Monetary-Fiscal policy mix in the Eurozone

The monetary-fiscal policy mix in the Eurozone

In this paper Reichlin et al. study the monetary-fiscal policy interaction in the Euro Area, through the lens of the aggregate government budget constraint and suggest an empirical framework to study the adjustment of fiscal variables, returns and inflation to unexpected monetary policy changes.

To this end, they are using a linearized version of the government budget constraint in conjunction with a Vector Autoregressive (VAR) model. This set-up allows them to analyze how the different components of the government budget constraint adjust to both conventional and unconventional monetary policies. They look at the four largest countries of the Euro Area: Germany, France, Italy and Spain and assume that inflation is determined by the aggregate fiscal and monetary stance, and the aggregate fiscal stance is the sum of the fiscal positions of individual states. Their results include:

• With conventional monetary policy, fiscal policy responds with a decline in the primary surplus in the short-run. In the long-run, this is absorbed by an increase in inflation, while the contribution of nominal returns is less important;
• With unconventional monetary policy, the short-run fiscal policy is nearly neutral, but contrary to the conventional case, the effect on inflation is smaller and movements in nominal returns are larger.

It is difficult to extract a clear policy message from these results. The mechanism related to the budget identity is telling us that many factors affect inflation in the long-run: debt maturity, yields and primary surplus. In principle, coordination between monetary and fiscal policy could determine the combination of these factors, given an inflation objective. Historical data suggest that the small effect of unconventional monetary policy on inflation is explained by an unresponsive fiscal policy.

Monetary-Fiscal Crosswinds in the European Monetary Union
Authors: Lucrezia Reichlin, Giovanni Ricco, Matthieu Tarbé
From: London Business School, University of Warwick

The need for an institutional framework

Effective macroeconomic stabilisation in the vicinity of the lower bound requires both unconventional monetary and fiscal policies. Central banks need to establish and preserve a level of financing conditions that enables sustainable private and public spending. Fiscal policy, in turn, needs to recognise its role in the transmission of monetary policy in a low inflation, low interest rate environment. Achieving this policy mix requires an institutional framework that creates the tools and the space for fiscal policy to support the efforts of the central bank when inflation is below its aim and that recognises the existence of a budget constraint in the long run.

Unconventional fiscal and monetary policy at the zero lower bound
By: Isabel Schnabel – ECB