Fighting inflation with conventional and unconventional fiscal policy: The case for a new macroeconomic policy assignment

Bo inge , Pe e
Resea ch Repo
Figh ing in la ion wi h con en ional and uncon en ional
iscal policy: The case o a new mac oeconomic policy
assignmen
IMK S udy, No. 92
P o ided in Coope a ion wi h:
Mac oeconomic Policy Ins i u e (IMK) a he Hans Boeckle Founda ion
Sugges ed Ci a ion: Bo inge , Pe e (2024) : Figh ing in la ion wi h con en ional and uncon en ional
iscal policy: The case o a new mac oeconomic policy assignmen , IMK S udy, No. 92, Hans-
Böckle -S i ung, Ins i u ü Mak oökonomie und Konjunk u o schung (IMK), Düsseldo
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STUDY
No. 92 • Feb ua y 2023 • Hans-Böckle -S i ung
FIGHTING INFLATION WITH CONVENTIONAL
AND UNCONVENTIONAL FISCAL POLICY:
THE CASE FOR A NEW MACROECONOMIC
POLICY ASSIGNMENT
Pe e Bo inge
1
,
ABSTRACT
The s udy discusses he dis ibu ion o oles be ween mone a y and iscal policy in s a-
bilising he p ice le el. I ques ions he iew ha p ice le el s abilisa ion should be he
sole esponsibili y o cen al banks. I a gues ha he e is a case o na ional go e n-
men s also being esponsible o p ice s abili y. The main esul s a e he ollowing: In
he case o demand shocks, iscal policy can eac in a mo e imely and a ge ed manne
han mone a y policy. In he case o supply shocks, iscal policy can shi he Phillips
cu e by a ying indi ec axes, wi h p ice b akes and income policies. This is an ad-
an age o e mone a y policy, which can only in luence in la ion indi ec ly by shi ing
he IS cu e. In he ecen ene gy c isis, he e ec s o his "uncon en ional iscal policy"
ha e been assessed qui e posi i ely. The case o a p ice s abili y manda e o na ional
iscal policy is pa icula ly s ong in he eu o a ea. In he case o na ional supply and
demand shocks in indi idual coun ies, he ECB can only p o ide an insu icien com-
pensa ion, and i s eac ion has coun e p oduc i e e ec s in he es o he mone a y
union. E.g., wi h a na ional p ice s abili y manda e, be ween 2014 and 2016, Ge many
would ha e been obliged o s imula e i s economies, he eby suppo ing he ECB's igh
agains de la ion.
—————————
1 Uni e si y o Wü zbu g
Figh ing in la ion wi h con en ional and
uncon en ional iscal policy:
The case o a new mac oeconomic policy assignmen
Pe e Bo inge
Uni e si y o Wü zbu g
Decembe 2023
Execu i e Summa y
Fo decades, in la ion con ol has been ega ded as he domain o cen al banks. An ac i e
ole in s abilising he alue o money is a ibu ed o iscal policy only in de la iona y phases,
when in e es a e policy eaches he limi s o he "e ec i e lowe bound" (ELB). This di ision
o mac oeconomic oles is also e lec ed in he Maas ich T ea y, which gi es he Eu opean
Cen al Bank sole esponsibili y o p ice s abili y and commi s budge a y policy p ima ily o
he objec i e o a balanced budge .
Wi h he wa e o in la ion igge ed by he wa in Uk aine, howe e , his dogma has begun o
al e . No on he basis o new mac oeconomic insigh s, bu ou o a need o p o ec households
om he huge p ice hikes, almos all coun ies ha e aken a ious measu es o di ec ly educe in-
la ion. These spon aneous and comple ely uncoo dina ed "uncon en ional iscal policies" (Dao,
Dizioli, Jackson, Gou inchas, & Leigh,2023) a e gene ally seen as qui e posi i e in e ospec .
This s udy akes his inno a ion in economic policy as an oppo uni y o undamen ally e hink
he widely accep ed "assignmen " o s abilisa ion policy. I begins by showing how his di i-
sion o esponsibili ies has become es ablished wo ldwide unde he in luence o mone a ism.
"In la ion a ge ing" by independen cen al banks became he model o success ul mone a y
policy in he 1990s.
Acco dingly, du ing he discussions on he c ea ion o a Eu opean Cen al Bank, he e was no
doub ha i had o be independen and commi ed o he objec i e o p ice s abili y. A ha
ime, he e was no discussion o he con ibu ion ha Membe S a es’ iscal policies could make
o s abilising he p ice le el wi hin he na ional amewo k and, ul ima ely, wi hin he o e all
sys em.
His o ical hindsigh shows ha he e has also been an al e na i e unde s anding o oles. In he
" unc ional inance" amewo k, which goes back o Abba Le ne , iscal policy is gi en symme i-
cal esponsibili y o igh ing unemploymen and in la ion. Almos iden ical o mula ions can be
i
ound in he Ge man S abili y and G ow h Ac o 1967, and US policy a he ime also ga e iscal
policy a leading ole in igh ing in la ion.
The heo e ical basis o his s udy is a simple new Keynesian model (IS/PC/MP model) which
can be used o s udy he s abilisa ion con ibu ion o mone a y and iscal policy in he p esence
o demand and supply shocks. In he case o demand shocks, he equi alence o mone a y
policy and con en ional iscal policy is shown. In his sense, he e is no heo e ical jus i ica ion
o he p imacy o mone a y policy in he igh agains in la ion. Wi hin he amewo k o he
model, i is also possible o illus a e he des abilizing dynamics ha a ise when he ELB is
eached when a shock canno be o se by iscal policy.
The equi alence o mone a y policy and uncon en ional iscal policy also holds when esponding
o supply shocks by changing agg ega e demand. Howe e , mone a y policy, like con en ional
iscal policy, aces he p oblem o a ade-o , whe eby s abilisa ion o he p ice le el is accom-
panied by ad e se e ec s on ou pu . This is he inno a ion o uncon en ional iscal policy.
Since i can shi he Phillips cu e di ec ly, o example by a ying indi ec axes, i opens up he
possibili y o con olling in la ion a no cos o ou pu and, a he same ime, wi hou a ec ing
in la ion expec a ions in he e en o empo a y shocks.
The equi alence o mone a y policy and con en ional iscal policy can be es ed beyond he
model amewo k using he c i e ia o a ge ing (" a ge ed") and lagged e ec s (" imely"). In
e ms o a ge ing, iscal policy has clea ad an ages as i s measu es ha e a di ec impac on ag-
g ega e demand. Mo eo e , measu es can be di e en ia ed acco ding o a ge g oups. Mone a y
policy, on he o he hand, aces he p oblem ha i s measu es need o be ansmi ed h ough he
inancial sys em and ha , in he case o agg ega e demand, hey p ima ily a ec he cons uc ion
indus y. They also end o ha e undesi able side e ec s on he exchange a e, he s abili y o
he inancial sys em, he sus ainabili y o public inances and he dis ibu ion o income and
weal h. The bene i s o iscal policy in he igh agains in la ion ha e been emphasised in ecen
publica ions by he In e na ional Mone a y Fund.
ii

Mone a y policy also does no pe o m pa icula ly well in e ms o ansmission lags. The
apid iscal esponse o many go e nmen s o he COVID pandemic and he impac o he
wa in Uk aine belies he ex book wisdom ha iscal policy is associa ed wi h long decision
lags ("inside-lag"). Con e sely, mone a y policy s ill has ansmission lags o a yea o mo e
("ou side-lag").
Wi h ega d o he bene i s o uncon en ional iscal policy p esen ed in he model amewo k,
i is impo an o bea in mind in p ac ical implemen a ion ha i is no easy o ell whe he la ge
ene gy p ice shocks a e pe manen o empo a y in na u e. In he case o a pe sis en shock,
uncon en ional iscal policy should no o se he p ima y e ec . Howe e , i can use income
policy measu es o help mi iga e he second- ound e ec s associa ed wi h such a shock. An
example o a success ul measu e is he in la ion compensa ion p emium adop ed by he Ge man
go e nmen in Sep embe 2022. I has helped o dampen collec i ely ag eed wage inc eases and
hus also second- ound e ec s.
Wi h ega d o he educ ions in ene gy and gene al excise axes implemen ed in many coun ies,
hindsigh shows ha hey we e able o make a s abilizing con ibu ion o in la ion de elop-
men s, no leas because he p ice shocks ha occu ed in 2022 u ned ou o be less pe sis en
han ini ially expec ed. This inding is suppo ed by analysis om bo h he In e na ional Mone-
a y Fund and he Eu opean Cen al Bank.
The e may be limi s o uncon en ional iscal policies based on educing indi ec axes in coun ies
wi h high deb le els. He e, howe e , he e is he possibili y o compensa ing by inc easing
di ec axes, which may p o e use ul anyway, gi en he demand-enhancing e ec s o lowe
indi ec axes.
The impo ance o iscal policy in igh ing in la ion, bu also in s abilising he p ice le el in
gene al, is pa icula ly e iden in he ins i u ional amewo k o he Eu opean Mone a y Union.
The IS/PC/MP model can be used o desc ibe, o a mone a y union, he ad e se e ec s o
idiosync a ic shocks on he es o he cu ency a ea. A posi i e demand shock in one membe
iii
coun y, which is no o se by na ional iscal policy, leads o nega i e e ec s in he o he membe
coun ies. Because o he single nominal in e es a e policy, he ECB canno p e en such dis-
u bances: I can pu sue a a ge ed policy o he cu ency a ea a e age. Howe e , he a e age
hen esul s om he coexis ence o oo high and oo low in la ion a es as well as posi i e and
nega i e ou pu gaps a he membe s a e le el.
The economic policy implica ion o his analysis is ha , a he cu en s age o mone a y union
in eg a ion, i would be sensible o commi na ional iscal policies o he objec i e o p ice
s abili y. Wi h he bene i o hindsigh , i can be shown ha in his way he o e hea ing in
he pe iphe y-coun ies in he i s hal o he 2000s could ha e been de ec ed a an ea ly s age.
Simila ly, in he yea s 2014 o 2016, when he ECB’s in e es a e policy was a he ze o lowe
bound, he e would ha e been an obliga ion o mos membe s a es o pu sue a mo e expan-
siona y iscal policy i in la ion a es a he na ional le el we e well below 2%. Coun ies wi h
deb - o-GDP a ios abo e 90%, o example, could ha e been exemp ed om such an obliga ion.
O e all, his s udy shows ha he e is no heo e ical o economic jus i ica ion o he adi ional
alloca ion o oles in s abilisa ion policy, which assigns mone a y policy a p imacy in he igh
agains in la ion. Mone a y policy ins umen s ha e li le speci ici y and long lags in hei e ec-
i eness. Finally, cen al banks a e only needed in he igh agains in la ion i iscal policy i sel
is he cause o in la ion, as desc ibed, o example, in he "Fiscal Theo y o he P ice Le el". O
cou se, one has o eckon wi h he ac ha , o poli ical-economic easons, a go e nmen may
be unable o unwilling o dampen agg ega e demand wi h es ic i e policies. Bu hen one mus
be awa e o he ac ha s abiliza ion by he cen al bank is only a "second-bes " solu ion.
i
Con en s
Execu i e Summa y i
Con en s
Lis o Figu es ii
Lis o Tables iii
1 In oduc ion 1
2 The changing ole o iscal policy in s abilising he p ice le el 3
2.1 Asymme ic ole assignmen . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 A Symme ical policy assignmen o iscal policy . . . . . . . . . . . . . . . . . . 8
2.3 Renaissance h ough he Uncon en ional Fiscal Policy . . . . . . . . . . . . . . . . 9
3 A simple mac oeconomic model as a heo e ical basis 11
3.1 Modeldesc ip ion..................................... 12
3.2 Demandshocks...................................... 14
3.3 Supply shocks: he ole o uncon en ional iscal policy . . . . . . . . . . . . . . . 17
3.4 Fiscalpolicyshocks.................................... 20
4 Limi s o equi alence in demand managemen : side e ec s and impac delays 22
4.1 Ta ge ing and undesi able side e ec s ("Ta ge ed") . . . . . . . . . . . . . . . . . . 22
4.2 Inside- and ou side-lags o s abilisa ion policies ("Timely") . . . . . . . . . . . . . 27
4.3 P imacy o iscal policy in igh ing in la ion . . . . . . . . . . . . . . . . . . . . . . 29
5 Use cases o uncon en ional iscal policy 30
5.1 Pe manen supply sho age: The p oblem o second- ound e ec s . . . . . . . . . 30
5.2 Tempo a y supply sho ages: S a ing wi h he p ima y e ec . . . . . . . . . . . 32
5.3 Posi i e e alua ion o uncon en ional iscal policy . . . . . . . . . . . . . . . . . . 33
5.4 Limi s o uncon en ional iscal policy . . . . . . . . . . . . . . . . . . . . . . . . . 34
5.5 The bes solu ion: P e en supply shocks om happening . . . . . . . . . . . . . 35
6 The impo ance o na ional iscal policies o s abilisa ion in a mone a y union 36
6.1 The IS/PC/MP model o a mone a y union . . . . . . . . . . . . . . . . . . . . . 37
6.2 Idiosync a ic demand shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
6.3 Idiosync a ic supply shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
6.4 Combinedshocks..................................... 42
6.5 The ad an ages o coo dina ed na ional iscal policies in a mone a y union . . . . 44
7 A commi men o na ional iscal policies o he objec i e o p ice s abili y 45
7.1 De ia ions om he ECB’s in la ion a ge . . . . . . . . . . . . . . . . . . . . . . . 45
7.2 The eu o a ea as an incomple e mone a y union . . . . . . . . . . . . . . . . . . . 48
8 Summa y 51
Re e ences 54
i
1974, Tz. 416)
E en hough he mone a is s a egy o con olling he money supply was only implemen ed by
he Ge man Bundesbank and he Swiss Na ional Bank in p ac ical mone a y policy, he e has
since been a widesp ead consensus ha he main esponsibili y o he goal o mone a y s abili y
mus lie wi h he cen al bank. Suppo ed by empi ical s udies (Alesina & Summe s,1993),
which showed a nega i e co ela ion be ween mone a y policy au onomy and he in la ion a e,
mos economis s in he 1990s called o he independence o mone a y policy as an essen ial
p e equisi e o he ealisa ion o his ask.
Michael Wood o d (2001) has summed up his pa adigm as ollows:
"On one hand, i is o en a gued ha in la ion is pu ely a mone a y phenomenon, and hence
ha only he choice o mone a y policy ma e s o wha le el o in la ion one will ha e.
And on he o he , he celeb a ed "Rica dian equi alence" p oposi ion implies ha inso a
as consume s ha e a ional expec a ions, iscal policy should ha e no e ec upon agg ega e
demand, and hence no e ec upon in la ion."
This hinking ound i s way in o p ac ical mone a y policy wi h he s a egy o "in la ion a -
ge ing". I was i s implemen ed in 1989 by he Rese e Bank o New Zealand and is cu en ly
p ac ised by 45 cen al banks (IMF,2001). The compa ison o in la ion o ecas s wi h he in la ion
a ge o he cen al bank is decisi e o his. I shows whe he i is possible o achie e he in-
la ion a ge wi h he pa h o cen al bank in e es a es expec ed by he ma ke s (Bo inge ,2021).
The ECB (2021, p. ) desc ibes his "consensus assignmen " (Ki sano a, Lei h, & W en-Lewis,
2009) as ollows:
"By he end o he las cen u y, a b oad ag eemen eme ged in a ou o cen al bank inde-
pendence wi h a medium- e m p ice s abili y objec i e o he cen al bank. Acco ding o
his iew, an independen cen al bank would achie e p ice s abili y o e he medium e m
by se ing sho - e m in e es a es. Fiscal policy would p o ide au oma ic business cycle
s abilise s (such as unemploymen bene i s), ul il o he social e iciency and equi y objec i es,
5

and keep public deb s able. The e would be li le ole o disc e iona y, coun e cyclical iscal
policy."
The asymme ical policy assignmen o oles also cha ac e ises he Maas ich T ea y, de eloped
in he ea ly 1990s, which ensh ines he ECB’s commi men o he objec i e o mone a y s abili y
and, a he same ime, i s poli ical independence as he co ne s one o he Eu opean Mone a y
Union. A icle 127 TFEU eads as ollows:
"The p ima y objec i e o he Eu opean Sys em o Cen al Banks (he eina e e e ed o as
he ESCB) shall be o main ain p ice s abili y."2
In con as , a esponsibili y o na ional iscal policies o p ice s abili y is add essed only
indi ec ly. A icle 120 TFEU s a es:
"Membe S a es shall conduc hei economic policies wi h a iew o con ibu ing o he
achie emen o he objec i es o he Union, as de ined in A icle 3 o he T ea y on Eu opean
Union, and in he con ex o he b oad guidelines e e ed o in A icle 121(2)."3
A icle 3 o he T ea y on Eu opean Union speci ies hese objec i es as ollows:
"The Union shall es ablish an in e nal ma ke . I shall wo k o he sus ainable de elopmen
o Eu ope based on balanced economic g ow h and p ice s abili y, (...)".4
The iscal policies o he eu o a ea membe s a es a e hus p ima ily go e ned by he 1997
S abili y and G ow h Pac , which essen ially limi s he ask o na ional budge a y policy o he
goal o budge a y discipline:
"Whe eas adhe ence o he medium- e m objec i e o budge a y posi ions close o balance o
in su plus will allow Membe S a es o deal wi h no mal cyclical luc ua ions while keeping
he go e nmen de ici wi hin he 3% o GDP e e ence alue." (A icle 4)5
The au ho s o he S abili y and G ow h Pac we e no awa e ha he e could be limi s o he
mac oeconomic s abiliza ion by mone a y policy:
2A icle 127 TFEU
3A icle 120 TFEU
4A icle 3, T ea y on Eu opean Union
5A icle 4, S abili y and G ow h Pac
6
"The SGP is no designed o suppo mone a y policy in a lowe bound en i onmen in which
mone a y and iscal policies can become s a egic complemen s a he han subs i u es." (ECB,
2021, p. 59)
Acco dingly, he e is a lack o ins i u ional a angemen s o he one s abili y policy esponsibili y
o na ional iscal policies:
"Mechanisms suppo ing he explici coo dina ion o disc e iona y mone a y and iscal
policymaking we e no o eseen, as he op imal con ibu ion o iscal policy o mac oeconomic
s abilisa ion was hough o ollow om allowing au oma ic s abilise s o ope a e eely and
symme ically o e he cycle." (ECB,2021, p. 29)
Subsequen ly, he idea ha na ional iscal policies could also bea a esponsibili y o he goal o
mone a y s abili y has no played a ole in economic policy discou ses. This is mos e iden in
he "mac oeconomic imbalance p ocedu e" in oduced in 2011. I s unc ion is " o iden i y, p e en
and co ec po en ially ha m ul mac oeconomic imbalances ha could a ec he economic s abili y o a
pa icula EU coun y, he eu o a ea o he EU as a whole" (Eu opean Commission,2023).
Speci ically, 14 mac oeconomic indica o s a e used o his pu pose. Howe e , he in la ion end
is no aken in o accoun , as no o he a iable is able o signal a mac oeconomic imbalance.
Reaching he ze o in e es a e limi in he mone a y policy o he Fede al Rese e and he ECB
a leas led o he ecogni ion o he necessi y o iscal policy in he igh agains de la ion:
"Fiscal policy, in conjunc ion wi h mone a y policy, can ha e a mo e signi ican impac on
he economy p ecisely when he e ec i eness o mone a y policy alone may be cons ained by
he lowe bound. A ise in go e nmen consump ion o in es men , a consump ion ax cu o
an inc ease in go e nmen ans e s a e likely o ha e la ge mul iplie e ec s nea he lowe
bound han u he away om i . Such iscal in e en ions may be expec ed o aise agg ega e
demand, ou pu and in la ion o some ex en , unde any ci cums ances." (ECB,2021, p. 7)
7
2.2 A Symme ical policy assignmen o iscal policy
Wi h he dominance o he asymme ical assignmen o oles o iscal and mone a y policy,
howe e , one could always ind economis s who ad oca ed a symme ical assignmen o iscal
policy. This idea is pa icula ly clea in concep o " unc ional inance" by Abba Le ne (1943, p.
39):
"The i s inancial esponsibili y o he go e nmen (since nobody else can unde ake ha
esponsibili y; my emphasis PB) is o keep he o al a e o spending in he coun y on goods
and se ices nei he g ea e no less han ha a e which a he cu en p ices would buy all
he goods ha i is possible o p oduce. I o al spending is allowed o go abo e his he e will
be in la ion, and i i is allowed o go below his he e will be unemploymen . The go e nmen
can inc ease o al spending by spending mo e i sel o by educing axes so ha he axpaye s
ha e mo e money le o spend. I can educe o al spending by spending less i sel o by
aising axes so ha axpaye s ha e less money le o spend. By hese means o al spending
can be kep a he equi ed le el, whe e i will enough he buy goods ha can be p oduced by
all who wan o wo k, and ye no enough o b ing in la ion by demanding (a cu en p ices)
mo e han can p oduced."
I is cha ac e is ic o his symme ical assignmen o oles o iscal policy ha mone a y policy in
" unc ional inance" is only assigned an accommoda i e ole in comba ing unde employmen :
"In applying his i s law o Func ional Finance, he go e nmen may ind i sel (...) spending
mo e han i collec s in axes." In his case, "i would ha e o p o ide he di e ence by
bo owing o p in ing money." (Le ne ,1943, p. 40)
In he pe iod a e he Second Wo ld Wa , he symme ical assignmen ini ially s ill played an
impo an ole in economic policy hinking. E.g. F i z Neuma k (1962, p. 185), a enowned
Ge man economis a ha ime s a ed:
"(...) applied iscal policy aims a con olling bo h in la ion and de la ion."
Acco dingly, he Ge man "Ac o P omo e he S abili y and G ow h o he Economy" o 1967, § 1
con ains a o mula ion ha la gely coincides wi h Le ne ’s s a emen s on " unc ional inance":
8
"The Fede al Go e nmen and he s a es shall obse e he equi emen s o mac oeconomic
equilib ium in hei economic and inancial policy measu es. The measu es shall be aken in
such a way ha , wi hin he amewo k o he ma ke economy, hey con ibu e a he same
ime o he s abili y o he p ice le el, o a high le el o employmen and o ex e nal equilib ium
wi h s eady and adequa e economic g ow h".6
This ole assignmen was p obably shaped no leas by he ac ha Ge many had been in ol ed
in he B e on Woods ixed exchange a e sys em a he ime. In his mone a y a angemen , he
Bundesbank’s oom o manoeu e in e ms o s abilisa ion policy was e y limi ed.
Howe e , a symme ical iscal ole assignmen is also ound a he same ime in he Uni ed S a es,
which would ha e had su icien oom o manoeu e in mone a y policy due o i s dominan
ole in his ixed exchange a e sys em. Thus, he Economic Repo o he P esiden om 1968
s a es:
"A e a ha d look a he al e na i es, i has been and emains he con ic ion o bo h he
Adminis a ion and he Fede al Rese e Sys em ha he Na ion should depend on iscal
policy, no mone a y policy, o ca y he main bu den o he addi ional es ain on he g ow h
o demand ha now appea s necessa y." (Council o Economic Ad iso s,1968, p. 83 )
(Council o Economic Ad iso s 1968)
As Blinde (2023) epo s, he e has been no subsequen use o iscal policy as an in la ion- igh ing
ool in economic his o y.
2.3 Renaissance h ough he Uncon en ional Fiscal Policy
A enaissance o he symme ical alloca ion o oles o iscal policy occu ed wi h he wa e o
in la ion a he beginning o he 2020s, which was mainly due o he ene gy p ice shock igge ed
by he Uk aine wa , bu also o o e ly expansi e compensa ion o he COVID shock in he
Uni ed S a es. In an e o o p e en he ull impac o he ise in ene gy p ices om being
6Ge man "Ac o P omo e he S abili y and G ow h o he Economy" o 1967
9
passed on o p i a e households and companies, almos all coun ies ha e aken a a ie y o
compensa o y measu es.
GBR
FRA
SVK
AUT
GRC
LTU
POL
ROU
ITA
HRV
NLD
LVA
PRT
TUR
DEU
A e age
LUX
CZE
NOR
EST
BEL
SVN
SWE
ESP
IRL
CYP
HUN
FIN
BGR
DNK
ISR
ISL
MNE
AND
0
1
2
3
4
5
Pe cen o GDP
To al
Ta ge ed/ Non-dis o iona y
Un a ge ed/ Non-dis o iona y
Ta ge ed/ Dis o iona y
Un a ge ed/ Dis o iona y
Figu e 1: Fiscal Cos s o Household Suppo Measu es in 2022 and 2023. (Sou ce: Amaglobeli e
al. (2023)).
As he cha based on calcula ions by he In e na ional Mone a y Fund (Amaglobeli e al.,2023)
makes clea , he measu es can be di ided in o "non-dis o iona y" and "dis o iona y", whe eby
he o me a e income ans e s ha ha e no in luence on he p ice sys em and he la e a e
in e en ions ha ha e a di ec impac on he p ices o ce ain ene gy sou ces and hus on he
in la ion a e. On a e age, he coun ies show a clea dominance o measu es wi h p ice e ec s
ha also bene i all popula ion g oups ("non- a ge ed"). I is ema kable ha in Ge many he
sha e o non- a ge ed measu es is a abo e a e age.
Fo he eu o a ea, he ECB (2023) es ima es ha oughly hal o he iscal suppo was used o
measu es o di ec ly in luence p ices and hal o di ec ans e s. The ins umen s used we e
mainly indi ec axes and subsidies.
In line wi h he adi ional pa adigm, Eu opean economis s su eyed by he Chicago Boo h in
June 2022 we e mos ly nega i e abou hese measu es. They we e o he opinion ha i would be
10

be e o aise in e es a es.
7
The Scien i ic Ad iso y Council a he Fede al Minis y o Finance
exp essed a simila opinion in a s a emen da ed 23 Augus 2023:
"Fiscal policy should no y o in luence p ice de elopmen s by lowe ing indi ec axes."
(BMF Scien i ic Ad iso y Council,2023, p. 16)
I e lec s he adi ional iew ha iscal measu es ha aim o cu b in la ion a e labelled as
"uncon en ional iscal policy" (Dao e al.,2023). Bu i becomes clea ha he con en ional
asymme ic ole assignmen , acco ding o which mone a y policy alone is esponsible o p ice
s abili y, needs o be econside ed.
The p oblem he e is ha he e is compa a i ely li le heo e ical and empi ical li e a u e on
he subjec . On he one hand, his is due o he ac ha he de eloped economies had no
been con on ed wi h any majo in la ion p oblems in he pas decades ("G ea Mode a ion").
Ra he , in he 2010s, he isk o de la ion was a he cen e o he discussion. On he o he
hand, he discussion on iscal policy has been so s ongly in luenced by he pe spec i e o
unde employmen ha he po en ial o igh ing in la ion has no ecei ed mo e a en ion. A
cu en example o his is he book by Blancha d (2023), in which " unc ional inance" is only
discussed o ull employmen policy.
3 A simple mac oeconomic model as a heo e ical basis
I is he e o e i s necessa y o c ea e a heo e ical basis o he mac oeconomic ole assignmen o
mone a y and iscal policy. A simple New Keynesian IS/PC/MP model de eloped by Bo inge ,
Maye , and Wollme shäuse (2006) is sui able o his pu pose. I consis s o h ee elemen s:
• an IS cu e dependen on he eal in e es a e,
• a Phillips cu e ex ended by expec a ions and
•
a desc ip ion o he beha iou o he cen al bank (MP), which ei he pu sues an op imal
policy by being guided by a mac oeconomic loss unc ion, o is guided by a ule, such as
7
The ques ion was: "Fiscal measu es pu ing a cap on consume ene gy p ices would be a mo e app op ia e immedia e esponse
o inc eased in la ion in he eu o a ea han aising in e es a es." Chicago Boo h (2023)
11
he Taylo ule in pa icula .
The main di e ence o his ype o model compa ed o o he simple mac oeconomic models is
ha i is based on he eal in e es a e (Rome ,2000), whe eas he IS/LM model and he AS/AD
model we e o mula ed o he nominal in e es a e.
8
We will show below ha he use o he
eal in e es a e o e s conside able analy ical ad an ages bo h o he case o a de la iona y
shock and o mapping mac oeconomic in e dependencies in a mone a y union. Mo eo e , he
model maps he in la ion a e, whe eas adi ional mac oeconomic models ope a e wi h he p ice
le el. Finally, he model explici ly deals wi h supply and demand shocks.
3.1 Model desc ip ion
The IS cu e can be mapped wi h he ollowing equa ion:
y=a−b· +g+ε1(1)
A nega i e unc ional ela ionship is assumed be ween he ou pu gap and he eal in e es a e
(
), which is desc ibed by he pa ame e
b
. This can be de i ed om an Eule equa ion, bu also
om a simple Keynesian in es men unc ion. Fiscal policy is ep esen ed in simpli ied o m by
he ac o
g
, which can be in e p e ed as he pe cen age de ia ion o go e nmen spending om
a neu al le el. Demand shocks can be ep esen ed wi h
ε1
. The pa ame e
a
is an unspeci ied
cons an .
The second building block o he model is an expec a ions-augmen ed Phillips cu e:
π=πe+d·y+ε2(2)
Acco dingly, he in la ion a e is de e mined by in la ion expec a ions
πe
, he ou pu gap
y
and
a supply shock
ε2
. Fo he sake o simplici y, i is assumed ha he cen al bank is c edible.
The e o e, in la ion expec a ions
πe
co espond o he cen al bank’s in la ion a ge
π0
. I is
assumed ha supply shocks ha e no e ec on agg ega e demand.
8As hese models a e o mula ed o a s able p ice le el, he nominal a e is iden ical wi he eal a e.
12
Uncon en ional iscal policy can be included in he model wi h a a iable
h
which is ze o in
no mal imes. In he case o posi i e supply shocks, i can ake on a nega i e alue, o example,
as iscal policy educes VAT.
π=π0+d·y+h+ε2(3)
The beha iou o he cen al bank is mapped wi h he concep o he mac oeconomic loss
unc ion, which was de eloped by S ensson (2003).
L= (π−π0)2+λ·y2, wi hλ ≥0(4)
The pa ame e
λ
desc ibes he ela i e p e e ence o he cen al bank o he in la ion gap and
he ou pu gap. A λ= 0 he cen al bank pu sues s ic "in la ion a ge ing", as i does no ake
ou pu cos s in o accoun in i s policy. Fo alues o
λ > 0
, S ensson speaks o " lexible in la ion
a ge ing".
Inse ing he Phillips cu e in o he loss unc ion and minimizing i o
y
, one ge s he op imal
ou pu gap:
yop =−d
(d2+λ)·(ε2−h)(5)
Inse ing i in o he Phillips cu e, one ge s he op imal in la ion a e:
πop =π0+λ
(d2+λ)·(ε2−h)(6)
Since bo h equa ions do no include
ε1
, one can al eady see ha demand shocks can be pe ec ly
compensa ed o in his model amewo k.
Subs i u ing he op imal ou pu gap in o he IS equa ion yields he cen al bank’s op imal eal
in e es a e:
13
op =a
b+1
b·(ε1+g) + d
b·(d2+λ)·(ε2+h)(7)
P o ided ha iscal policy beha es passi ely (i.e.
g
and
h= 0
), he op imal eal in e es a e
esul s om one o he componen s
a
b
, which can be in e p e ed as a neu al in e es a e in
he sense o -s a (Laubach & Williams,2003). The cen al bank eac s o bo h demand shock
(
ε1
) and supply shock (
ε2
). A he same ime, he equa ion illus a es ha he cen al bank can
beha e passi ely i iscal policy eac s o he demand shock wi h go e nmen spending and o
he supply shock wi h uncon en ional iscal policy.
3.2 Demand shocks
In he case o demand shocks, his model shows an equi alence o mone a y policy and iscal
policy in mac oeconomic s abilisa ion. In he case o a posi i e shock, he IS cu e shi s upwa ds.
This leads o a posi i e ou pu gap. In he
π/y
diag am, he Phillips cu e yields an in la ion a e
ha is abo e he cen al bank’s in la ion a ge . As equa ions o
Yop
and
πop
show, his shock
can be pe ec ly compensa ed.
•
Mone a y policy can ealise a poin on he new IS cu e ha closes he ou pu gap h ough
highe eal in e es a es.
•
Fiscal policy can shi he IS cu e back o i s ini ial posi ion h ough lowe go e nmen
spending.
In his simple model amewo k, i does no ma e whe he he shock is compensa ed by iscal
policy di ec ly ia a a ia ion o
g
( igu e 2, igh ), o indi ec ly by he cen al bank ia an in e es
a e eac ion when
g= 0
( igu e 2, le ). F om his poin o iew, mone a y policy and iscal
policy can be used in he same way o igh in la ion.
14
( igu e 7).
2017-12
2018-12
2019-12
2020-12
2021-12
2022-12
100
105
110
115
120
125
130
Index: 2018Q1=100
Eu o a ea
Uni ed S a es
Figu e 7: Household Disposable Income (Index: 2018Q1=100). (Sou ce: FRED S . Louis FED,
Eu os a ).
The in la iona y e ec s o hese measu es a e illus a ed by an analysis by Di Gio anni, Kalemli-
Özcan, Sil a, and Yildi im (2023, p. 1):
"Ou baseline esul s show ha o e he Dec19-Jun22 pe iod, agg ega e demand shocks
explained oughly wo- hi ds o o al model-based in la ion, and ha he iscal s imulus
con ibu ed hal o mo e o he o al agg ega e demand e ec ."
In he model amewo k used he e, such a iscal policy would be depic ed as
g > 0
. F om he
pe spec i e o mone a y policy, his is hen an in la iona y demand shock, which would equi e
a simila in e es a e policy esponse as wi h
ε1>0
. In p inciple, in his model amewo k he
cen al bank is able o compensa e o all expansiona y iscal shocks wi h an opposi ely di ec ed
es ic i e in e es a e policy.
Such iscal shocks a e he essen ial jus i ica ion o an independen cen al bank. I he s a e’s
iscal policy comes in o con lic wi h mone a y policy, i mus ine i ably lose ou , since, unlike
he ZLB, he e is no uppe limi o he eal in e es a e. Fo a de ailed analysis o he in e ac ion
o mone a y and iscal policy, see Bo inge and Maye (2007).
21

4
Limi s o equi alence in demand managemen : side e ec s
and impac delays
The simple model analysis leads o he conclusion ha mone a y policy and con en ional iscal
policy a e equally capable o con olling he in la ion a e ia agg ega e demand, p o ided ha
he cen al bank does no hi he ZLB. Howe e , i one goes beyond his model amewo k,
subs an ial di e ences in he use o he wo policies can be iden i ied. These become clea i
one akes as a c i e ion he gene ally accep ed ule ha s abilisa ion policy measu es should be
" imely, a ge ed and empo a y" (ECB,2009). The di e ences mainly conce n he a ge ing and
he ime lags o he measu es used.
4.1 Ta ge ing and undesi able side e ec s ("Ta ge ed")
I has become clea om he model s uc u e ha iscal policy can di ec ly in luence agg ega e
demand, while con en ional mone a y policy can only do so indi ec ly ia he in e es a e
mechanism.
The COVID pandemic and he Uk aine c isis ha e illus a ed how iscal policy can di ec ly and
speci ically con ol agg ega e demand (IS cu e) and he PC cu e wi h a a ie y o con en ional
and uncon en ional measu es. In Ge many, o example, he pu chasing powe o p i a e
households was s abilised wi h di ec ans e s (such as he ene gy p ice la a e and sho - ime
allowance) and hyb id measu es (gas p ice b ake). Tax measu es (e.g. he expansion o he loss
ca yback) and lump-sum ans e s suppo ed businesses du ing he pandemic. As pa o he
uncon en ional iscal policy, indi ec axes we e elimina ed (EEG le y) o educed (VAT on gas).
The ad an ages o iscal policy o e mone a y policy in e ms o calib a ion a e also emphasised
by he In e na ional Mone a y Fund:
"Di e en iscal policies can be calib a ed and used o suppo he disin la ion e o while
mi iga ing he inc ease in po e y and income inequali y a he same ime. Mone a y policy
22
does no ha e he manda e o add ess income inequali y, no can i be a ge ed in he way ha
iscal policy can." (IMF,2023, p. 37)
These ad an ages o iscal policy can also be shown in mac oeconomic models:
"Fiscal policymake s a e able, in p inciple, o design policies ha a ge a speci ic subse
o households o i ms. As an example, mac oeconomic models wi h he e ogeneous agen s
sugges ha he e ec s on agg ega e demand o a budge a y ans e policy a e likely o be
g ea e i he ans e a ge s households ha ha e a high ma ginal p opensi y o consume."
(ECB,2021, p. 8)
Compa ed o iscal policy, he e ec s o mone a y policy a e hus undi e en ia ed and associa ed
wi h majo side e ec s. This is due o he ac ha he cen al banks basically only ha e he
ansmission channel o sho - e m and, in he case o bond pu chases, also longe - e m in e es
a es. The ansmission is indi ec as i a ec s he eal economy mainly ia he inancial sys em
(cha ).
Domes ic
p ices
Wage and
p ice-
se ing
Bank a e
Money
ma ke
in e es
a es
Money and
c edi
P ice de elopmen s
Asse
p ices and
isk p emia
Exchange
a e
Shocks
ou side he
con ol o
he cen al
bank
Changes in
isk
p e e ences
Changes in
he global
economy
Changes in
iscal policy
Changes in
commodi y
p ices
S age 1:
T ansmission
h ough
inancial
ma ke s
S age 2:
T ansmission
o he eal
economy
Expec a ions
Impo
p ices
Supply and
demand in
goods and
labou
ma ke s
Figu e 8: T ansmission p ocess o mone a y policy. Sou ce: based on Mann (2023)
23
Theo e ically, he ansmission p ocess can be accele a ed ia expec a ion e ec s, bu he empi ical
e idence o his channel is low.
"(...) he bulk o he e idence does no suppo he no ion ha changes in mone a y policy
di ec ly a ec household o i m in la ion expec a ions in a sys ema ic way- o e and abo e
any impac on ac ual in la ion and ac i i y." (Bande a, Ba nes, Cha az, Ten ey o, &
on dem Be ge,2023, p. 26) (Ten ey o 2023)
Ca he ine Mann, a membe o he Mone a y Policy Commi ee o he Bank o England, he e o e
desc ibes he e ec i eness o mone a y policy as ollows:
"Mone a y policy is a ela i ely blun ins umen and wo ks mos ly a he ma gin, i is
ill-equipped and no in ended o deal wi h la ge ela i e p ice mo emen s like he one we’ e
seeing cu en ly. We do no ha e in ou oolki he policies ha can cushion he blow o hose
in need o ha can sp ead he weigh ac oss ime and ac oss he income dis ibu ion..." Mann
(2022)
In heo e ical models, he in luence o in e es a es on consump ion decisions plays a cen al
ole. In eali y, howe e , i u ns ou ha he e is no empi ical e idence o he Eule equa ion
ha depic s his ela ionship. Fo an o e iew, see Asca i, Magnusson, and Ma oeidis (2021, p.
131):
"Ye , nume ous s udies ha e poin ed ou ha he baseline Eule equa ion model does no i
he agg ega e consump ion da a well. Fi s , (...) agg ega e consump ion appea s un esponsi e
o he eal in e es a e. In o he wo ds, he es ima ed EIS in consump ion is e y low o
he s anda d speci ica ion o he Eule equa ion. Ha ánek (2015) conduc ed a me a-analysis
on 169 published s udies and concluded ha he a e age es ima e o he EIS [elas ici y o
in e empo al subs i u ion; PB] in agg ega e da a is ze o, once co ec ed o publica ion bias."
Wi h ega d o he e ec s on bank lending, he p oblem a ises ha in mos coun ies a la ge
p opo ion o bank loans a e g an ed o he eal es a e sec o :
"The sha e o mo gage loans in banks’ o al lending po olios has oughly doubled o e he
cou se o he pas cen u y- om abou 30% in 1900 o abou 60% oday." (Jo dà, Schula ick,
& Taylo ,2016, p. 110)
24
As can also be seen in he cu en es ic i e phase, in e es a e policy measu es hus p ima ily
a ec o e all economic demand ia he eal es a e sec o .
The p oblem wi h mone a y policy ansmission is no only he indi ec e ec s o es ic i e
in e es a e policy measu es, bu also he associa ed undesi able side e ec s.
•
Highe in e es a es end o lead o an app ecia ion o he domes ic cu ency. This e ec
can be desi able because he app ecia ion dampens in la ion (Mann,2023). Bu i can also
be undesi able i he in e na ional compe i i eness o domes ic indus y su e s as a esul .
•
Highe in e es a es can h ea en he s abili y o he domes ic banking sys em, especially
i , as is cu en ly he case in he eu o a ea, hey ollow a long pe iod o e y low in e es
a es du ing which banks ha e engaged in a high deg ee o ma u i y ans o ma ion.
•
Highe in e es a es also ha e a nega i e impac on he sus ainabili y o public inances.
This is especially ue o coun ies ha ha e a high public deb a io.
•
Highe in e es a es also ha e undesi able e ec s on income dis ibu ion ia highe
in e es a es o smalle businesses and due o he ac ha low-income households hold
ewe in e es -bea ing asse s (Al a o, Faia, & Minoiu,2022)
Ad ian and Gaspa (2022) ha e examined hese di e en e ec s o mone a y and iscal s abilisa-
ion in a s udy. They show ha bo h app oaches lead o simila e ec s on he in la ion a e and
economic g ow h.
•
Howe e , wi h mone a y s abilisa ion, highe in e es a es lead o ising public deb and
cu ency app ecia ion.
•
In he case o iscal s abilisa ion, he di ec nega i e demand e ec s ha e he ad an age
ha no inc ease in in e es a es is equi ed. The cu ency dep ecia es. Wi h lowe in e es
a es and a lowe p ima y de ici , public deb alls. The decline in in la ion is somewha
smalle because o he de alua ion. Ad ian and Gaspa (2022) poin ou , howe e , ha his
e ec could be educed i mo e coun ies we e o ollow his app oach.
25
Figu e 9: Cu bing in la ion. Sou ce: Ad ian and Gaspa (2022)
Ad ian and Gaspa (2022) poin o he p oblems caused by he an i-in la iona y policy o he
Uni ed S a es in 1980/81 unde Fede al Rese e Chai man Paul Volcke as a nega i e example.
The sha p ise in in e es a es led o a collapse o he eal es a e ma ke and a his o ically unique
app ecia ion o he US dolla . Since indus y was hi e y ha d by his, he e we e calls o ade
es ic ions. The wo au ho s conclude:
"Tha his o ical episode is ele an o many coun ies acing simila challenges oday. A
mo e balanced emo al o policy s imulus, including iscal es ain , can educe he isk ha
some pa s o he economy – especially hose mos sensi i e o in e es a es – expe ience
disp opo iona e e ec s, o ha la ge swings in he cu ency heigh en ade ensions."
(Ad ian & Gaspa ,2022)
26

4.2 Inside- and ou side-lags o s abilisa ion policies ("Timely")
In assessing he e ec i eness o mone a y and iscal policy in comba ing in la ion, i is no only
he accu acy o a ge ing ha is c ucial bu also he lags in he e ec s o he s abilisa ion policy
measu es. A dis inc ion is usually made be ween inside lag and ou side lag:
•
Inside-lag desc ibes he ime lag be ween he occu ence o a shock and he decision o
ake an economic policy measu e o a e i .
•
Ou side-lag is he ime lag be ween he adop ion o an economic policy measu e and i s
e ec on he shock.
Despi e he g ea impo ance o his opic o economic policy, he e is ha dly any ecen li e a u e
on i .
T adi ionally, one disad an age o iscal policy is ha i has a long inside-lag. Fo example,
Mankiw (2019, p. 473) w i es:
"A long inside lag is a c ucial p oblem wi h using iscal policy o economic s abiliza ion. This
is especially ue o he Uni ed S a es, whe e changes in spending o axes equi e he app o al
o he P esiden and bo h houses o Cong ess. The slow and cumbe some legisla i e p ocess
o en leads o delays, making iscal policy an imp ecise ool o s abilizing he economy."
Howe e , he COVID pandemic and he Uk aine c isis ha e shown ha iscal policy can eac
e y quickly in an eme gency. In Ge many, he so-called "Bazooka", a comp ehensi e package o
iscal measu es as a p o ec i e shield o he economy, was al eady passed in Ma ch 2020. On 27
Ma ch 2020, he US go e nmen passed he Co ona i us Aid, Relie , and Economic Secu i y Ac
(CARES Ac ), a s imulus p og amme wo h 2.2 illion US dolla s.
Mone a y policy has he ad an age ha i can make quick decisions, so ha he inside-lag
is low. Howe e , due o he only indi ec in luence on agg ega e demand, he ou side-lag is
ela i ely long compa ed o iscal policy, which can di ec ly con ol demand (Dupo ,2023).
Mil on F iedman (1961, p. 87) o mula ed his as ollows:
27
"The e is much e idence ha mone a y changes ha e hei e ec only a e a conside able lag
and o e a long pe iod and ha he lag is a he a iable."
Mann (2023) assumes a mone a y policy lag o 18 o 24 mon hs. Model analyses by he ECB
(Lane,2023) show, depending on he model, impac lags o a ound one yea o mo e han wo
yea s.
Figu e 10: Model analysis o ou pu de ia ions. Sou ce: Lane (2023)
In an ex eme c isis si ua ion, he possibili ies o mone a y policy a e limi ed by he ac ha
in he case o g ea unce ain y, as was he case du ing he COVID pandemic and he ou b eak
o wa in he Uk aine, e en e y low in e es a es can only p o ide a limi ed s imulus o new
in es men s. This could be ep esen ed in he IS/PC/MP model by a empo a y decline in he
pa ame e
b
in he IS cu e, which would hen be e y s eep, i.e. wi h a low in e es a e elas ici y.
The cen al bank would hen e y quickly hi he ELB wi h in e es a e policy. The necessi y o
iscal policy in c isis si ua ions is also emphasised by he ECB (2021, p. 67):
"Fiscal policy is he mos sui able ins umen o add essing he de imen al impac o he
pandemic on he economy."
28
4.3 P imacy o iscal policy in igh ing in la ion
Unless iscal policy is i sel he cause o a posi i e demand shock, he lags and side e ec s o
mone a y policy clea ly a gue o assigning iscal policy a leading ole in igh ing in la ion in he
case o demand shocks as well as supply shocks. The IMF (2023, p. 40) comes o a simila o e all
conclusion in i s analysis o he s abili y policy ole o iscal policy:
"To summa ize, a gene alized iscal con ac ion helps con ain in la ion, wi h a smalle d op in
p i a e consump ion han in he mone a y policy scena io, bu i s impac a o s highe -income
g oups a he expense o he lowe -income g oups. These ad e se dis ibu ional e ec s can be
emedied i he iscal con ac ion is accompanied by a a ge ed ans e p og am."
Howe e , i is no gua an eed ha iscal policy can also ul il his ask. The measu es equi ed
o his, such as ax inc eases, a e no e y popula and he e o e no always easy o implemen
poli ically. This is whe e he poli ical-economic ad an age o an independen cen al bank lies.
Howe e , one mus be awa e o he ac ha in la ion con ol by he cen al bank is always a
"second-bes " solu ion.
In any case, he ad an ages o iscal policy in igh ing in la ion call o mo e coo dina ion be ween
iscal and mone a y policy. Cen al bank independence does no mean ha mone a y policy is
conduc ed in an au is ic way. A posi i e example o such coope a ion is p o ided by he Bank
o Canada:
"Finally, ecognizing he limi s o mone a y policy, he Go e nmen and he Bank
also acknowledge hei join esponsibili y o achie ing he in la ion a ge and
p omo ing maximum sus ainable employmen ." Join S a emen o he Go e nmen
o Canada and he Bank o Canada (2022) on he Renewal o he Mone a y Policy
F amewo k, Decembe 13, 2021.
29
5 Use cases o uncon en ional iscal policy
Uncon en ional iscal policy did no eme ge om he d awing boa d o mac oeconomic heo ies
and analyses. Ra he , i is a child o he ha dship igge ed by he sha p ise in ene gy p ices in
he wake o he Uk aine wa . In sec ion 3, we ha e he e o e i s p esen ed a simple heo e ical
model amewo k o show wha i s ad an ages a e in igh ing in la ion compa ed o mone a y
policy and con en ional iscal policy. Fo a mo e comp ehensi e analysis, i is necessa y o
speci y he supply shock mo e p ecisely in o de o de elop he iscal he apy ha i s i .
Since he i s oil c isis in 1973/74, supply shocks ha e p ima ily in ol ed an ab up inc ease in
he p ice o oil o , as in he cou se o he wa in Uk aine, o ene gy sou ces in gene al.
The esponse o s abilisa ion policy depends on whe he he p ice inc ease is pe manen o
ansi o y. The p oblem o economic policy is ha i is di icul o dis inguish ex an e be ween
empo a y and pe sis en shocks (Dao e al.,2023).
5.1 Pe manen supply sho age: The p oblem o second- ound e ec s
I he cause o highe p ices is a pe manen sho age o supply, he p ima y e ec on he in la-
ion a e should in p inciple be compensa ed nei he by mone a y policy no by iscal policy.
Ideally, he shock would esul in a jump in he gene al p ice le el. The in la ion a e would ise
yea -on-yea o wel e mon hs, only o all back o he p e ious end. This is e e ed o as a
"looking h ough" policy (Schnabel,2022).
Howe e , expe ience shows ha in p ac ice i is no possible o isola e he e ec s o such shocks.
The ise in he in la ion a e usually leads o a demand om employees o a leas pa ial
compensa ion in wage se lemen s. Such a "second- ound e ec " can hen lead o in la ion expec-
a ions and in la ion abo e he cen al bank’s a ge due o ising uni labou cos s. This in u n
c ea es he need o he cen al bank o slow down he economy wi h a es ic i e mone a y policy.
30
6.1 The IS/PC/MP model o a mone a y union
The p oblems ha a ise when na ional iscal policies beha e passi ely in e ms o s abilisa ion
policy can again be illus a ed wi h he IS/PC/MP model, which mus be ex ended acco dingly
o his pu pose. We assume ha he mone a y union consis s o wo coun ies o equal size
(coun y A and coun y B). Fo each coun y, he IS cu e and he PC cu e can be o mula ed as
ollows:
yA=a−b· A+gA+ε1,A =a−b·(iop −πA) + gA+ε1,A (10)
πA=π0+d·yA+hA+ε2,A (11)
yB=a−b· B+gB+ε1,B =a−b·(iop −πB) + gB+ε1,B (12)
πB=π0+d·yB+hB+ε2,B (13)
The decisi e ac o he e is ha a uni o m nominal in e es a e applies in he mone a y union,
so ha he eal in e es a e o he indi idual coun ies esul s om he di e ence be ween he
op imal nominal in e es a e de e mined by he cen al bank and he na ional in la ion a es.
No hing undamen al changes o he cen al bank in he mone a y union. As desc ibed abo e,
i de e mines he op imal eal in e es a e acco ding o he agg ega e demand and supply shocks:
op =a
b+1
b·(ε1+g) + d
b·(d2+λ)·(ε2+h)(14)
The op imal nominal in e es a e o he mone a y union is ob ained by adding he in la ion a e
o he op imal eal in e es a e:
37

iop = op +π(15)
The mac oeconomic in e dependencies exis ing in a mone a y union can be discussed by
analysing he e ec s o na ional demand and supply shocks in his model amewo k.
Fo his pu pose, we desc ibe he model wi h conc e e alues o he indi idual pa ame e s:
a= 1.2; b= 0.4; d= 1; π0= 2; λ= 1 (16)
The ini ial si ua ion is cha ac e ized by:
op = 3 and iop = op +π0= 3 + 2 = 5 (17)
y=yA=yB= 0 (18)
π=π0=πA=πB= 2 (19)
6.2 Idiosync a ic demand shock
Fo an idiosync a ic demand shock, we assume ha he e is a posi i e demand shock in coun y
Ao
εA,1= 0.8
. This shi s he IS cu e in coun y A and he agg ega e IS cu e o he mone a y
union upwa ds. The ECB eac s o his shock acco ding o equa ion 14 and aises he eal in e es
a e om 3% o 4%. The cen al bank is hus able o compensa e pe ec ly o he shock: he
nega i e ou pu gap is closed and he in la ion a e in he cu ency a ea is back a 2%. The
nominal in e es a e, which applies o bo h coun ies, ises om 5% o 6%.
The inc ease in he nominal in e es a e leads o di e en adjus men s in he wo coun ies. In
coun y A, he combina ion o he IS cu e and he PC cu e esul s in a posi i e ou pu gap o
0.67%. F om he PC cu e, his esul s in an in la ion a e o 2.67%. Wi h a nominal in e es a e
38
o 6%, he eal in e es a e o coun y A is hus 3.33%. As a esul , he ECB’s in e es a e hike
does ha e a dampening e ec on agg ega e demand in coun y A. Howe e , i is insu icien o
b ing abou pe ec s abilisa ion.
Fo coun y B, he shock in coun y A has de la iona y e ec s. I is con on ed wi h a highe eal
in e es a e, which has a nega i e impac on agg ega e demand. The assump ions made he e
esul in a nega i e ou pu gap o - 0.67. The in la ion a e alls o 1.33% and wi h a nominal
in e es a e o 6% he eal in e es a e ises o 4.67%. As a esul , he insu icien ly compensa ed
demand shock in coun y A leads o a ecession in coun y B.
Wi h a passi e iscal policy in coun y A, such a nega i e ansmission o a shock in a mone-
a y union is una oidable, since he cen al bank wi h i s uni o m in e es a e policy can only
deal wi h he agg ega e shock con on ing he mone a y union. Fo his eason, he discussion
on op imal cu ency a eas emphasises he necessi y o shocks ha a e as closely co ela ed as
possible among he pa icipa ing coun ies o a mone a y union (Eicheng een,1991).
The p oblem o a uni ied mone a y policy in he ace o idiosync a ic shocks becomes clea when
desc ibing he example o he loss unc ion discussed he e ea lie :
L= (π−π0)2+λ·y2, wi hλ ≥0.(20)
Fo he eu o a ea as a whole, he e is nei he an in la ion gap no an ou pu gap. The cen al bank
has achie ed he "bliss poin " cha ac e ized by a loss o
L= 0
. Howe e , in he wo Membe
S a es, an ou pu gap o
+0.67
and
−0.67
and an in la ion gap o also
+0.67
and
−0.67
esul in a
loss o 7.58 each. This would also be he a e age loss o he mone a y union.
39
! " #$
!!"# = 3
$$= 0 $$= 0 $$= 0
!
!
! !
! !
&& &
$ $ $
$
$
$ $
$ $
'( '( '(
!
%= 3 1
3
!&= 4 2
3!!"# = 4
$ = + 2
3$ = − 2
3
$ = 0
./$,% ./$,& ./$,()
./$,% ./$,& ./$,()
./*,% ./*,()
&%= 2 2
3
&&= 1 1
3
&() = &$= 2
Figu e 13: IS-MP-PC mul i-coun y demand shock.
Nega i e ansmission can be a oided i iscal policy in coun y A is willing o compensa e o
he shock by a es ic i e iscal policy, by a ying g, e.g. by educing public spending. In Cha
13, his would lead o a shi o he IS cu e back o i s ini ial posi ion. In his case, he e would be
no impac o he na ional demand shock on he o e all sys em and hus on unin ol ed Membe
S a es. This eac ion is no sel -e iden , since he impac on coun y B is a nega i e ex e nal
e ec om coun y A’s poin o iew and i s s abiliza ion e o implies posi i e ex e nali ies.
This p oblem is also seen by he ECB (2021, p. 17):
"(...) ela i e o a coope a i e benchma k, he iscal s abilisa ion e o s o membe coun ies
in a mone a y union will be sub-op imally aligned (demand ex e nali y). Once again, his
ou come is suppo ed by an ex e nali y as changes in agg ega e demand ia a ia ions o iscal
policy a e decided and unded a coun y le el, while he associa ed bene i s a e enjoyed pa ly
by o he coun ies, and a e ansmi ed ia spillo e s in in eg a ed ma ke s."
40
6.3 Idiosync a ic supply shock
Fo he idiosync a ic supply shock, we assume a nega i e supply shock in coun y B igge ed,
o example, by a wage mode a ion (
ε2,A =−0.8
). The cen al bank’s eac ion is again de i ed
om equa ion 14: i lowe s he eal in e es a e om
3%
o
2.5%
o he en i e cu ency a ea.
Since he supply shock canno be pe ec ly compensa ed, he in la ion a e alls o
1.8%
. The
common nominal in e es a e o he cu ency a ea hus alls om
5%
o
4.3%
. The e is a posi i e
ou pu gap o 0.2%
Fo coun y B, his esul s in a sligh ly nega i e ou pu gap o
−0.07%
and an in la ion a e o
1.13%
. The eal in e es a e is
3.17%
. Again, he e is a nega i e ansmission o coun y A.
Due o he alling nominal in e es a e in he en i e cu ency a ea, he in la ion a e in coun y
A inc eases o
2.47%
and he e is a posi i e ou pu gap o
0.47%
. De la ion in coun y A hus
gene a es in la ion in coun y B.
! " #$
!!"# = 3
$$= 0 $$= 0 $$= 0
!
!
! !
! !
&& &
$ $ $
$
$
$ $
$ $
'($,% '( '($,()
!
%= 3,17
!&= 1.83
!!"# = 2.5
$ = −0.07 $ = +0.47 $!"# = +0.2
./%./&./()
./%./&./()
&%= 1.13
'(*,% '(*,()
&!"# = 1.8
&&= 2.47
Figu e 14: IS-MP-PC mul i-coun y supply shock.
41
I he nega i e supply shock in coun y B we e igge ed by an ene gy p ice shock in ha coun y,
an uncon en ional iscal policy, o example in he o m o a empo a y inc ease in ene gy
axes, would be he app op ia e solu ion. This could compensa e o he shi in he PC cu e.
In e en ion by he common cen al bank would no be necessa y. This would o cou se also
apply in he case o a posi i e supply shock (ε2,A >0) wi h he opposi e sign.
6.4 Combined shocks
This simple model amewo k can also be used o simula e combined shocks. Fo example, in
he ea ly yea s o he Eu opean Mone a y Union he e was a p olonged di e gence o na ional
in la ion a es (Angeloni & Eh mann,2004).
1998-10
1999-10
2000-10
2001-10
2002-10
2003-10
2004-10
2005-10
2006-10
2007-10
0
1
2
3
4Eu o a ea
Ge many
Spain
ECB In la ion Ta ge
Figu e 15: HICP in la ion 1999 - 2007. Sou ce: ECB S a is ical Da a Wa ehouse.
The eason o his can be a ibu ed o he jux aposi ion o a posi i e demand shock in he
pe iphe y coun ies, d i en by a eal es a e bubble, wi h a nega i e supply shock in Ge many
due o wage mode a ion a he ime (Bo inge ,2015).
The ampli ica ion o he posi i e demand shock by he Ge man wage mode a ion can be seen i
one i s de e mines he alues o he isola ed demand shock in coun y A and hen compa es
42

hem wi h hose o he combined shock ( able 2). Since he ECB eac s o he wage mode a ion
(coun y B) wi h a lowe eal in e es a e, he economic o e hea ing in coun y A is ampli ied.
Ini ial
si ua ion
Demand shock
Coun y A
Supply shock
Coun y B
Mone a y union
Nominal in e es a e 5.0 6.0 5.3
Real in e es a e 3.0 4.0 3.5
Ou pu gap 0.0 0.0 0.2
In la ion a e 2.0 2.0 1.8
Loss 0.0 0.0 0.08
Coun y A
Nominal in e es a e 5.0 6.0 5.3
Real in e es a e 3.0 3.33 2.7
Ou pu gap 0.0 0.66 1.1
In la ion a e 3.0 2.66 3.1
Loss 0.0 0.82 2.42
Coun y B
Nominal in e es a e 5.0 6.0 5.3
Real in e es a e 3.0 4.66 4.8
Ou pu gap 0.0 -0.66 -0.7
In la ion a e 2.0 1.33 0.5
Loss 0.0 0.82 2.74
Table 2: Ge man wage mode a ion simula ion in he IS-MP-PC model.
Again, he compa ison o he na ional loss unc ions wi h he agg ega e loss unc ion is o
in e es . Fo he cu ency a ea, he combina ion o demand shock and supply shock esul s in
a loss o
0.08
, o coun y A i is
2.02
and o coun y B
2.74
. The a e age loss o
2.58
is hus
conside ably highe han he agg ega e one o only 0.08.
Since i can be assumed ha he economic cos s o in la ion and unemploymen a e no expe-
ienced a he agg ega e bu a he na ional le el, one should o ien onesel o he a e age o
he na ional loss unc ions and no he agg ega e loss unc ion. The e o e, he ECB’s abili y o
achie e i s in la ion a ge e en wi h uncoo dina ed iscal policies in he agg ega e does no
a gue agains coo dina ing iscal policies:
"In uncons ained en i onmen s, in which sho - e m policy a es a e se by he cen al bank
43
su icien ly a away om he lowe bound, he single mone a y policy may be able o achie e
i s p ice s abili y objec i e e en i he cyclical iscal s ance o coun ies is no coo dina ed and
deb le els may show signi ican , bu sus ainable, di e ences." ECB (2021, p. 17)
6.5
The ad an ages o coo dina ed na ional iscal policies in a mone a y
union
An analysis by he ECB (2021) shows ha na ional iscal policies ha e o en been p o-cyclical.
O e he en i e li e ime o he mone a y union, p o-cyclical policies we e consis en ly pu sued in
a leas one hi d o he eu o a ea ( igu e 16). P o-cyclicali y was pa icula ly p onounced in he
ea ly yea s o he eu o, du ing he eu o c isis and in he second hal o he 2010s.
ECB Occasional Pape Se ies No 273 / Sep embe 2021
39
suppo ed g ow h, he sha e o p ocyclical iscal policies was e en highe . This
asymme y in he iscal s abilisa ion o he business cycle also showed up in he (lack
o ) compliance wi h he common iscal ules, which is shown by a ise in he (GDP-
weigh ed) sha e o eu o a ea coun ies subjec o an excessi e de ici p ocedu e and
by he e y low sha e o coun ies wi h a balanced budge in s uc u al e ms o
which mee hei medium- e m budge a y objec i e be o e 2008 (see Cha 3, panel
b). An impo an p emise in he a chi ec u e o EMU was ha a budge balance
“close o balance o in su plus” in good imes would c ea e su icien iscal space o
enable he au oma ic s abilise s o ope a e in down u ns (see Box 7 o es ima es o
he s abilise s in he eu o a ea).
Cha 3
Cyclicali y o iscal policies
a) Cyclicali y o iscal policy in EMU b) S a us unde he SGP
(le -hand scale: annual change in he ou pu gap coinciding wi h
he change in he s uc u al p ima y budge balance in eu o a ea
coun ies, weigh ed by hese coun ies’ sha e o eu o a ea GDP,
exp essed as a pe cen age o po en ial GDP; igh -hand scale:
ou pu gap, pe cen age poin s)
(weigh ed by coun ies’ sha e o eu o a ea GDP, pe cen ages)
Sou ces: AMECO, Eu opean Fiscal Boa d, own calcula ions.
No es: Cha 3, panel a: Fiscal policy is classi ied as coun e cyclical in a eu o a ea coun y i he annual change in he s uc u al
p ima y budge balance ( he p ima y cyclically adjus ed budge balance be o e 2009) and he change in he (ex pos ) ou pu gap
es ima ed by he Eu opean Commission ha e he same sign, p ocyclical i hey ha e he opposi e sign, and neu al i he change in
bo h is below he lowes decile in he sample. Cha 3, panel b: S a us unde he SGP is based on a Eu opean Fiscal Boa d da ase
(La ch and San ac oce, 2020), wi h a coun y’s posi ion in espec o i s medium- e m budge a y objec i e assessed, in a backwa d-
looking exe cise, agains he coun y-speci ic medium- e m budge a y objec i es since 2006 and a balanced budge in s uc u al e ms
be ween 1998 and 2005. Un il 2003, he s uc u al imp o emen is measu ed by he change in he cyclically adjus ed balance.
O e ime, insu icien and une en consolida ion in good imes ha e educed
he iscal space a ailable in he eu o a ea coun ies o espond o shocks, and
he abili y o all so e eigns o con ibu e equally o mac oeconomic
s abilisa ion. As insu icien bu e s we e buil up in good imes, he 3% e e ence
alue in he SGP implied he e would be some es ic ions on budge de ici s in bad
imes.80 In many cases his equi ed disc e iona y iscal consolida ion in he con ex
o excessi e de ici p ocedu es, which mean ha he e ec o au oma ic s abilise s
80 The SGP o esees he possibili y o opening excessi e de ici p ocedu es on he basis o deb c i e ion
alone, bu his was no ope a ionalised un il he 2011 SGP e o m. A e 2011, wide de ac o
di e en ia ion in he equi ed speed o deb educ ion was implemen ed in EU iscal su eillance
h ough new in e p e a ions and by ex ending elemen s o disc e ion and judgemen (see Eu opean
Fiscal Boa d, 2020).
-4.5
-3.0
-1.5
0.0
1.5
3.0
0
10
20
30
40
50
60
70
80
90
100
1999 2003 2007 2011 2015 2019
P ocyclical
Neu al
Coun e cyclical
Ou pu gap ( igh -hand scale)
0
10
20
30
40
50
60
70
80
90
100
1998 2001 2004 2007 2010 2013 2016 2019
Economic adjus men p og amme
P e en i e a m (< 3% de ici )
Excessi e de ici p ocedu e
A MTO
Figu e 16: Cyclicali y o iscal policy in EMU. Sou ce: ECB (2021, p. 39)
Simula ions by he ECB (2021, p. 61) con i m he heo e ical analysis made he e and desc ibe he
bene i s ha would ha e esul ed om i s coo dina ed iscal policy in he pas :
"Fiscal policies esponding in a mo e coun e cyclical manne would ha e smoo hed he eal
ou pu gap and educed he in la ion gap. Compa ed wi h he baseline, less iscal spending
be o e he g ea inancial c isis would ha e dampened he posi i e ou pu gap (...) and educed
he deb - o-GDP a io (...). In he absence o an in la ion gap du ing hose yea s, he esul s
44
a e simila o bo h al e na i e scena ios. A e he inancial c isis, and abs ac ing om
inancing di icul ies du ing he so e eign deb c isis, addi ional iscal spending would ha e
ensu ed quicke closu e o he ou pu gap and a smalle in la ion gap (...), wi h a s ongly
posi i e ou pu gap o he pa ien iscal policy scena io."
7
A commi men o na ional iscal policies o he objec i e o
p ice s abili y
Coo dina ing wen y na ional iscal policies is a di icul ask. An al e na i e solu ion could
he e o e be o implemen a commi men o na ional iscal policies o he goal o p ice s abili y
by ea y. In conc e e e ms, such a ule could consis in obliging he go e nmen s o all membe
s a es o con ibu e o p ice s abili y a he na ional le el. As a benchma k, a co ido o he
na ional in la ion a e could be en isaged, wi h a bandwid h o one pe cen age poin a ound he
ECB’s in la ion a ge o 2%.
7.1 De ia ions om he ECB’s in la ion a ge
In e ospec , such a ule in he 2000s would ha e helped o add ess ea ly on he imbalances ha
mani es ed hemsel es in he eu o c isis in 2010-12. G eece, I eland, Spain and Po ugal had
in la ion a es ha we e mo e han one pe cen age poin abo e he ECB’s 2 pe cen a ge on
se e al occasions and in some cases o yea s. Con e sely, p ice de elopmen s in Ge many we e
subdued due o wage mode a ion. Howe e , he de ia ions emain below he h eshold o one
pe cen age poin .
45
1999 2000 2001 2002 2003 2004 2005 2006 2007
Aus ia -1.5 0.0 0.3 -0.3 -0.7 0.0 0.1 -0.3 0.2
Belgium -0.9 0.7 0.4 -0.5 -0.5 -0.1 0.5 0.3 -0.2
Finland -0.7 1.0 0.7 0.0 -0.7 -1.9 -1.2 -0.7 -0.4
F ance -1.4 -0.2 -0.2 -0.1 0.2 0.3 -0.1 -0.1 -0.4
Ge many -1.4 -0.6 -0.1 -0.7 -0.9 -0.2 -0.1 -0.2 0.3
G eece 1.6 1.9 1.5 1.0 1.5 1.3 1.0
I eland 0.4 3.3 2.0 2.7 2.0 0.3 0.2 0.7 0.9
I aly -0.3 0.6 0.3 0.6 0.8 0.3 0.2 0.2 0.0
Luxembou g -1.0 1.8 0.4 0.1 0.5 1.2 1.8 1.0 0.7
Ne he lands 0.0 0.3 3.1 1.9 0.2 -0.6 -0.5 -0.3 -0.4
Po ugal 0.2 0.8 2.4 1.7 1.2 0.5 0.1 1.0 0.4
Spain 0.2 1.5 0.8 1.6 1.1 1.1 1.4 1.6 0.8
Posi i e de ia ions by mo e han one pe cen age poin in ed.
Nega i e de ia ions by mo e han one pe cen age poin in blue
Table 3: De ia ions o na ional in la ion a es om he 2% a ge o he Eu opean Cen al Bank
(1999-2007).Sou ce: IMF Wo ld Economic Ou look, Ap il 2023.
In he yea s 2014-2016, when he ECB’s in e es a e policy was a he ze o lowe bound, a
symme ical commi men o na ional go e nmen s o p ice s abili y would ha e mean ha
almos all coun ies would ha e been obliged o pu sue a mo e expansiona y budge policy.
46
hing speaks in a ou o assigning iscal policy a dominan ole in s abilising he in la ion a e
in he e en o demand and supply shocks. Mone a y policy is ul ima ely only needed when
go e nmen s hemsel es a e he cause o a posi i e demand shock o when hey a e unwilling
o unable o ake a s abilisa ion policy leade ship ole due o sho - e m in e es s o lack o poli i-
cal suppo . I he cen al bank akes o e in la ion con ol o poli ical economy easons, one
mus be awa e o he ac ha i is always a "second-bes " solu ion compa ed o iscal s abilisa ion.
In a mone a y union, he e a e e en u he implica ions o he mac oeconomic policy assign-
men . As he New Keynesian model shows, in he e en o na ional demand and supply shocks,
he common cen al bank can only eac o such dis u bances pa ially - acco ding o a coun y’s
sha e in he economic ou pu o he cu ency a ea. Thus, he shock in he coun y o o igin is only
pa ially compensa ed and ansmi ed wi h a nega i e sign o he es o he cu ency a ea. E en
i a a ge in la ion a e can hen be achie ed o he cu ency a ea as a whole, wel a e losses
esul a he membe s a e le el due o ou pu gaps and de ia ions om he cen al bank’s
in la ion a ge . Such e ec s can only be a oided by obliging na ional iscal policies o con ibu e
o he achie emen o p ice s abili y in hei coun y.
The expe ience wi h he Eu opean Mone a y Union shows ha wi h such an assignmen , he
o e hea ing in he pe iphe al coun ies in he 2000s could ha e been ecognised ea ly and
app op ia e s abilisa ion policy measu es aken. Likewise, in he yea s 2014 o 2016, when he
ECB was ope a ing a he ELB, na ional iscal policies could ha e con ibu ed o b inging he
in la ion a e close o he ECB’s in la ion a ge , a leas in he coun ies wi h ela i ely low
deb - o-GDP a ios, h ough expansiona y iscal s imuli.
Since s abilisa ion policy ac i i ies a he na ional le el a e associa ed wi h posi i e ex e nali ies,
na ion s a es a e no expec ed o unde ake hem on hei own ini ia i e. The e o e, a con ac ual
obliga ion should be c ea ed ha assigns he membe s a es a esponsibili y o mone a y s abili y
in hei coun y. This ole assignmen can be included in he S abili y and G ow h pac and be
condi ioned o he le el o public deb o a coun y in he case o oo low in la ion a es which
equi e expansiona y iscal policies.
53

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