1887

OECD Economics Department Working Papers

Working papers from the Economics Department of the OECD that cover the full range of the Department’s work including the economic situation, policy analysis and projections; fiscal policy, public expenditure and taxation; and structural issues including ageing, growth and productivity, migration, environment, human capital, housing, trade and investment, labour markets, regulatory reform, competition, health, and other issues.

The views expressed in these papers are those of the author(s) and do not necessarily reflect those of the OECD or of the governments of its member countries.

English, French

Interactions Between Monetary and Fiscal Policy

How Monetary Conditions Affect Fiscal Consolidation

This paper assesses how and in what circumstances, fiscal consolidations are affected by monetary conditions, using data covering 24 OECD countries over the past 25 years, Focusing on fiscal consolidation “episodes”, it is found that these tend to occur when large budget deficits threaten sustainability and usually when other macroeconomic indicators -- inflation, the exchange rate and unemployment -- suggest a “crisis” situation. After controlling for these factors, the paper finds strong econometric evidence that consolidation efforts are more likely to be pursued and to succeed if the monetary policy stance is eased in the initial stages of the episode, thus contributing to offsetting the contractionary impact of fiscal tightening. However, the link is far from mechanical and there are also counter-examples where monetary easing was followed by aborted consolidation efforts. Central bank independence explicitly precludes direct responses of monetary policy to fiscal actions. However, the paper also provides evidence that the indirect reaction of monetary policy and financial markets to fiscal consolidation may be influenced by the quality of fiscal adjustment, as short and long-term interest rates are more likely to fall during episodes characterised by greater reliance on current expenditure cuts. While this means that causality runs both ways, the paper provides evidence that, even after controlling for this proxy of fiscal adjustment quality, changes in monetary stance do affect the chances that a fiscal retrenchment plan will be successfully pursued.

English

Keywords: fiscal stance, financial markets, interest rate, fiscal consolidation, monetary policy, quality of fiscal adjustment, monetary conditions, central bank, policy co-ordination, fiscal adjustment, fiscal policy
JEL: G12: Financial Economics / General Financial Markets / Asset Pricing; Trading volume; Bond Interest Rates; H62: Public Economics / National Budget, Deficit, and Debt / National Deficit; Surplus; E63: Macroeconomics and Monetary Economics / Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook / Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy; E58: Macroeconomics and Monetary Economics / Monetary Policy, Central Banking, and the Supply of Money and Credit / Central Banks and Their Policies
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