Monetary Financing and Fiscal Discipline

Abstract

Rules governing monetary state financing vary across jurisdictions. The mainstream rationale for bans of state financing rests on the empirical assumption that monetary financing undermines fiscal discipline. We address the plausibility of this assumption by estimating panel vector auto-regressive (VAR) models for euro area Mediterranean crisis countries over the period 2010-2018 to explore the reaction of the sovereigns’ fiscal position to a monetary policy shock. Our results suggest that fiscal discipline is not waning after an expansionary monetary policy innovation related to unconventional measures, as expressed through an improvement of the primary balance despite declining borrowing costs. While no compelling inferences can be made as to the driving force of this improvement – political pressure channeled through conditionality may be a plausible explanation – our results suggest that we can dismiss empirical claims on the adverse effect of unconventional monetary policy on fiscal discipline.

Keywords: Monetary Financing, Fiscal Discipline, Unconventional Monetary Policy, Panel Vector Auto-regressive Model

JEL Classification: E52, E62, H63, K33