Does monetary policy influence euro area fiscal sustainability?

Abstract

This paper studies the impact of monetary policy on fiscal sustainability in the euro area. We extend a standard fiscal reaction function by introducing a monetary policy stance variable as an interaction term, allowing us to assess how monetary policy influenced fiscal dynamics. Our study yields two main findings. First, an expansionary monetary policy stance in response to rising debt-to-GDP levels is associated with lower primary balance changes, potentially supporting fiscal sustainability in the short term. Second, when considering exogenous monetary policy shocks, a monetary tightening significantly deteriorates primary balances, potentially straining fiscal sustainability. These results highlight the importance of monetary-fiscal interactions for fiscal sustainability in the euro area.