplified the effect of the
monetary policy on changes in the discretionary fiscal component. The results denote
that inflation targeting causes an impact on fiscal policy in Colombia. In particular,
the greater monetary credibility the less change in discretionary fiscal component is
observed.

Keywords Discretionary fiscal policy · Fiscal impulse · Inflation targeting ·

Credibility · Reputation

JEL Classification E52 · E58 · E62 · H50

We thank an Associate Editor and an anonymous referee for helpful comments on an earlier version of
this paper. Any remaining errors are the sole responsibility of the authors.

B Helder Ferreira de Mendonça

helderfm@hotmail.com
Juan Camilo Galvis Ciro
jcgalvisciro@gmail.com

1 Department of Economics, Universidad Pontifica Bolivariana, Circular 1 No. 70-01,

Medellín, Colombia
2 Department of Economics, Fluminense Federal University and National Council for Scientific and
Technological Development (CNPq), Rua Dr. Sodré, 59, Vila Suíça, Miguel Pereira, Rio de Janeiro
CEP: 26900-000, Brazil

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1530 J. C. G. Ciro, H. F. de Mendonça

1 Introduction

Nowadays inflation targeting is a framework that cannot be neglected by developing

economies (Mendonça and de Guimarães e Souza 2012). Moreover, one of the main
pillars for the success of this monetary regime is the lack of fiscal dominance (Allsopp
and Vines 2005). As pointed out by Sargent (1994), when the monetary policy is
implemented by a government that is not committed to fiscal balance, persistent public
budget deficits are a consequence. Therefore, the possibility of monetization of the
public debt increases creating high inflation expectations and thus a possible loss of
control over inflation (Mendonça and Tostes 2015). In other words, fiscal discipline
is essential to a low and stable inflation rate (Fatás and Mihov 2003a; Wyplosz 2005).
Most of the time, the adoption of inflation targeting in developing countries is not
associated with the case of central banks with consolidate credibility. Therefore, infla-
tion expectations are insufficiently anchored to the inflation target. In general, the main
instrument used by central banks to the convergence between inflation expectation and
the target is the interest rate. This fact is a problem particularly when the public debt is
high and the average maturity is short, which makes public finances more vulnerable
to interest rate shocks (Aktas et al. 2010). As a consequence, additional government’s
revenue (primary surplus) to offset an increase in the public debt is necessary (Men-
donça and Silva 2009). In short, the development of monetary credibility, as a result of
the convergence between inflation expectations and the target, is a possible medicine
to avoid the unpleasant fiscal effects.
In general, inflation targeting has three implications for the fiscal policy. The first is
that inflation targeting builds institutional mechanisms that protect central bank from
political cycle, thus reducing the chance of monetizing deficits (Masson et al. 1997).
The second is related to the fact that the adoption of inflation targeting in developing
countries contributes to low and stable inflation rate (Lin and Ye 2009; Mendonça
and de Guimarães e Souza 2012). Hence, a low inflation target should induce the
government to improve institutional quality in order to limit the erosion of tax revenue
(Lucotte 2012). The third is connected with credibility. The lack of credibility implies
a higher interest rate which, in turn, increases the debt service cost (Blanchard 2005).
Consequently, an increase in primary surplus is demanded to reduce the debt service
burden.
Although there exists a comprehensive literature on the limits of inflation targeting
in the presence of loose fiscal policies, little is said about the effect of inflation targeting
on fiscal discipline (Minea and Tapsoba 2014). The present paper is a contribution to the
literature on the possible effect of inflation targeting on fiscal discipline in developing
countries.1 In particular, we present empirical evidence to address this issue based on
the Colombian experience. The analysis on Colombia (second largest Latin American
economy) deserves attention because since 2000 central bank has adopted inflation
targeting, institutions have strengthened since Uribe’s government (2002), the GDP
per capita nearly doubled between 2002 and 2014, reached the lowest country risk

1 About this subject, see Lucotte (2012).

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Effect of credibility and reputation on discretionary fiscal policy 1531

in its history, and adopted primary fiscal surplus targets, and the inflation in 2013
(1.97 %) was the lowest in Latin America (Moody’s Investors Service 2014).
This study relies on two main issues. The first is to verify whether the adoption
of inflation targeting in Colombia affected the discretionary fiscal component in the
period 2004–2014. The second issue is to analyze whether the monetary credibility
caused a large effect of the monetary policy on changes in the discretionary fiscal
component. With this purpose, this paper is divided into two parts. The first step
is the estimation of the discretionary fiscal component inspired by the methodology
supported by Fatás and Mihov (2003a) and Afonso et al. (2010). The second step
takes into consideration the effect of credibility under inflation targeting, measured as
proposed by de Mendonça (2007) and Mendonça and de Guimarães e Souza (2009),
on discretionary fiscal component. The results suggest that inflation targeting causes
impact on fiscal policy in Colombia. In particular, the greater monetary credibility
the less change in discretionary fiscal component is observed. In other words, an
improvement in the central bank’s efficiency (capacity of driving inflation expectations
to the target) causes less change in public expenditures that are not related to business
cycle.
The remainder of this paper is organized as follows: Sect. 2 shows the performance
of credibility and reputation over inflation targeting’s time in Colombia. Section 3
analyzes the discretionary fiscal policy. Section 4 provides empirical evidence, through
an econometric analysis, of the effect of credibility and reputation on fiscal impulse.
Section 6 concludes the paper.

2 Inflation targeting and credibility in Colombia

The last political constitution of Colombia was enacted in 1991. The new constitution
established that the main objective of monetary policy is to ensure price stability. In
addition, the constitutional reform created the institutional conditions for the presence
of an independent central bank (CáRdenas and Partow 1998). At the beginning of the
1990s, the challenge of the central bank to find inflation rates of one digit was not
a possible task. Formal contracts such as wages, taxes, and prices of public services
were indexed to past inflation. Furthermore, the economic liberalization process ini-
tiated in 1991 combined with an international context marked by the Mexican crisis
of 1994 and the Asian crisis of 1998 brought great volatility of capital flows. As a
consequence, inflation targets were not reached systematically. Table 1 presents the
annual performance of inflation regarding the respective target.2
Only after the adoption of a full-fledge inflation targeting in 1999, and thus with the
end of fixed exchange rate regime, the Colombian economy began reaching one-digit
inflation rates (see Hamann et al. 2014). As highlighted by Gómez et al. (2002), the
introduction of this monetary regime has been an improvement of the communication
mechanism of monetary policy through, for example, inflation reports to anchor the
expectations of economic agents. In order to show commitment to inflation targeting,
the year 1999 is also marked by an agreement of the Colombian government with the

2 See Table 5 (Appendix) for sources of data and description of all variables used in the study.

123
1532 J. C. G. Ciro, H. F. de Mendonça

Table 1 Inflation targeting in Colombia. Source of data Central Bank of Colombia (see Table 5 in
Appendix)

Year Target (%) Inflation (%) Year Target (%) Inflation (%)

1992 22 25.13 2003 5.5 6.49

1993 22 22.60 2004 5.5 5.50
1994 19 22.59 2005 5 4.85
1995 18 19.46 2006 4.5 4.48
1996 17 21.63 2007 4 5.69
1997 18 17.68 2008 4 7.67
1998 16 16.70 2009 5 2.00
1999 15 9.23 2010 3 3.17
2000 10 8.75 2011 3 3.73
2001 8 7.65 2012 3 2.44
2002 6 6.99 2013 3 1.94
2014 3 3.60

International Monetary Fund. The agreement sought to eliminate fiscal imbalances and
the Colombian government has pledged to reduce the primary fiscal deficit of 6 % of
GDP from the year 2000 to 3.5 % of GDP permanently. Therefore, a set of tax reforms
and privatizations were designed that led to a reduction in dependence on seigniorage
revenue and an improvement in the management of tax revenue (see Junguito and
Rincón 2004). As a result, the seigniorage revenues (annual percentage variation of
monetary base/GDP) decreased from an average of 2 % of GDP in the decade from
1990 to 2000 to an average of 1 % of GDP after 2000 (see Fig. 1). In short, there are
clear signs that there was a reduction in the problem of fiscal dominance due to the
introduced reforms. 3
An essential point in the inflation targeting analysis is the forward-looking behavior
of the public regarding inflation because the success of this monetary regime depends
on the public’s expectations concerning inflation. Therefore, credibility can be mea-
sured as the absolute value of the difference between the policymaker’s plans and
the public’s beliefs about those plans (Cukierman and Meltzer 1986). In other words,
credibility is a result of the gap between inflation target and inflation expectations
(Faust and Svensson 2001).
Among several indices that measure credibility, the index proposed by de Mendonça
(2007) is particularly useful for this study because it fits well in the case of develop-
ing countries that have adopted inflation targeting.4 The credibility index (CRED)
developed by de Mendonça (2007) takes into account the tolerance interval around

3 Before adoption of inflation targeting, monetary policy in Colombia cannot be classified as active in the
Leeper’s sense (1991) because, in general, it was used to support the exchange rate bands system (see Vargas
2005).
4 For several examples of the use of this credibility index in the literature, see Doğan and Bozdemir (2014),
Fernandes (2013), Salle et al. (2013), Montes (2013), Khemiri and Ali (2012), and Dieters (2010).

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Effect of credibility and reputation on discretionary fiscal policy 1533

Seigniorage in Colombia
7%

6%

5%

4%

3%

2%

1%

0%

-1%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Fig. 1 Seigniorage in Colombia. Source of data Central Bank of Colombia (see Table 5 in Appendix)

the inflation target. In other words, the index considers the public’s forward-looking
behavior on inflation and it is a useful tool for measuring the public’s trust vis-à-vis
the capacity of the central bank to achieve the inflation target. In this sense, credibil-
ity is maximum when the inflation expectations (E(INF)) are equal to the inflation
target (INF*) and decrease in a linear fashion as inflationary expectations deviate
from this target. When the inflation exceeds the limits of the tolerance interval, the
CRED is equal to 0. Therefore, the scale of the index is from 0 to 1, and it is a result
of:
⎧ ⎫
⎪
⎨1 if E (INFt ) = INF∗t ⎪
⎬
 ∗
 lower _bound upper _bound
CREDt = 1− INFbound−INF∗ E(INFt )−INFt if INFt < E (INFt ) < INFt
1
⎪
⎩ t t
upper _bound
⎪
_bound ⎭
0 if E (INFt ) ≥ INFt or E (INFt ) ≤ INFlower
t

(1)

where INFbound
t is the limit of tolerance interval inflation defined for each year and
INF∗t is the inflation target for each year.
In developing countries, reputation can be essential for developing credibility.
According to Andersson and Berg (1995), a high operational credibility of inflation
targeting is a result of the central bank proving its competence in achieving the infla-
tion target. As pointed out by Mendonça and de Guimarães e Souza (2009), central
banks with little or no reputation would suffer limitations in the conduct of the mon-
etary policy. In order to observe the performance of reputation of central bank under
inflation targeting in Colombia, a backward-looking index (REPUT) proposed by Men-
donça and Galveas (2013) is considered in this analysis. As reputation is essentially
backward-looking (depends on past behavior of the monetary authority), the result of
the index depends on the success of the central bank in achieving the inflation target.
Hence, REPUT is a result of:

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1534 J. C. G. Ciro, H. F. de Mendonça

Inflation, Inflation Expectation and Inflation targets

8%

7%

6%

5%

4%

3%

2%

1%
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Observed inflation Inflation expectations
Tolerance intervals Inlfation target

Fig. 2 Inflation, inflation expectation, and inflation targets. Source of data: Central Bank of Colombia
(see Table 5 in Appendix)

⎧ ⎫
⎪
⎨1 if INFt = INF∗t ⎪
⎬
1
(INF −INF ∗ ) if INFlower _bound < INF < INFupper _bound
REPUTt = 1−
INFbound−INF∗t t t t t t
⎪
⎩ t
upper _bound
⎪
⎭
0 if INFt ≥ INFt or INFt ≤ INFlower
t
_bound

(2)

where INFt is the inflation accumulated in 12 months (measured by Consumer Price

Index); INF∗t is the inflation target; INFbound
t is the limit of tolerance interval inflation
defined for the current year; and INF∗t is the inflation target (current year).
Therefore, when the reputation is maximum (the situation where the inflation accu-
mulated in the last 12 months corresponds to the inflation target), the REPUT is equal
to 1. On the other hand, when the inflation exceeds the bounds of the tolerance inter-
val, the REPUT is equal to 0. As a consequence, the scale of the REPUT is from
0 to 1.
Taking into account monthly data, the behavior over time regarding inflation and
inflation expectations (in 12 months), which are essential for building the credibility
and reputation indices, is presented in Fig. 2.5 Our analysis begins in 2004 because
this is when Central Bank of Colombia starts to provide information regarding infla-
tion expectations. Moreover, the Central of Colombia adopted tolerance intervals
only in 2013. In general, it is possible to identify three phases. The first, before the
subprime crisis (2007), presents both inflation and inflation expectations near the
upper bound of the tolerance interval. The second represents the peak of the sub-

5 Survey of inflation expectations of the Central Bank of Colombia considers an average of 40 participants
from banks, financial market brokerage firms, pension funds, and international organizations.

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Effect of credibility and reputation on discretionary fiscal policy 1535

Credibility and reputation in Colombia

1.0

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Credibility Reputation

Fig. 3 Credibility and reputation in Colombia

prime crisis (2007 to 2009), and both inflation and inflation expectations exceed
the upper bound of the tolerance interval. After 2009, inflation expectations are
close to the target and the observed inflation is lower than the target most of the
time.
Figure 3 shows the performance of credibility and reputation from 2004 to 2014
in Colombia. As expected, there exist differences between the paths. In general, the
path of credibility is smoother than observed for reputation. This observation clearly
captures the idea that credibility is something that we have achieved slowly and also
lose slowly, while reputation is something that we have achieved quickly and also
lose quickly. However, both paths allow one to see two phases. The first shows that
the period from 2004 to 2010 is unstable indicating an increase in the beginning and
shows a drop from 2006 probably caused by the subprime crisis. The second phase
(after 2010) is marked by a sustainable improvement in the credibility which in turn
denotes a greater ability of the central bank to anchor inflation expectations inside the
tolerance interval. Although the reputation has decreased in 2014 due to an inflation
rate less than the lower bound of the tolerance interval, it captures an increase in the
most of time.

3 Discretionary fiscal policy

Discretionary fiscal policy refers to the changes made in fiscal policy resulting from
intentional actions by the policymakers, and therefore, it is not a result of changes in
the business cycle, but a consequence of new political preferences (Blanchard 1990;
Alesina and Perotti 1995). In general, it is assumed that the fiscal policy is more
sustainable and more disciplined the lower the discretionary change in fiscal policy.

123
1536 J. C. G. Ciro, H. F. de Mendonça

According to Fatás and Mihov (2003a, 2009), the discretionary fiscal policy generates
excessive deficits, increases public debt, eliminates the effectiveness of automatic
stabilizers, and produces unnecessary volatility in the output. Moreover, discretionary
fiscal policy is more correlated with political cycles than with smoothing economic
fluctuations (Alesina 1987; Alesina et al. 2008). In other words, the reduction in the
use of discretionary fiscal policy generates fiscal balance because it allows a better
match of changes in public spending and taxes in accordance with the phases of the
business cycle (Fatás and Mihov 2003a).
As pointed out by Fatás and Mihov (2003b), there is no consensus in the literature on
the appropriate methodology for building a cyclically adjusted measure of fiscal policy.
The main reason for this difficulty is the simultaneity in the determination of output
and the budget. In general, the government spending is commonly used in the literature
because it is less subject to endogeneity problems.6 Hence, for analyzing fiscal policy
in Colombia and taking into account the components of responsiveness, persistence,
and discretion in government spending, we consider the following equation:7

G t = β0 + β1 G t−1 + β2 Yt−1 + β3rt−1 + β4 ΔOilt−6 + εt , (3)

where G log of the government spending (% GDP), Y the log of annual growth rate of
real GDP—accumulated in the last 4 quarters (IMACO index—available at monthly
frequency), r real short-term interest rate, and ΔOil variation of the oil price.
The variable G t−1 represents the persistence of the fiscal policy, while the variables
Y and r capture the responsiveness of the fiscal policy to the state of the economy.
Economic growth determines the adoption of stabilization policies and real interest
rate affects the decision to invest in public infrastructure. In short, both variables
define the procyclicality or countercyclicality of the fiscal policy. As indicated by
Afonso et al. (2010), oil prices are also included because they affect the state of the
economy and contribute significantly to total revenue. In the case of the Colombian
economy, exportation depends on large measure of the primary sector in which oil
represents 50 % of the total (López et al. 2013). A major source of national govern-
ment revenue of Colombia is the state-owned oil company (Ecopetrol accounts for
approximately 30 % of income tax), and the government budget is set based on the
oil price in the futures market (Villar and Forero 2014). Due to the Colombian gov-
ernment’s stance to save the revenue from the oil exports, it is expected that positive
changes in oil prices negatively affect public spending. The indicator of discretionary
fiscal policy is the residual denoted by ε, and thus, it does not represent reaction to
economic conditions. The variables associated with the business cycle were lagged
one period to eliminate problems of endogeneity, while the variable Δ Oil was lagged
six periods because the effect on the Colombian economy occurs after six months
(Perilla 2010).

6 See, for example, Fatás and Mihov (2003b), Afonso et al. (2010), Agnello et al. (2013), and Blanchard
and Perotti (2002).
7 Because inflation rate in Colombia was lower than one digit during the period under analysis (2004–2014),
it was not included as a control variable in the model.

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Effect of credibility and reputation on discretionary fiscal policy 1537

Such as Fatás and Mihov (2003b), after estimation of Eq. (3), the residual is used to
observe the changes in the discretionary fiscal policy, that is, the fiscal impulse (FI)8 :

FIt = εt − εt−12 . (4)

In order to calculate the discretionary fiscal policy component, Eq. (3) is estimated
through two approaches: ordinary least squares with heteroskedasticity and autocor-
relation covariance matrix estimators (HAC), and one-step generalized method of
moments (GMM) with HAC (see Davidson and Mackinnon 2004). As pointed out by
Greene (1993), the main reason for using GMM is that although the OLS estimator is
useful, it is not reliable in the presence of serial autocorrelation, heteroskedasticity, or
nonlinearity (tests in Appendix—Table 6). In particular, the problem of heteroskedas-
ticity is common in macroeconomic time series and there is a risk of endogeneity in
the analysis of fiscal policy discretion (see Fatás and Mihov (2003b). In this sense,
the use of GMM is a good choice because it can deal with potential endogeneity
(Wooldridge 2001). However, for the estimation, it is important to be conscious that
the inclusion of relatively large numbers of moment conditions (highly overidenti-
fied models) can have an adverse effect on finite sample behavior (see Hall 2015). In
order of treating this possible problem in our analysis, we perform a Chi-square test to
evaluate the over-identifying restrictions. Therefore, the J-statistic is shown for each
model as a test of over-identifying moment conditions. In addition, the instruments
considered in the regressions are the lagged independent variables. Furthermore, to
eliminate any possibility of skewing the results, the number of instruments/number of
observations ratio is lower than 0.18 in all GMM estimations.9 In addition, we perform
the Durbin–Wu–Hausman test to analyze the endogeneity of the equation regressors.
Taking into account the information available from Central Bank of Colombia,
the data in this study have monthly frequency for the period from January of 2004
to September of 2014 (descriptive statistics are presented in Table 8—Appendix).
As usual, the use of time series data in estimations entails checking whether the
series have a unit root (non-stationary data series) to avoid the possibility of spurious
regression. Therefore, the augmented Dickey–Fuller (ADF), Phillips–Perron (PP), and
Kwiatkowski–Phillips–Schmidt–Shin (KPSS) tests are performed. The results denote
that all series are I(0) (see Table 9—Appendix).10
Likewise Afonso et al. (2010), the results of the estimations in Table 2 indicate
that the parameter associated with the fiscal persistence is greater than the parameter
associated with the economic growth. In other words, there is evidence that fiscal
policy is more persistent than countercyclical. In fact, such as observed by Lózano
(2009) and Lózano and Toro (2007), in the Colombian economy public spending
reacts little to economic growth. Furthermore, the positive and significant parameter
on the real interest rate indicates that the fiscal policy was not countercyclical in

8 We use a lag of 12 months because it is long enough to measure important changes in the fiscal position.
Furthermore, the lag helps to decrease the possible simultaneity for analysis of the fiscal and monetary
policy interactions that can cause econometric problems.
9 List of GMM instruments is available on Table 7—Appendix.
10 Taking into account the three tests, at least two indicate that the series under analysis are I(0).

123
1538 J. C. G. Ciro, H. F. de Mendonça

Table 2 Estimates of the government spending

Estimator: regressors OLS GMM

Constant −1.4999*** −1.3345***

(0.1733) (0.2127)
[−8.6476] [−6.2727]
G t−1 0.2170** 0.2883**
(0.0899) (0.1126)
[2.4128] [2.3697]
Yt−1 −0.0364** −0.0234**
(0.0151) (0.0098)
[−2.4002] [−2.3697]
rt−1 2.2932** 2.1916***
(0.8926) (0.8273)
[2.5689] [2.6489]
ΔOilt−6 −0.0032*** −0.0036***
(0.0012) (0.0008)
[−2.6328] [−4.2943]
Adj. R2 0.20 0.17
F-Statistic 7.45
P(F-statistic) 0.00
J-Statistic 13.77
P(J-statistic) 0.61
D–W–H test 0.72
Probability 0.95
No. Instr./No. Obs. 0.17

Marginal significance levels: *** 0.01, ** 0.05, and * 0.10. Robust (Newey–West) standard errors are in
parentheses and t-statistics in brackets. P(F-statistic) report the respective p value of the F-test. P(J-statistic)
report the respective p valued of the J-test. D–W–H test is the Durbin–Wu–Hausman test (difference in
J-stats) and null hypothesis is that the regressors are exogenous

the period. Regarding the variation of the oil price, it is observed that the parameter
is negative and significant, and thus, it provokes a negative effect on government
spending.
Because the low level of adjustment in the models, a usual result in the estimations
for fiscal impulse (see, for example, Agnello et al. 2013; Fatás and Mihov 2003a, the
discretionary component of fiscal policy is significant. With the purpose of calculating
the fiscal impulse based on Eq. (4), the residuals from OLS were considered and the
result is plotted out in Fig. 4.

4 Effect of credibility and reputation on fiscal impulse

The use of discretionary fiscal policy is associated with the political environment
in each country. However, because there is a lack of long time series that allows

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Effect of credibility and reputation on discretionary fiscal policy 1539

Fiscal impulse in Colombia

.3

.2

.1

.0

-.1

-.2
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Fig. 4 Fiscal impulse in Colombia

one to measure the quality of the political system, another way of capturing the
institutional quality is making use of macroeconomic variables associated with the
performance of the country. Therefore, a first variable is the gross domestic product
per capita (GDPPC). According to Afonso et al. (2010), greater GDPPC is a result
of solid institutions where the discretionary behavior is constrained by constitutional
rules.
As pointed out by Rodrick (1998) in economies open to international trade, the
weight of the public sector is greater because these economies are more vulnerable
to external shocks. Furthermore, there is a frequent use of countercyclical policies to
smooth consumption. Therefore, a second variable in this study that explains discre-
tionary fiscal policy is the degree of trade openness (OPEN).
According to Wei (2000), good government is associated with high rates of eco-
nomic growth and can attract higher capital flows in the form of direct investments.
Moreover, there exists empirical evidence that foreign direct investment flows are
directed to economies with stable economic fundamentals and strong institutions
(Walsh and Yu 2010). Furthermore, as pointed out by MendonçA and Veiga (2014)
financial openness work as a commitment technology, which contributes to the suc-
cess of the inflation targeting. Thus, because foreign investment flows are directed
by political and economic stability, the discretionary component of fiscal policy is
more restricted in economies with higher capital flows. Therefore, a third variable that
explains the discretionary component of fiscal policy is the foreign direct investment
flows as a percentage of GDP (FDI).
Since inflation targeting is an incentive mechanism to fiscal discipline and that the
efficiency of the monetary policy improves when the credibility is high, it is expected
that there is a negative relation between the variables associated with inflation targeting
and the fiscal impulse. In short, greater credibility (CRED) and reputation (REPUT)
should help to reduce the discretionary fiscal policy (FI). This view is confirmed by

123
1540 J. C. G. Ciro, H. F. de Mendonça

.4 .4

.3 .3
Fiscal Impulse

Fiscal Impulse
.2 .2

.1 .1

.0 .0

-.1 -.1

-.2 -.2

Correlation:-0.22 -.3 Correlation:-0.19

-.3
-.06 -.04 -.02 .00 .02 .04 .06 .08 -.10 -.08 -.05 -.03 .00 .02 .05 .08 .10
Credibility Reputation

Fig. 5 Credibility × fiscal impulse and reputation × fiscal impulse

the negative correlation between credibility (and also reputation) and fiscal impulse
(see Fig. 5).11 Hence, with the purpose of observing the effect of inflation targeting
performance (through credibility and reputation) on discretionary fiscal impulse, the
following models are considered:

F It = α0 + α1 ΔDCREDt + α2 X t + u 0t ; (5)
F It = α3 + α4 ΔDREPUTt + α5 X t + u 1t ; and (6)
F It = α6 + α7 ΔDCREDt + α8 ΔD R E PU T t + α9 X t + u 2t . (7)

where X is a vector of control variables (Δ GDPPC, OPEN, and FDI).

Using the same methodology of the previous section (OLS and GMM), the estima-
tions of Eqs. (5)–(7) are presented in Table 3. It is important to note that all series in
the models are I(0)—see Table 9 (Appendix). Furthermore, because the effect caused
by variables used in the model that explains fiscal impulse is not immediate, the use
of lags in the regressors is applied. The selection of lags of the variables follows the
general to specific methodology (best adjustment of the models). In general, the results
regarding credibility and reputation have the expected behavior from the theoretical
perspective. In all models, the coefficient on credibility is negative and significant.
This result is in consonance with the idea that an increase in credibility represents less
need for increasing interest rate in order for inflation to converge to the target. As a
consequence, there is an inverse effect on the discretionary component of fiscal policy.
In other words, the credibility in inflation targeting regime is an important constraint
to adopt fiscal impulses. In this sense, such as observed by Fatás and Mihov (2003a)
there is evidence that inflation targeting is an incentive mechanism to improve fiscal
discipline.
The behavior of the control variables in the models is also in line with the theoretical
view. Such as observed in the literature, an increase in GDPPC is associated with an

11 The correlation between credibility and reputation is 0.22.

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 Table 3 Effect of credibility and reputation on fiscal impulse

Estimator: regressors OLS GMM

Model 1 Model 2 Model 3 Model 1 Model 2 Model 3

Constant −0.1464** −0.2128*** −0.1408** −0.3175** −0.2833* −0.2231*

(0.0640) (0.0800) (0.0659) (0.1298) (0.1604) (0.1145)
[−2.2859] [−2.6609] [−2.1368] [−2.4453] [−1.7655] [−1.9470]
ΔC R E Dt −0.9566*** −0.9157*** −0.8590** −1.2778***
(0.2894) (0.2628) (0.3906) (0.2654)
[−3.3155] [−3.4835] [−2.1991] [−4.8135]
ΔR E PU Tt −0.5834*** −0.5483*** −0.8737*** −0.9570***
(0.2098) (0.2068) (0.1878) (0.1985)
[−2.7800] [−2.6507] [−4.6518] [−4.8193]
ΔG D P PCt−7 −1.46E−06** −1.24E−06** −1.42E−06** −1.93E−06*** −1.31E−06** −1.68E−06***
Effect of credibility and reputation on discretionary fiscal policy

(5.76E−07) (5.87E−07) (5.41E−07) (6.78E−07) (5.43E−07) (4.79E−07)

[−2.5321] [−2.1151] [−2.6159] [−2.8439] [−2.4074] [−3.4993]
O P E N t−3 0.8226*** 0.9720*** 0.8296*** 1.3920*** 1.2079** 1.1718***
(0.2082) (0.2687) (0.2186) (0.4585) (0.5608) (0.3933)
[3.9506] [3.6166] [3.7942] [3.0357] [2.1537] [2.9787]
FDIt−7 −1.1769* −0.9998* −1.4859** −1.1064* −1.1242** −1.9475***
(0.7088) (0.6065) (0.5664) (0.6159) (0.5301) (0.4377)
[−1.6602] [1.6684] [−2.6233] [−1.7966] [−2.1205] [−4.4487]

123
1541
 Table 3 continued
1542

Estimator: regressors OLS GMM

Model 1 Model 2 Model 3 Model 1 Model 2 Model 3

123
Adj. R2 0.13 0.11 0.20 0.11 0.11 0.17
F-statistic 5.23 4.56 5.47
P(F-statistic) 0.00 0.00 0.00
J-statistic 12.50 12.88 15.19
P(J-statistic) 0.32 0.45 0.18
D–W–H test 1.46 0.08 1.27
Probability 0.69 0.96 0.87
No. Instr/No. Obs 0.15 0.17 0.16

Marginal significance levels: *** 0.01, ** 0.05, and * 0.10. Robust (Newey–West) standard errors are in parentheses and t-statistics in brackets. P(F-statistic) report the
respective p value of the F-test. P(J-statistic) report the respective p valued of the J-test. D–W–H test is the Durbin–Wu–Hausman test (difference in J-stats) and null
hypothesis is that the regressors are exogenous
J. C. G. Ciro, H. F. de Mendonça
Effect of credibility and reputation on discretionary fiscal policy 1543

1.0
Maturation period Wisdom period
0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Chow Breakpoint Test 2009M12 – Sample: 2004M03 2014M09
F-statistic 5.0856 Prob. F(3, 121) 0.0024
Log likelihood ratio 4.8014 Prob.Chi-Square(3) 0.0017
Wald Statistic 15.2570 Prob.Chi-Square(3) 0.0016

Fig. 6 Maturation period and wisdom period in Colombia

improvement in the quality of the institutions and thus implies a lower fiscal impulse.12
The coefficients on OPEN confirm the argument present, for example, in Agnello and
Souza (2014) that an increase in trade openness amplifies the discretionary component
of fiscal policy. The coefficients on FDI (negative and significant) are in consonance
with the idea that foreign direct investment flows represents a commitment that helps
to reduce the fiscal impulse.

4.1 Two phases of credibility

It is natural that the behavior of credibility in developing economies is not stable

over time. Taking into account the performance of the inflation targeting credibility in
Colombia, it is possible to see that there exists two distinct phases (see Fig. 6). Similar
to de Mendonça and Faria (2013) for the Brazilian case, we can identify a “maturation
period” (January of 2004 to December of 2009), which is a period of instability marked
by the effects from the subprime crisis and the effort to develop credibility, and a
“wisdom period” (January of 2010 to September of 2014) which represents a period
of domestic macroeconomic stability and improvement in the credibility.
Because there exists a change in the credibility over time, it is possible to check if
there is a difference in the impact of credibility on fiscal impulse for the two phases.
Hence, using the same methodology adopted in the previous sections we reestimate

12 Similar results are found in Fatás and Mihov (2003b), Afonso et al. (2010), and Agnello and Souza
(2014).

123
1544 J. C. G. Ciro, H. F. de Mendonça

Table 4 Effect of credibility on fiscal impulse (OLS and GMM—model 3

Estimator: regressors OLS GMM

Maturation period Wisdom period Maturation period Wisdom period
2004–2009 2010–2014 2004–2009 2010–2014

Constant −0.1343 0.3770 −0.1209 0.3860

(0.0861) (0.1643) (0.0922) (0.3509)
[−1.5586] [2.2941] [−1.3114] [1.1000]
ΔC R E D t −0.4820* −3.6533*** −1.1089** −3.6960***
ΔR E PU Tt (0.2526) (0.7081) (0.5279) (1.1001)
[−1.9080] [5.1590] [−2.1004] [−3.3596]
−0.1826 −0.9043*** −0.2400 −1.0121***
(0.2510) (0.2765) (0.4722) (0.3617)
[−0.7277] [3.2696] [−0.5083] [−2.7980]
ΔG D P PC t−7 −11.6746** −34.6379** −7.9918* −32.9222**
(4.5764) (13.0110) (4.3954) (15.0578)
O P E N t−3 [−2.5509] [−2.6621] [−1.8181] [−2.1863]
0.8846*** −0.4678 0.7881*** −0.3691
F D I t−7 (0.2681) (0.4865) (0.2827) (1.0716)
[3.2987] [−0.9616] [2.7875] [−0.3444]
−2.2247*** −1.5154* −2.2852*** −2.6844**
(0.5940) (0.8124) (0.5772) (1.2153)
[−3.7450] [−1.8652] [−3.9588] [−2.2087]
Adj. R 2 0.23 0.32 0.27 0.29
F-statistic 4.14 5.79
P(F-statistic) 0.00 0.00
J-statistic 5.95 5.78
P(J-statistic) 0.20 0.22
D–W–H test 0.44 1.39
Probability 0.80 0.71
No .Instr/No. Obs 0.17 0.17

Marginal significance levels: *** 0.01, ** 0.05, and * 0.10. Robust (Newey–West) standard errors are in
parentheses and t-statistics in brackets. P(F-statistic) report the respective p value of the F-test. P(J-statistic)
report the respective p valued of the J-test. D–W–H test is the Durbin–Wu–Hausman test (difference in
J-stats) and null hypothesis is that the regressors are exogenous

Eq. (7)—model 3—for “maturation period” and “wisdom period,” respectively.13 The
results are present in Table 4.
The results of the estimation in Table 4 allow us to observe that the fit of the model
in the “maturation period” is lower than in the “wisdom period” (lower R2 adjusted).
Therefore, we can conjecture that in “maturation period” credibility was not strong

13 The integration order of the series is the same as that observed for the full period (see Table 9—
Appendix).

123
Effect of credibility and reputation on discretionary fiscal policy 1545

enough to reduce the discretionary fiscal policy. In fact, the results show that in the
“maturation period” the decrease in fiscal impulses was explained more by increases
in GDP per capita and the foreign direct investment flows than the variables associated
with the conduct of the monetary policy. Furthermore, comparing the two periods, it
is observed that the effect of monetary policy credibility is higher in the “wisdom
period” for all models. In other words, it is possible to say that a better performance
of the monetary policy (measured by credibility) helps to attenuate the discretionary
fiscal impulses.

5 Robustness analysis

Taking into account Eq. 7 (model 3), we extend our analysis providing new empirical
evidence of the effect of credibility and reputation on fiscal impulse through a vector
autoregressive (VAR) model. As usual, the dynamic analysis of VAR is made through
impulse response functions because it allows one to observe the impulse on the indices
of credibility and reputation caused by shocks (or innovations) provoked by residual
variables over time. As suggested by Koop et al. (1996) and Pesaran and Shin (1998),
we make use of the generalized impulse response function (impulse responses are
invariant to any reordering of the variables in the VAR).
Figure 7 shows the results of the generalized impulse response functions and are
plotted out to the 12th month.14 Both graphs suggest that an unexpected positive shock
on credibility and reputation provokes a significant decrease in the fiscal impulse. The
impact effect is significant over time for credibility, and it abides around 6 months
for reputation. In brief, the gain of credibility and reputation due to the success in
achieving the inflation target helps to reduce the discretionary fiscal policy.

6 Concluding remarks

The measures of credibility and reputation used in this study allow one to see that the
period from 2004 to 2014 is unstable, and it is possible to identify two phases in the
conduct of the monetary policy. A first phase (“maturation period”) goes from 2004
to 2009 and is subject to the effect caused by the subprime crisis. The second phase
(“wisdom period”—2010–2014) presents a sustainable growth in the credibility, and
thus, it indicates an improvement of the Central Bank of Colombia to anchor inflation
expectations.
The estimations regarding the discretionary fiscal policy, making use of public
spending as dependent variable, are in consonance with Afonso et al. (2010), Lózano
(2009), and Lózano and Toro (2007). Therefore, the results revealed that the fiscal
persistence is greater than the effect of economic growth, and thus, fiscal policy is
more persistent than countercyclical in Colombia.
The estimations of credibility and reputation on fiscal impulse indicate that an
improvement in the performance of inflation targeting (convergence of both inflation

14 The VAR order is 1 based on Akaike, Schwarz, and Hannan–Quinn criteria. Furthermore, VAR satisfies
the stability condition. Tests are available from the authors on request.

123
1546 J. C. G. Ciro, H. F. de Mendonça

Accumulated response of FI to DCRED

.00

-.02

-.04

-.06

-.08

-.10

-.12
1 2 3 4 5 6 7 8 9 10 11 12

Accumulated response of FI to DREPUT

.02

.00

-.02

-.04

-.06

-.08

-.10
1 2 3 4 5 6 7 8 9 10 11 12

Fig. 7 Accumulate response to generalized one s.d. innovations ±2 S.E. Note FI fiscal impulse, DCRED
Δ credibility, and DREPUT Δ reputation

and inflation expectations to the target) is capable of reducing the discretionary com-
ponent of fiscal policy. Furthermore, the analysis of “maturation period” and “wisdom
period” revealed that the effect of credibility reducing the fiscal impulse is greater in
the last phase. In brief, such as observed by Minea and Tapsoba (2014) and Lucotte
(2009), inflation targeting is an incentive mechanism capable of improving fiscal dis-
cipline.

7 Appendix

See Tables 5, 6, 7, 8 and 9.

123
Effect of credibility and reputation on discretionary fiscal policy
Table 5 Sources of data and description of the variables
Variable name Variable description
Seigniorage Seigniorage revenue is the annual
percentage variation of monetary
base/GDP
E(INF) Inflation expectations - expectations
computed by the Central Bank of
Colombia relating to inflation in the
last 12 months
INF Inflation accumulated in 12 months
measured by the variation of the
consumer price index
INF* Inflation target—Central Bank of
Colombia
G Government spending (% GDP)—cash
method—seasonal adjustment X12
Y Annual growth rate of real
GDP—accumulated in the last 4
quarters—IMACO index—available at
monthly frequency
r Real interest rate—is the nominal interest
rate minus inflation rate measured by
the Consumer Price Index. Nominal
interest rate has been built on the DTF
rate (fixed term deposits)
ΔOil Variation of the oil price—West Texas
Intermediate (WTI)
CRED Monetary credibility index
REPUT Reputation credibility index
GDPPC Gross domestic product per
capita—series was built on real GDP
per capita (Colombian currency)
OPEN Trade openness - total trade (i.e. the sum
of exports and imports of goods and
services) relative to GDP
FDI foreign direct investment flows as a
percentage of GDP (Colombian
currency)
CBC Central Bank of Colombia
1547
Data source (CBC)
http://www.banrep.gov.co/es/
agregados-monetarios-crediticios
http://www.banrep.gov.co/es/graficas-
series-encuesta-expectativas-analistas-
economicos
http://www.banrep.gov.co/es/ipc
http://www.banrep.gov.co/es/meta-
inflacion
http://www.banrep.gov.co/es/series-
estadisticas/see_finanzas_publi.
htm
http://www.banrep.gov.co/es/imaco
http://www.banrep.gov.co/es/tasas-
captacion
http://www.banrep.gov.co/es/
balanza-comercial
Devised by authors, based on de
Mendonça (2007) methodology
Devised by authors, based on Mendonça
and Galveas (2013) methodology
http://www.banrep.gov.co/es/pib
http://www.banrep.gov.co/es/
balanza-comercial
http://www.banrep.gov.co/es/
inversion-directa
123
1548 J. C. G. Ciro, H. F. de Mendonça

Table 6 Specification (RESET), heteroskedasticity (BPG), and autocorrelation (LM) tests

Estimates Model RESET BPG LM(2) LM(1)

Table 2 F-stat 1.05 0.32 1.02 0.15

Prob. 0.29 0.85 0.34 0.69
Table 4 1 F-stat 1.04 0.40 2.73 0.91
Prob. 0.28 0.80 0.06 0.34
2 F-stat 0.09 0.13 2.00 1.16
Prob. 0.92 0.97 0.14 0.28
3 F-stat 0.46 0.23 2.08 1.71
Prob. 0.64 0.94 0.12 0.19
Table 5 Maturation 1 F-stat 1.27 2.82 0.61 0.17
period Prob. 0.20 0.06 0.54 0.67
2 F-stat 0.37 1.54 0.60 0.48
Prob. 0.71 0.19 0.54 0.48
Wisdom 1 F-stat 0.41 0.35 2.30 3.11
period Prob. 0.68 0.70 0.11 0.08
2 F-stat 1.55 0.78 3.62 7.47
Prob. 0.12 0.56 0.03 0.00

RESET, Ramsey RESET test—number of fitted terms = 1; BPG, Breusch–Pagan–Godfrey test; LM(1),
serial correlation LM test with 1 lag; LM(1), serial correlation LM test with 2 lags

Table 7 List of GMM instruments

Estimates Model Instruments

Table 2 G (−2 to −4) Y (−2 to −10) r (−3 to −5) Δ

Oil (−7 to −11)
Table 4 1 FI (−1 to −5) ΔCRED (−2 to −5) Δ
GDPPC (−8 to −9) OPEN (−4 to −5)
FDI (−7 to −8)
2 FI (−1 to −5) Δ REPUT (−1 to −4) Δ
GDPPC (−7 to −9) OPEN (−5 to −6)
FDI (−7 to −9)
3 FI (−1 to −4) Δ CRED (−1 to −4) Δ
REPUT (−2 to −3) Δ GDPPC (−8 to −9)
OPEN (−4 to −5) FDI (−7 to −8)
Table 5 Maturation period 1 FI (−1 to −3) ΔCRED (−1 to −2) Δ
REPUT (−1 to −2)
2 FI (−2 to −3) Δ CRED (−2 to −3) Δ
REPUT (−1) ΔGDPPC (−7 to −8) OPEN
(−3) FDI (−7)
Wisdom period 1 FI (−1 to −3) Δ CRED (−1 to −2) Δ
REPUT (−1 to −2)
2 FI (−2) Δ CRED (−1 to −2) Δ REPUT (−1
to −2) Δ GDPPC (−7) OPEN (−4) FDI
(−7 to −8)

123
 Table 8 Descriptive statistics

Variables Mean Median Maximum Minimum SD

G −1.7184 −1.7202 −1.4406 −1.9414 0.0882

Y −3.1082 −2.9570 −2.4996 −4.5752 0.4573
r 0.0191 0.0190 0.0400 −0.0087 0.0079
ΔOil 0.4601 1.0750 14.2800 −27.5000 6.3245
CRED 0.3935 0.3133 0.9345 0.0271 0.2727
REPUT 0.2996 0.2572 0.7816 0.0000 0.2426
Effect of credibility and reputation on discretionary fiscal policy

GDPPC 8,961,124 8,980,843 10,728,929 7,298,207 947,627

OPEN 0.2990 0.29070 0.3739 0.2260 0.0296
FDI 0.0355 0.0377 0.0703 0.0011 0.0131

123
1549
 1550

Table 9 Unit root tests (ADF, PP, and KPSS)

Series ADF PP KPSS

123
Lags I /T Test C.V. (5 %) Band I /T Test C.V. (5 %) Band I /T Test C.V. (10 %)

CRED 5 I +T −3.20 −3.44 1 I +T −0.73 −1.94 9 I +T 0.17 0.11

REPUT 1 I −2.71 −2.88 7 −1.10 −1.94 9 I 0.13 0.34
ΔC R E D 4 −2.54 −1.94 13 −4.45 −1.94 7 I 0.09 0.34
ΔR E PU T 12 −2.38 −1.94 1 −4.32 −1.94 7 I 0.08 0.34
G 2 I −3.44 −2.88 1 I −9.78 −2.88 9 I 0.33 0.34
Y 8 I −3.01 −2.88 1 I −2.50 −2.88 9 I 0.16 0.34
r 1 I −3.84 −2.88 1 I −2.88 −3.61 8 I 0.20 0.34
GDPPC 4 I +T −3.53 −3.44 9 −8.63 −1.94 8 I +T 0.12 0.11
ΔG D P PC 8 I −3.69 −2.88 8 I −2.36 −2.88 9 I 0.11 0.34
OPEN 1 I −4.85 −2.88 4 I −6.79 −2.88 7 I +T 0.07 0.34
ΔOil 0 I −7.44 −1.94 1 I −1.94 −7.40 4 I 0.04 0.34
FDI 3 I −2.97 −2.88 7 I −6.54 −2.88 8 I 0.21 0.34
Wisdom period
FI 1 −3.18 −1.94 4 I +T −8.09 −3.49 4 I +T 0.05 0.11
ΔC R E D 6 −3.39 −1.94 3 −1.37 −1.94 5 I +T 0.10 0.11
ΔG D P PC 9 I +T −6.30 −3.50 I +T −0.29 −1.94 I +T 0.11 0.34
Maturation period
FI 0 −7.08 −1.94 3 −7.08 −1.94 3 I 0.16 0.34
ΔC R E D 4 −2.43 −1.94 0 −4.35 −1.94 3 I 0.071 0.11
ΔG D P PC 1 I +T −3.73 −3.47 1 I +T −1.91 −3.47 10 I 0.32 0.34

C.V., critical value. Trend (T ) and intercept (I) are included based on Schwarz criterion. ADF—the final choice of lag was made based on Schwarz criterion. PP and
KPSS—spectral estimation method is Bartlett kernel and the Newey–West Bandwidth is used
J. C. G. Ciro, H. F. de Mendonça
Effect of credibility and reputation on discretionary fiscal policy 1551

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