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Fiscal-monetary crosswinds in the euro area: Conventional and unconventional shocks

Monetary policy has fiscal implications since its effect on interest rates, inflation and output relaxes or tightens the general government inter-temporal budget constraint. Inflation dynamics is the result of both monetary policy and the fiscal response to it via the adjustment of the primary deficit. This column discusses estimates of the fiscal responses to monetary policy in the euro area. It shows that the more modest impact of unconventional monetary policy easing on inflation, if compared with the impact of conventional easing, can be explained by a more modest increase in the primary deficit in the former case.

The topic of coordination between monetary and fiscal policy has become the focus of policy discussion in recent years (Draghi 2014, Lagarde 2020, Schnabel 2021). One reason is that there is limited space for traditional monetary policy based on steering the short-term interest rate when the latter is at (or close to) the effective lower bound (ELB). Many recent papers have advocated mechanisms to implement a coherent a monetary-fiscal policy mix (see, for example, the policy report by Barsch et al. 2021).

Empirically, there is limited knowledge about how the combination of monetary and fiscal policy affects inflation. This is a complex topic since there are multiple channels of interaction. Monetary policy, by affecting interest rates, output, and inflation, has an impact on the government’s budget constraint. The response of fiscal authorities via the adjustment of the primary deficit depends on the fiscal framework or the stabilisation objectives of fiscal authorities. The effect on inflation depends on the combined effects of fiscal and monetary actions, as these affect the adjustment which is required to satisfy the intertemporal budget constraint of the consolidated government sector (central bank and governments). This is because the constraint is a binding identity which depends on inflation, returns on government debt, and primary surpluses.

In the governance of the euro area, the central bank is an independent institution and the treaties have delegated to it the responsibility for price stability. As a consequence, the budget constraints of the central bank and governments must be thought as separate ex ante. But, ex post, what matters to understand the dynamics of inflation is the consolidated budget constraint of the central bank and the 19 fiscal authorities. If we want to understand the causes of the under-shooting of the inflation target since 2013 in the European Monetary Union (EMU), we therefore need to consider how primary deficits and returns have responded to monetary policy.

In a recent paper (Reichlin et al. 2021), we estimated empirically the response of fiscal variables, inflation, and the market value of government debt to monetary policy changes affecting the short-term (traditional policy) or long-term rates (forward guidance or quantitative easing). Beside estimating VAR-based impulse response functions, we used the intertemporal budget constraint identity to obtain a decomposition of unexpected inflation (conditional on monetary policy), split several components: the primary deficit, returns on the market value of government debt, and output growth. We modelled this relationship using a newly constructed dataset for France, Germany, Italy, and Spain, as well as euro area aggregate data. 

Our framework is inspired by Hall and Sargent (1997) and Cochrane (2019, 2020). Common to their approach is to start from the general government intertemporal budget constraint as an equilibrium identity linking the market value of the debt to future discounted primary surpluses. 

From that budget constraint, it is possible to obtain a ‘linearised identity’ in the following form:

Inflation (impact) – Nominal Returns (impact) =
– (cumulated future Surplus + cumulated future Growth) 
+ (cumulated future Nominal Returns - cumulated future Inflation),

Each term is to be thought of as an unexpected change.

The intuition is that an unexpected increase in inflation – if not matched by a movement in contemporaneous returns – has to correspond to either a decline in the (cumulated) surplus to GDP ratios, a decline in GDP growth, or a rise in the discount rates due to a decline in nominal long-term bond prices. These adjustments in the aggregate can happen as combination of symmetric or asymmetric changes at country level.

Since this identity involves bond returns, inflation, and fiscal variables, it can be used to learn about the fiscal-monetary adjustment dynamics in an otherwise unrestricted empirical model. 

To apply this framework to the euro we need to extend it to the case of a single central bank and multiple fiscal authorities. 

We focus on a stylised description of the EMU in which each country can issue debt and hence faces different market rates (and returns). Inflation at the euro area level is determined by the aggregate fiscal and monetary stance, and the aggregate fiscal stance is the sum of the fiscal positions of individual states that may or may not balance their budgets independently, and take inflation as given. Such a description is open to nuances such as divergences in the national inflation rates in the medium-run, and fiscal transfers across countries to help balancing out national fiscal imbalances. Whether such mechanisms operate or not is an entirely empirical matter.

Conventional monetary policy and the fiscal stance

We identify the shocks in the model using a combination of sign restrictions (Uhlig 2005) and the recently proposed narrative sign restrictions of Antolin-Diaz and Rubio-Ramirez (2018). In addition to traditional sign restrictions, we constrain an expansionary conventional monetary policy shock to have a negative impact on the short- and long-term interest rates, a positive impact on output, and a positive impact on inflation and inflation expectations for the first three quarters (inflation moving by a larger amount). We separately identify the monetary policy shock and unconventional monetary policy shocks based on their differential impacts on the yield curve. The monetary policy shock is assumed to move short-term interest rates by a larger amount than long-term rates, leading to a steepening of the yield curve. The unconventional monetary policy shock has the opposite effect on the slope. We also assume that monetary policy shocks are neutral and do not affect real GDP in the long run.1

A first set of results pertains to conventional monetary policy (Figure 1). GDP and inflation respond as expected: there is a hump-shaped impact on GDP, peaking at about 0.1% in the second year, and an immediate impact on inflation and inflation expectations. In line with the transitory nature of the shock, the impact on long-term yields is both small in magnitude and short lived. 

What is more interesting for our discussion are the responses of the fiscal variables. For the aggregate (not shown), we estimate an immediate decline in the surplus-to-GDP ratio which, as shown in Figure 1, is driven mostly by Germany and Italy. The response of the French surplus ratio is negative but not significant, and the Spanish surplus responds with a positive sign. The value of the debt-to-EA-GDP ratio falls for all countries in the first two years, although the aggregate response is not significant.

Figure 1 Impulse response functions to a one standard deviation conventional monetary policy shock (easing) in the euro area

Note: The shock is small cut in the short-term interest rate, of about 10 basis points. The impulse response of real GDP is reported in level, i.e. as percentage deviation from the steady state. All other impulse responses are reported as deviations from the steady state.

The response of the return on government debt is ambiguous since it is driven by both short- and long-term interest rate movements while sovereign spreads do not appear to react significantly to the conventional monetary policy shock, indicating a symmetric transmission across the euro area.

To summarise, we report evidence of fiscal-monetary coordination to a conventional monetary policy easing: in response to the decline in interest rates, the fiscal authorities allow the ‘surplus-to-EA-GDP ratio’ to decline. The overall impact of the policy is an increase in output, an increase in inflation, and an insignificant decline in the ratio.

This is not the case for an unconventional monetary policy easing driving long-term interest rates down. 

Unconventional monetary policy and crosswinds

A second set of results for unconventional monetary policy is reported in Figure 2. We observe a positive reaction of output and inflation, and no significant movements in fiscal variables. This happens despite an unambiguous response in the return on government debt, which maps to an increase in the market value of the debt due to the decline in longer-term yields. While the value of the debt increases on impact, the response is not significant beyond the first period.

To bring more insight to these results, we can decompose unexpected inflation into various components using the intertemporal budget constraint identity. An unexpected increase in inflation has to correspond to a decline in the present value of surpluses, coming either from a decline in the surplus-to-GDP ratio, a decline in GDP growth, or a rise in the discount rate due to a decline in nominal long-term bond prices. These adjustments in the aggregate can happen as a combination of symmetric or asymmetric changes at country level. We report results on the decomposition relative to the exercise on QE monetary policy in Table 1 below.

The unexpected inflation decomposition reported in the table shows that the 10 basis points decline in the long-term rate due to the unconventional monetary policy shock corresponds to a large adjustment in the nominal returns which jump 93 basis points in the short run, but contract by 81 points in the long run. Inflation movements are muted with a jump of nine basis points in the short run and 15 basis points of additional cumulative unexpected inflation in the long-run. As a result, the long-run real discount rate declines by 96 basis points. 

This points to the strong and persistent effects of unconventional monetary policy on the real rates – one of the key mechanisms through which monetary policy operates. But differently from the case of conventional monetary policy, the cumulated primary deficit-to-GDP ratio increases by only 14 basis points.

Figure 2  Impulse response functions to a one standard deviation unconventional monetary policy shock (easing) in the euro area 

Note: A one standard deviation shock corresponds to a 10 basis points decline in the long-term average yield.  The impulse response of real GDP is reported in level, i.e. as percentage deviation from the steady state.

Table 1 Unexpected Inflation decomposition in terms of changes to returns and future cumulated changes to growth, surplus, returns and inflation

Note: The country columns display numbers weighted by country shares. “Surplus” denotes 400 times Primary Surplus over Euro Area GDP, scaled by Debt over Euro Area GDP at steady state.

The muted fiscal response conditional on an unconventional monetary policy shock is telling us that when that policy was active – i.e. since the 2008 crisis (first via targeted loans, then via forward guidance, and asset purchases) – fiscal authorities did not use the fiscal space provided by the decrease in long-term rates. Overall, the response to a monetary policy easing was a small decrease in the primary surplus – much smaller than what we estimate for the conditional response to conventional monetary policy. The estimates (not shown here) point to an increase in the deficit of 42 basis points in that case. The reason is that the increase in the cumulated primary deficit-to-GDP ratios of Italy and France is partly compensated by the increase in Germany’s surplus.

To sum up, in contrast with the conventional monetary policy case where the decline in real rates (and some extra inflation) was matched by a relatively large increase in the primary fiscal deficit-to-GDP ratio, in the case of unconventional monetary policy the large decline in the discount rate is not associated with a fiscal expansion. The response of inflation is muted, and so is the response of output at business cycle frequency. 


In the euro area, the empirical fiscal-monetary mix appears to vary depending on the conventional (i.e. affecting the short-term interest rate) or unconventional (i.e. shifting the long end of the yield curve) nature of the monetary policy shock. 

Key in this difference are two factors: (i) the movement of the returns on the value of the debt, which depends on the change in yields at the relevant maturity; and (ii) the response of the primary surplus, which depends on fiscal policy.

Nonstandard monetary policy has a larger effect on returns since, given the average debt maturity, long-term yield changes have a higher impact on returns than changes in the short run. In the long run, the shock is absorbed by a small effect on inflation (about half than in the case of conventional policy) and a change in returns which is ten times higher than in the case of conventional policy. The primary surplus hardly moves. 

The interpretation of this result is that, when unconventional monetary policy was implemented (post Global Crisis) the combination of high legacy debt and fiscal rules constrained the fiscal response determining a situation in which the monetary and fiscal authorities worked against one another.

Paradoxically, when the economy was at the effective lower bound, in a situation in which fiscal policy is more powerful than monetary policy, the responsibility for stabilisation fell on the shoulders of monetary policy alone.


Antolin-Diaz, J and J F Rubio-Ramirez (2-18), “Narrative Sign Restrictions for SVARs", American Economic Review 108(10): 2802-2829.

Bartsch, E, A Bénassy-Quéré, G Corsetti, and X Debrun (2021), It's All in the Mix: How Monetary and Fiscal Policies Can Work or Fail Together, Geneva Reports on the World Economy 23, ICMB and CEPR.

Cochrane, J H (2019), “The fiscal roots of inflation", Technical Report, National Bureau of Economic Research.

Cochrane, J H (2020), “The Fiscal Theory of the Price Level”, unpublished.

Draghi, M (2014), “Unemployment in the euro area", speech by Mario Draghi, President of the ECB, Annual central bank symposium in Jackson Hole, European Central Bank.

Hall, G J and T J Sargent (2011), “Interest rate risk and other determinants of post-WWII US government debt/GDP dynamics", American Economic Journal: Macroeconomics 3(3): 192-214.

Lagarde, C (2020), “Monetary policy in a pandemic emergency", keynote speech by Christine Lagarde, President of the ECB, at the ECB Forum on Central Banking, European Central Bank.

Reichlin, L and G Ricco and M Tarbé (2021), “Monetary-Fiscal Crosswinds in the European Monetary Union”, CEPR Discussion Paper 16138.

Schnabel, I (2005), “Unconventional fiscal and monetary policy at the zero lower bound," keynote speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the Third Annual Conference organised by the European Fiscal Board, European Central Bank.

Uhlig, H (2005), “What are the effects of monetary policy on output? Results from an agnostic identification procedure", Journal of Monetary Economics 52(2): 381-419.


1 We complement the restrictions on impulse responses with narrative sign restrictions, following Antolin-Diaz and Rubio-Ramirez (2018). In particular we assume that: (i) a contractionary (negative) conventional monetary policy shock happened on the third quarter of 2008 and the first quarter of 2011, being the single largest contributor to the unexpected movement in the short-term interest rate during those two periods; (ii) an expansionary (positive) unconventional monetary policy shock took place on the first quarter of 2015, and it was the single largest contributor to the unexpected movement in the term spread between the German long-term interest rate and the short-term interest rate during that period.

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