Can Fiscal Consolidation Help Central Banks Fight Inflation?

51 Pages Posted: 28 Dec 2023

See all articles by Jiaqian Chen

Jiaqian Chen

International Monetary Fund (IMF)

Era Dabla-Norris

International Monetary Fund (IMF)

Carlos Goncalves

International Monetary Fund (IMF)

Zoltan Jakab

International Monetary Fund

Jesper Lindé

International Monetary Fund (IMF)

Abstract

This paper argues case that a tighter fiscal policy stance can meaningfully support central banks in fighting inflation in both advanced and emerging market economies. While the standard textbook result suggest that monetary policy is much more effective than fiscal policy in battling inflation in open economies due to the exchange rate channel, we show that a tighter fiscal stance is notably more effective in the current situation. This is so because when many countries currently need to tighten the policy stance simultaneously, the exchange rate channel does not provide monetary policy with an edge over fiscal policy. We also show that fiscal consolidation can be helpful in small open emerging markets and developing economies by reaffirming their commitment to price stability, and by putting the fiscal house in order which reduces risk premiums and strengthens the currency. Furthermore, we show that spillovers from major economies can be more adverse from tighter monetary policy. By applying a two-agent New Keynesian modeling framework with unconstrained and hand-to-mouth households, we show that any adverse effects of tighter fiscal policy (relative to tighter monetary policy) on consumption inequality can be handled with a combination of general spending cuts and targeted transfers to vulnerable households.

Keywords: Policy Coordination, Monetary Policy, Fiscal Policy, High Inflation, fight inflation, inflation risk, fiscal policy stance, discretionary monetary policy, exchange rate channel, Inflation, Monetary tightening, Fiscal consolidation, Central bank policy rate, Global

JEL Classification: E52, E58, E60, E62, E31, E43, F31

Suggested Citation

Chen, Jiaqian and Dabla-Norris, Era and Goncalves, Carlos and Jakab, Zoltan and Lindé, Jesper, Can Fiscal Consolidation Help Central Banks Fight Inflation?. IMF Working Paper No. 2023/260, Available at SSRN: https://ssrn.com/abstract=4676933 or http://dx.doi.org/10.5089/9798400261640.001

Jiaqian Chen (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Era Dabla-Norris

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Carlos Goncalves

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Zoltan Jakab

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Jesper Lindé

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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