Euro area fiscal policy reacts to monetary policy, debt, and economic cycles
A new working paper examines how fiscal policy in the euro area reacts to monetary policy, government debt, and the business cycle from 1999-2019. It finds fiscal policy acts substitutively to monetary policy, though this effect weakened during quantitative easing.
Fiscal policy's counter-move to monetary tightening
The paper estimates fiscal policy reaction functions for 1999-2019, revealing a substitutive relationship with monetary policy: tight monetary policy leads to loose fiscal policies, and vice versa.
This effect, however, appears to have diminished during the period of quantitative easing (QE), possibly due to governments perceiving QE as a monetary backstop.
Over the medium term, this substitutive effect initially increases but then broadly fades to a neutral or slightly complementary relationship.
The study also finds that governments with high debt levels pursue budgetary surpluses to maintain long-run fiscal sustainability.
Furthermore, there is evidence of countercyclical fiscal behavior, with expansionary policies during economic downturns and a neutral stance when output exceeds potential.
Measuring the interplay of fiscal and monetary policy
The paper introduces a novel aspect by including the monetary policy stance, approximated by a shadow interest rate, in its fiscal reaction function analysis.
This approach aims to enhance the calibration of monetary policy for price stability.
The study also explores governments' responses to elevated debt levels, which are critical for monetary policy's primary objective, and fiscal policy's countercyclical behavior to smooth economic fluctuations.
Fiscal policy reaction functions are estimated using the structural budget balance for ten euro area countries over the 1999-2019 period.
A nuanced interplay, not a simple dance
This research provides crucial insights into the complex dynamics between fiscal and monetary policies, highlighting the often-overlooked substitutive reactions.
The finding that QE may have altered this relationship is particularly relevant, suggesting central bank actions can inadvertently influence fiscal space.
However, the caution warranted in interpreting QE-related outcomes underscores the need for further research to fully understand these evolving policy interactions.