Monetary-fiscal crosswinds in the European Monetary Union

Summary

Focus

This paper studies the monetary-fiscal mix in the European Monetary Union. When economies are hit by large shocks, such as the Covid crisis, the pre-set fiscal rules in a monetary union could be a constraint and offset the conduct of accommodative monetary policy. In addition, a more active fiscal policy could be a powerful tool to stabilise economic conditions when short-term interest rates hit the zero lower bound. The paper develops an econometric framework to study the dynamics between primary deficits, yields and returns, the market value of the debt, and inflation, under different monetary policy scenarios.

Contribution

This paper extends the literature, which has long focused on the United States, to a monetary union. It thus allows a scrutiny of the dynamic interaction between a single central bank and multiple fiscal authorities. In addition, the paper provides a new quarterly fiscal dataset of market value of government debts for the four main euro area economies covering the period 1991–2019.

Findings

The paper finds that fiscal policy in the monetary union responds differently under various monetary policy scenarios. In response to a conventional easing of the policy rate – reduction in short-term interest rates – fiscal policy leans in the same direction. The increase in fiscal deficit will be absorbed by that in inflation in the long run. Conversely, in response to an unconventional easing – through term spread compression at the long end of the yield curve – primary fiscal surplus barely moves and the discount rate declines strongly. The long-run effect of unconventional monetary easing on inflation is about half than that of conventional. These results vary little across countries.

Abstract

We study the monetary-fiscal mix in the European Monetary Union. The medium and long-run effects of conventional and unconventional monetary policy can be analysed by combining monetary policy shocks identified in a Structural VAR, and the general government budget constraint featuring a single central bank and multiple fiscal authorities. In response to a conventional easing of the policy rate, the real discount rate declines, absorbing the increase in deficit due to the fiscal policy leaning towards the easing. Conversely, in response to an unconventional easing of the long end of the yield curve, the discount rate declines strongly, while the primary fiscal surplus barely moves. The long-run effect of unconventional monetary easing on inflation is about half than that of conventional, a result which is also consistent with the muted response of fiscal policy. Results do not point to large differences across countries.

JEL classification: E31, E63, E52
Keywords: monetary-fiscal interaction, fiscal policy, monetary policy, intertemporal government budget constraint