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The effectiveness of fiscal policy depends on the financing and monetary policy mix

Governments are crafting fiscal stimulus packages to counter the crisis. This column highlights factors that are crucial in determining the effectiveness of such measures: the financing mix (taxes vs future spending cuts), and accompanying monetary policy. To illustrate the importance of these considerations, simulation results are presented for several stimulus packages.

Policymakers around the world realise that they need a broad range of policies to contain the ongoing financial crisis. Fiscal policy is clearly in the minds of all, as stressed by the essays by Alesina and Tabellini and others in the recent VoxEU.org book.

The main feature of this recession, namely, the emergence of widespread credit constraints, is a strong argument in favour of fiscal policy. The reason is that the monetary policy transmission becomes weaker and more uncertain when credit markets are dysfunctional. Moreover, as our economies have become more open, international coordination of fiscal expansions is increasingly necessary to achieve the maximum impact without worsening trade balances.

Both issues are discussed in a previous Vox column by one of us. Here we want to highlight two additional aspects that are crucial for the effectiveness of fiscal policy interventions:

  1. The financing mix of a fiscal expansion, and;
  2. The stance of monetary policy.

Even though they are fundamental, these points are not receiving sufficient attention in the debate.

Fiscal stimulus: How it’s financed matters

First, the effect of a fiscal expansion depends on how the expansion is financed. This applies not only to the short-term debt-tax mix used to finance a current increase in government expenditure, but also – and perhaps even more importantly – to the long-term financing source, i.e., taxes versus spending cuts in the future.

The impact of higher current expenditure is strengthened when complemented with a credible plan that ensures it is financed at least in part by future spending cuts. How?

  • Future spending cuts tend to raise current private consumption and investment via their effects on the long-term interest rate.

This channel is emphasized by both Keynesian and neoclassical models.

  • Lower future spending commitments mean that future taxes won’t have to rise as much.

In other words, such a financing plan, if credible, will help sustaining the spending plans by firms and households who are currently not credit-constrained, and who therefore immediately respond to long-term fiscal prospects.

Admittedly, a commitment to reduce spending in the future may lack credibility, especially in a situation like today, when the uncertainty about the length and the overall fiscal implications of the crisis is enormous. Even in countries with explicit fiscal rules (like the UK), one may doubt if these provide sufficient commitment devices.

It may nonetheless pay to identify measures which are inherently temporary, i.e., matched by future cuts in spending. An obvious example consists of measures that bring forward in time investment projects that are already planned, thereby raising current spending while simultaneously reducing future spending. This is not a perfect solution to the commitment problem, but it may help.

Monetary and fiscal policy should work together

Second, fiscal policy is more effective if monetary policy is accommodative. For fiscal stimulus to work, central banks should not adhere too narrow-mindedly to their mandate of price stability – a criticism often raised against the Bank of Japan in the ‘lost decade.’ This risk is hopefully small today.

Yet, one could envision a situation in which, even if policy interest rates were brought close to zero, it would still be possible that the overall monetary stance of the economy remain too tight. In this situation, the lower bound of zero for nominal interest rates – while providing a rationale for a fiscal expansion – may at the same time limit the effectiveness of any given fiscal intervention.

Evidence from model simulations

Now we back our arguments using a standard new-Keynesian model to track the macroeconomic consequences of an unexpected increase in government spending in an economy which is otherwise undisturbed (Corsetti, Meier and Müller 2008a). Although the model and simulations fail to capture all elements of today’s reality (as always), the exercise shows the extent to which the impact fiscal policy depends on the financing mix and monetary policy.

To illustrate the mechanism, we model an open economy, and, for simplicity, assume it is small; this allows us to abstract from macro interdependence. We also assume away all kinds of credit-constrained agents, whose presence would increase the consumption multiplier above what we report. The results from this exercise are shown in the graphs we attach to this text.

The graphs show the evolution of government consumption, private consumption, output, the government budget balance and debt, the real exchange rate, inflation and interest rates, over 40 quarters in response to an increase in government spending by one percent of (quarterly) GDP.

(All variables are expressed relative to their trend values (note that a negative value for the nominal interest rate means a fall relative to the initial level). Quantity variables are expressed in percent of quarterly GDP, the real exchange rate is measured in percentage deviation relative to its pre-intervention value, interest rates and inflation are measured in annualized percentage points. Each graph includes three lines.)

In the diagram:

  • The dashed black line refers to a spending shock which is entirely financed by taxes.
  • The solid blue and the dash-dotted red lines refer to a spending shock which is partly financed by cuts in spending in the future. (You can see this in the upper left panel since government spending falling below trend about 3-4 years after the initial measures were taken.)
  • The dash-dotted lines refer to the case of no monetary accommodation as the central bank pursues complete price stability.
  • The solid blue line to the case of accommodative monetary policy – in the sense that central banks adopt a Taylor rule with a relatively low coefficient on inflation (1.2 in this example, with prices remaining fixed for 5 quarters on average).


The message from our diagram is unequivocal. The response of consumption is positive for the ‘right mix’ of accommodative monetary policy and financing by spending cuts in the future, but negative either when spending is entirely financed through higher taxes (the dashed lines), or when the monetary reaction is non-accommodating (the dash-dotted lines). Comparing the difference in the response of consumption and output across monetary stances (accommodating, not accommodating), one can observe a gap of about half a percentage point of GDP through many quarters.

Monetary accommodation is measured by the difference in the response of real interest rates depicted by the solid and the dash-dotted lines in the lower right panel (ex ante real rates): under the accommodating stance (solid lines) real rates are lower by about a quarter of a percentage point (annualized) relative to the tight monetary stance (dashed-dotted line). Importantly, under the ‘right’ policy mix the path of real short term interest rates implies a fall in the long-term real interest rate, because future short rates fall below their long term average value.

We may note that the response of interest rates is by and large consistent with empirical findings on the effects of fiscal expansions identified in historical time series. Moreover, with the ‘right’ financing and policy mix, the model also predicts a positive consumption multiplier together with exchange rate depreciation, a stylized fact which has been established by several recent studies (e.g. Monacelli and Perotti 2006, Ravn et al. 2007). While apparently difficult to reconcile with conventional wisdom, this stylized fact has motivated quite a bit of recent theoretical work, generating the widespread impression that the standard model needs to be adapted in a significant way to fit the fact. The message from our study is different: the standard model works. However, sufficient attention must be given to the financing of fiscal expansions and the fiscal-monetary policy mix – a message that is strongly related to the argument by Dornbusch (1980).

These exchange rate-related considerations bring us to a final point, which is particularly relevant in the current situation, in which governments are contemplating cooperative action. Looking at our results, depreciation may be interpreted as an unwelcome beggar-thy-neighbour effect of domestic policies – domestic economic activity is sustained by ‘stealing’ foreign demand.

We would like to stress here that exchange rate depreciation is not crucial for the size of fiscal multipliers (our results also go through in a closed economy model). Most important, depreciation will be contained, or eliminated altogether, when fiscal expansion is coordinated across borders.

Actually, our analysis provides support to the idea of including a specific item in an agenda for international policy cooperation, that is, the opportunity of pursuing fiscal plans where current expansions are matched in part by offsetting correction of spending down the line.

Notes of caution

Some notes of caution are in order as concluding remarks. It is hard to believe that the impact of fiscal expansions will be independent of the initial budgetary conditions of a country. Indeed, in related empirical work based on a sample of OECD countries, we find that consumption multipliers are much lower and even negative in economies with high debt and deficits (Corsetti, Meier and Müller 2008b). In a sense, however, we could argue that for these economies our point applies with unusual force: when initial budget conditions are weak, rigorous financing plans may be a precondition for fiscal policy to work at all.


The case for fiscal stimulus may be strongest when there is a presumption of a coordination failure in the economy, as is apparently the case in the running dry of credit markets. Yet in many countries the current juncture also shares characteristics of an inevitable hangover after some excessive binge. While fiscal policy can soften the blow and it is wise to use it, the truth remains that American consumers, for instance, have to repair their balance sheet, rather than resume old spendthrift ways. The way stimulus programs are designed matters here. We should not lose sight of this plain observation.


Corsetti Giancarlo, André Meier and Gernot Müller (2008a) “The transmission of fiscal policy: the role of financing and policy mix”, mimeo European University Institute.
Corsetti Giancarlo, André Meier and Gernot Müller (2008b) “The transmission of fiscal policy in open economy”, mimeo European University Institute.
Dornbusch Rudiger (1980), "Exchange Rate Economics: Where Do We Stand", Brookings Papers on Economic Activity 1, pp. 143-185.
Monacelli, Tommaso and Roberto Perotti (2006) Fiscal Policy, the Trade Balance and the Real Exchange Rate: Implications for International Risk Sharing, mimeo.
Ravn, Morten, Stephanie Schmitt-Grohé and Martín Uribe (2007), Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate, CEPR Discussion Paper No. 6541, October 2007


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