Impact of Institutional Quality on the Effectiveness of Monetary and Fiscal Policies in Peru Between 2005 and 2020

Abstract

This study examines how institutional quality (measured by the ICRG and POLCON indices) impacts the effectiveness of monetary and fiscal policies in Peru between 2005 and 2020. Specifically, a Taylor-style monetary policy rule and a fiscal reaction function are jointly estimated, each augmented with an interaction between the output gap and the institutional quality measures. Moreover, the models incorporate inflation, exchange rate, and terms-of-trade gaps, alongside instrument lags and dummy variables. Monthly financial data come from the Central Reserve Bank of Peru, whereas ICRG and POLCON are annualized via Ecotrim. The equations are then estimated using the Generalized Method of Moments (GMM) to address potential endogeneity through lagged instruments. As a result, critical quality thresholds emerge (POLCON ≈ 0.86 for both rules, ICRG ≈ 72 in the Taylor framework, and ICRG ≈ 68 in the fiscal model) that distinguish procyclical from countercyclical regimes. Additionally, the interest-rate gap exhibits high persistence (exceeding 0.93), while the real-expenditure gap persists around 0.30. Furthermore, inflation, exchange rate, and terms-of-trade gaps significantly influence both policy instruments, and dummy variables capture the structural impacts of banking and fiscal reforms. In conclusion, strong institutional quality enhances the autonomy and credibility of both the Central Bank and fiscal authorities, thereby enabling countercyclical measures that stabilize economic fluctuations; conversely, periods of weak institutional frameworks in the 1980s and 1990s constrained such policy effectiveness. Finally, deepening institutional independence, transparency, and oversight is recommended to strengthen countercyclical policy, reduce macroeconomic volatility, and bolster economic agents’ confidence.