The European Central Bank published an ECB Working Paper (authors’ views) analysing how alternative monetary and fiscal policy responses interact after an inflationary cost-push shock in a monetary union. Using model simulations calibrated to the euro area, it finds that faster disinflation from more aggressive rate hikes comes with larger losses in economic activity and a stronger rise in public debt, while fiscal support can cushion consumption but generally has limited influence on inflation dynamics. The analysis uses the EAGLE global DSGE model with euro area blocs representing low- and high-debt countries (public debt set at 60% and 120% of annual GDP). Compared with a benchmark Taylor rule, a two-year delay in policy rate tightening softens the downturn but keeps inflation higher for longer, while an additional 100 basis point tightening reduces inflation faster at the cost of weaker output and higher debt servicing costs, with high-debt countries more exposed to the debt impact. On the fiscal side, measures with a direct budgetary impact of 1% of pre-shock output (a cut in consumption taxes, untargeted transfers, and productive public investment) and targeted transfers calibrated to match the consumption effect for constrained households all mitigate the shock to consumption, but do not materially change inflation: tax cuts lower inflation only temporarily, while transfers and public investment slightly raise inflation initially and prompt a somewhat stronger monetary response. All fiscal measures increase the debt-to-GDP ratio, with smaller debt increases under public investment (via higher growth) and targeted transfers (lower fiscal cost for similar support). Sensitivity analysis suggests that more frequent price changes raise the initial inflation spike and increase the importance of the monetary policy response, while different assumptions on public investment productivity materially change output and debt paths but have little effect on inflation and the implied interest rate trajectory.
European Central Bank 2025-11-06
European Central Bank working paper models monetary and fiscal policy trade-offs after an inflationary shock
The European Central Bank's working paper analyzes monetary and fiscal policy responses to an inflationary cost-push shock in a monetary union using euro area model simulations. It finds that aggressive rate hikes lead to faster disinflation but result in greater economic activity losses and increased public debt, while fiscal support can cushion consumption with limited impact on inflation. The study highlights that fiscal measures increase the debt-to-GDP ratio, with variations depending on the type of fiscal intervention.