Interactions between Monetary and Fiscal Policy: How Monetary Conditions Affect Fiscal Consolidation

44 Pages Posted: 30 Aug 2007

See all articles by Rudiger Ahrend

Rudiger Ahrend

Centre for Entrepreneurship, SMEs, Regions and Cities

Pietro A. Catte

Organization for Economic Co-Operation and Development (OECD)

Robert Price

Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO)

Date Written: November 2006

Abstract

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.

Keywords: Fiscal adjustment, fiscal consolidation, fiscal policy, fiscal stance, monetary policy, monetary conditions, central bank, financial markets, interest rate, quality of fiscal adjustment, policy co-ordination

JEL Classification: E63, E58, G12, H62

Suggested Citation

Ahrend, Rudiger and Catte, Pietro A. and Price, Robert, Interactions between Monetary and Fiscal Policy: How Monetary Conditions Affect Fiscal Consolidation (November 2006). OECD Economics Working Paper No. 2006/49, Available at SSRN: https://ssrn.com/abstract=1010655 or http://dx.doi.org/10.2139/ssrn.1010655

Rudiger Ahrend (Contact Author)

Centre for Entrepreneurship, SMEs, Regions and Cities ( email )

2 rue Andre Pascal
Paris, 75016
France
75016 (Fax)

Pietro A. Catte

Organization for Economic Co-Operation and Development (OECD) ( email )

2 rue Andre Pascal
Paris Cedex 16, 75775
France

Robert Price

Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO) ( email )

2 rue Andre Pascal
Paris Cedex 16, MO 63108
France

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