Monetary Policy Effectiveness under Unsustainable Fiscal Policy

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This study examines the effectiveness of a pure monetary policy shock under varying fiscal policy regimes through its impact on asset prices and macroeconomic variables. The European Central Bank (ECB) currently imposes tightening conditions on credit markets to control for high inflation levels. On the contrary, European fiscal authorities extend fiscal stimulus to limit the burden of higher food and energy prices on households. This raises the question how contractionary monetary policy affects the European economy when fiscal authorities do not commit to debt stabilization. First, I separate the data into sustainable and unsustainable policy regimes by estimating a fiscal response function with rolling window regressions. Subsequently, this study employs a non-linear panel local projections model with an identified exogenous monetary policy shock. This study contributes to the literature by investigating the response of asset prices to monetary policy shocks under varying fiscal regimes. The response of asset prices is useful as it provides accurate information about the impact of monetary-fiscal policy interactions on future economic conditions. I find that the response of asset prices to a contractionary monetary policy shock is insignificant or significantly positive under the unsustainable fiscal policy regime. The response of GDP reveals a similar pattern. Therefore, I conclude that contractionary monetary policy is only effective upon the condition that fiscal authorities comply with fiscal rules.
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