## MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED (_sdn1609)

## Source details

**Canonical URL:** [MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED (_sdn1609)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2016/_sdn1609.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2016/_sdn1609.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2016/_sdn1609.pdf.json)

---

### Executive summary — context and recommended approach
- Recovery since the global financial crisis has been halting and weak; an aggressive and internationally–coordinated policy stimulus in 2009–10 turned around a severe recession.
- Since the initial recovery:
  - global output remains below potential;
  - unemployment above its natural rate;
  - inflation below target.
- Since 2014, renewed demand deceleration accompanied by global declines in investment, trade, and manufacturing and by undesirably low inflation.
- Perceptions of limited policy space stem from:
  - the effective lower bound on policy interest rates limiting conventional monetary stimulus;
  - high peacetime public debt-to-GDP ratios and demographic pressures constraining fiscal policy and automatic stabilizers.
- Core prescription: a three-pronged policy approach—monetary, fiscal, and structural—implemented in a manner that is comprehensive, consistent, and coordinated across instruments, over time, and across countries.
  - Benefits: exploits synergies; anchors long-term expectations while allowing decisive short- to medium-term accommodation; improves resilience; amplifies cross-border spillovers.

### Why comprehensive, consistent, and coordinated
- Why comprehensive:
  - Combine monetary, fiscal, structural, and financial-sector policies when single instruments are constrained.
  - Examples: fiscal support when monetary policy is at the ELB; monetary accommodation to prevent crowding out; financial policies to strengthen transmission; structural reforms to raise potential growth and lower debt-to-GDP ratios; demand management to offset short-term costs of reforms.
- Why consistent:
  - Link instruments to objectives over time to anchor expectations.
  - Operational roles:
    - Monetary: achieve the inflation target while minimizing adverse output/employment effects.
    - Fiscal: prudent management of public sector balance sheet risks and discretionary countercyclical support in large shocks.
  - Illustration: an inflation-forecast-targeting (IFT) framework can allow planned temporary overshoots of the inflation target while holding policy rates at the floor.
- Why coordinated:
  - International coordination of fiscal and monetary stimulus can boost global GDP when interest rates are very low and output gaps wide.
  - Coordinated action generates positive spillovers and helps keep debt-to-GDP ratios under control through stronger nominal GDP.

### Operational elements and policy tools
- Unconventional monetary tools: quantitative and qualitative easing, negative interest rates—use when conventional policy is constrained while recognizing uncertain transmission and potential macro-financial side-effects.
- Fiscal priorities:
  - Emphasize measures with high multipliers—government investment and transfers to cash-strapped households—especially when central banks plan to hold policy rates at or near the ELB long enough to allow inflation to accelerate.
- Structural reforms: raise potential output and mitigate distributional and short-term contractionary effects via demand support.
- Financial-sector policies: bolster banking systems and markets and improve policy transmission.
- Incomes policies may be needed in some cases (example: Japan) to raise inflation expectations to target.

### Country tailoring (illustrations)
- Canada:
  - Long-term expectations anchored; fiscal space exists and is being used.
  - Recommendation: strengthen fiscal framework by establishing a credible medium-term fiscal consolidation plan to make current stimulus more credible.
- Japan:
  - Much more limited policy space.
  - Recommendation: a well-designed package of demand-management policies, structural reforms, and measures to strengthen the wage-setting process to create momentum for stronger growth and inflation closer to target.
- Simulation emphasis: central banks can plan to hold policy interest rates near the ELB long enough for inflation to exceed the 2 percent target temporarily; fiscal initiatives prioritized are those with high multiplier effects (investment and transfers to cash-strapped households).

### Framework mechanics and policy-design implications
- Analytical starting point: map instruments to objectives and make conditional commitments on instrument adjustment to achieve objectives.
- Consistent communication and credible long-term frameworks reduce market volatility and allow temporary policy accommodation to be effective.
- Key implications:
  - Countries with fiscal space and anchored inflation expectations can deploy fiscal stimulus supported by credible medium-term fiscal frameworks.
  - Countries with limited fiscal space should focus on growth-friendly fiscal rebalancing, pace adjustment appropriately, and deploy structural and financial-sector measures.
  - Central banks near the ELB should consider frameworks (e.g., IFT) permitting temporary overshoots of inflation targets.
  - Coordinated fiscal and monetary stimulus across major economies is especially valuable if growth revival falters or a large negative shock occurs.

---

### Fiscal policy: effectiveness, design, caveats
- Premise: under extremely low interest rates, high unemployment, and below-target inflation, fiscal stimulus effectively supports output following a negative shock because monetary policy can support the stimulus and the policy interest rate stays at the ELB for longer.
- Findings:
  - A well-designed fiscal stimulus can protect against persistent contractionary shocks, especially if conducted within a credible fiscal framework.
  - Under certain conditions, comprehensive, consistent, and coordinated policies that raise nominal GDP sufficiently can improve the debt ratio relative to a no-policy-response scenario—even in the near term.
  - Short-term multiplier size depends on:
    - type of fiscal instrument (government investment, government consumption, transfers, taxes, others);
    - structure of the economy (marginal propensity to consume, degree of openness, others);
    - existence of a sound and credible fiscal framework;
    - cyclical position and monetary policy response.
  - Credibility is critical: stimulus lacking a credible fiscal framework may widen sovereign spreads and undermine confidence.
  - With long-term nominal bond rates at extremely low levels and a boost to nominal GDP growth, a short-term fiscal stimulus need not weaken the public balance sheet.
  - When slack is substantial, multiplier effects raise incomes and tax revenues so the government debt-to-GDP ratio does not necessarily rise relative to a no-response scenario.
  - Many infrastructure projects pass a cost test given low real rates: “the present value of the increase in future potential output would exceed the consumption sacrifice today.”
- Policy recommendations / design principles:
  - Implement fiscal stimulus within a credible long-term fiscal framework that manages public sector balance sheet risks, considering assets and liabilities.
  - Articulate a clearly defined long-term fiscal anchor and adopt a systematic behavioral rule for fiscal policy relative to deviations from the anchor.
  - Embed strong fiscal risk-management: identify and quantify risks, develop mitigating strategies, provision for residual risks.
  - Prioritize high-return public investment and ensure efficient project selection and management.
  - Include well-designed escape clauses in fiscal frameworks for exceptional circumstances.
  - Where fiscal space is limited, maximize output effect per unit of deficit by focusing on instruments with larger multipliers (notably government investment).

---

### Fiscal multipliers and GIMF simulation evidence
- Simulation setup:
  - Model: Global Integrated Monetary and Fiscal (GIMF) Model for a generic large open economy.
  - Temporary shock: deficit-financed government spending equal to 1 percent of baseline GDP in years 1 and 2, 0.5 percent in year 3, and zero thereafter.
  - Baseline monetary policy: inflation-forecast-based reaction function; variants include central bank holding policy rate flat for one or two years (monetary accommodation).
- Findings on instrument ranking and multipliers:
  - Efficiently managed government investment > government consumption > targeted transfers > general transfers in impact on real GDP.
  - Transfers have the smallest effect due to leakages; targeted transfers outperform general transfers but are only about half as large as government investment multipliers.
  - Multipliers are larger if monetary policy keeps interest rates lower for longer.
  - Over the long term, inflation stabilizes at the official target with a regular reaction function.
  - Coordinated fiscal, monetary, and structural policies can raise nominal GDP enough that the debt-to-GDP ratio declines even though the deficit rises temporarily.
- Illustrative discretionary fiscal multipliers with monetary accommodation (Real GDP percent deviation from baseline):
  - Government investment: Year 1: 1.2; Year 2: 1.1; Year 3: 0.5
  - Government investment with one-year monetary accommodation: Year 1: 1.3; Year 2: 1.3; Year 3: 0.6
  - Government investment with two-year monetary accommodation: Year 1: 1.7; Year 2: 1.7; Year 3: 0.8
  - Government consumption: Year 1: 0.9; Year 2: 0.8; Year 3: 0.2
  - Government consumption with one-year monetary accommodation: Year 1: 1.1; Year 2: 0.9; Year 3: 0.2
  - Government consumption with two-year monetary accommodation: Year 1: 1.4; Year 2: 1.3; Year 3: 0.4
  - Targeted transfers: Year 1: 0.5; Year 2: 0.5; Year 3: 0.2
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.6; Year 2: 0.6; Year 3: 0.2
  - Targeted transfers with two-year monetary accommodation: Year 1: 0.8; Year 2: 0.8; Year 3: 0.3
  - General transfers: Year 1: 0.1; Year 2: 0.1; Year 3: 0.0
  - General transfers with one-year monetary accommodation: Year 1: 0.2; Year 2: 0.1; Year 3: 0.0
  - General transfers with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.2; Year 3: 0.1
- Government debt (percent of GDP deviation from baseline) under these instruments:
  - Government investment: Year 1: -0.9; Year 2: -0.2; Year 3: 0.8
  - Government investment with one-year monetary accommodation: Year 1: -1.2; Year 2: -0.5; Year 3: 0.5
  - Government investment with two-year monetary accommodation: Year 1: -1.8; Year 2: -1.4; Year 3: -0.2
  - Government consumption: Year 1: -0.5; Year 2: 0.2; Year 3: 1.3
  - Government consumption with one-year monetary accommodation: Year 1: -0.8; Year 2: -0.0; Year 3: 1.1
  - Government consumption with two-year monetary accommodation: Year 1: -1.4; Year 2: -0.8; Year 3: 0.3
  - Targeted transfers: Year 1: 0.2; Year 2: 0.9; Year 3: 1.6
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.0; Year 2: 0.7; Year 3: 1.5
  - Targeted transfers with two-year monetary accommodation: Year 1: -0.4; Year 2: 0.2; Year 3: 1.0
  - General transfers: Year 1: 0.8; Year 2: 1.7; Year 3: 2.1
  - General transfers with one-year monetary accommodation: Year 1: 0.7; Year 2: 1.6; Year 3: 2.1
  - General transfers with two-year monetary accommodation: Year 1: 0.6; Year 2: 1.4; Year 3: 2.0
- Inflation (percentage point deviation from baseline) under these instruments:
  - Government investment: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government investment with one-year monetary accommodation: Year 1: 0.2; Year 2: 0.2; Year 3: 0.2
  - Government investment with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.4; Year 3: 0.4
  - Government consumption: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government consumption with one-year monetary accommodation: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government consumption with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.3; Year 3: 0.3
  - Targeted transfers: Year 1: 0.1; Year 2: 0.1; Year 3: 0.1
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.1; Year 2: 0.1; Year 3: 0.1
  - Targeted transfers with two-year monetary accommodation: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - General transfers: Year 1: 0.0; Year 2: 0.0; Year 3: 0.0
  - General transfers with one-year monetary accommodation: Year 1: 0.0; Year 2: 0.0; Year 3: 0.0
  - General transfers with two-year monetary accommodation: Year 1: 0.0; Year 2: 0.1; Year 3: 0.1

---

### Public investment: structural case and efficiency
- Findings:
  - Permanent increase in government investment is strongly productivity-enhancing given very low long-term borrowing costs and infrastructure deficiencies.
  - A permanent increase in government investment equal to 1 percent of baseline GDP leads to higher private sector productivity, permanently higher private investment and consumption, and higher imports.
  - Increased potential output creates future policy space by raising government revenues, reducing debt-to-GDP ratios, and raising the neutral interest rate.
  - Growth dividends depend critically on investment efficiency: the most efficient public investors get twice the growth impact from their public investment than the least efficient.
  - Shifting spending from general consumption to investment (no net change in outlays) yields smaller but sizable gains.
- Caveat:
  - Infrastructure development biased toward sectors with chronic and growing excess capacity may delay necessary adjustments and provide only short-term output boosts.

---

### Monetary policy role at the effective lower bound and IFT
- At the ELB, a slow monotonic return to the inflation target may not anchor long-term inflation expectations or provide sufficient demand support.
- Option: aim for a faster increase in the inflation rate with an expected modest overshoot; the target would then be approached from above.
- IFT framework:
  - Purpose: allow temporary inflation overshoots to restore expectations without undermining medium-term price stability.
  - Mechanics: targeting symmetric around a point target so overshoots and undershoots balance over time; aggressive expansion warranted when slack and expectations are below target.
  - Transparency and communication critical: publish inflation forecasts, output gap outlook, and model-consistent policy-rate paths; provide robust forward guidance about interest rate paths conditional on developments.
- Empirical evidence (surveys 2015–2016):
  - In almost all economies covered, expected inflation is below target.
  - Non-IFT advanced-economy group: expected negative deviation persists at least until the third year ahead; positive correlation between expected deviation this year and in three years.
  - IFT group: expected three-year-ahead deviation from target is near zero; no such correlation.
  - Conclusion: non-IFT economies’ negative shocks tend to shift medium-term expectations downward; IFT economies’ medium-term expectations remain stable at the target rate.
- Adoption and credibility build-up:
  - Inflation targeting can be adopted quickly, often after a crisis; full credibility takes time and requires comprehensive policies and assurances against fiscal dominance.
  - Example noted: United States adopted flexible inflation targeting in 2012 with an explicit numerical objective and clear statement of the dual mandate.

---

### Synergies between demand management, structural policies, and fiscal space
- Demand, structural, and fiscal policies can be mutually supportive:
  - Reforms that raise potential growth and the neutral interest rate can revive investment demand.
  - Higher potential output raises fiscal space via higher nominal GDP and a broader tax base, reducing debt-to-GDP ratios.
- Structural reform caveat:
  - Some reforms may be deflationary in the short term when monetary policy is constrained; monetary policy should be ready to ease further if reforms cause notable short-term deflationary effects.
- Labor market reforms and fiscal interactions:
  - Fiscal stimulus enhances short-term macroeconomic effects of labor market reforms.
  - Estimated average outcomes: significant decline in unemployment when reforms are accompanied by large fiscal expansion; increase in unemployment when reforms occur with major fiscal contraction.
  - Fiscal policy can mitigate distributive effects of reforms to ease resistance (e.g., bundling relaxation of employment protection with more generous unemployment benefits, higher active labor market spending, labor tax cuts).
- Fiscal structural reform (tax policy and administration, strengthening fiscal institutions, expenditure reform) can create fiscal space usable for short-term stimulus where needed.

---

### Financial sector policy, macroprudential measures, and monetary transmission
- Monetary policy transmission requires a healthy financial system; banks are critical in extending credit.
- Macro- and microprudential policies that enhance financial resilience and decisive action on nonperforming loans reduce the risk that the financial system amplifies shocks.
- Macroprudential policy actions:
  - Targeted constraints (caps on loan-to-value and debt-service-to-income ratios) can contain housing and household leverage dynamics.
  - Built-up buffers can be relaxed when systemic risks materialize to sustain credit flows.
- Crisis response measures to restore transmission and financial health:
  - Supervisory action for prompt loss recognition; asset quality reviews; stress tests; capital strengthening; well-designed resolution frameworks.
  - State solvency support as last resort; asset management companies to relieve banks of troubled assets with moral hazard and fiscal cost considerations.
  - Central bank liquidity lines to address temporary market distortions.
- Interaction with accommodative monetary policy:
  - Accommodation boosts growth, decreases nonperforming loans, improves valuations and balance sheets, and eases credit conditions.
  - Risk: cheap funding can postpone recognition and restructuring of loans (evergreening).
- Supply-side and demand-side measures:
  - Supply-side: strengthen capital bases, resolution frameworks, stress testing, recapitalization where necessary.
  - Demand-side: swift restructuring of distressed loans to clean balance sheets and jump-start credit demand.

---

### Country examples — Canada and Japan
- Canada:
  - Substantial fiscal space (variable by province) and room for further monetary stimulus, subject to regulatory measures to cool overheated housing markets.
  - Long-term inflation expectations anchored at the 2 percent target.
  - Model simulations show fiscal support complemented by monetary accommodation can close the output gap, raise inflation quickly, raise nominal interest rates away from the ELB over the medium term, boost nominal GDP, and help stabilize government finances while lowering short-term debt service cost.
- Japan:
  - Challenging: low growth and inflation expectations after decades of deflation; perceived policy limits.
  - Recommendation: “Three-Arrows-Plus” package building on Abenomics:
    - Fiscal: gradual VAT increase to manage public sector balance sheet risks (VAT chosen for low multiplier and low allocative distortions); gradual increases avoid abrupt consumption reallocations.
    - Monetary: Bank of Japan could adopt a transparent IFT regime.
    - Structural: labor market reforms to offset declining workforce and reduce dualism; ease barriers excluding workers; invest in human capital; consider incomes policy to support nominal wage growth toward 2 percent inflation objective.
  - Model simulations indicate the Three-Arrows-Plus package could deliver Abenomics’ ambitious targets.

---

### International coordination: simulated quantitative findings
- Hypothetical coordinated fiscal stimulus (GIMF simulation) design:
  - Stimulus size per region: 1 percent of baseline GDP in year 1, 1 percent in year 2, and 0.5 percent in year 3.
  - Composition: government investment (1/4), government consumption (1/4), targeted transfers (1/2).
  - Monetary accommodation: nominal policy interest rates kept unchanged for two years.
- Key simulation results — Effects on Real GDP Level (percent deviation from baseline):
  - World: stimulus in all regions: 2.4 (Year 1); 2.4 (Year 2); 1.1 (Year 3)
  - United States: stimulus in all regions: 1.6 (Year 1); 1.6 (Year 2); 0.8 (Year 3)
  - Euro Area: stimulus in all regions: 1.5 (Year 1); 1.6 (Year 2); 0.9 (Year 3)
  - Japan: stimulus in all regions: 1.8 (Year 1); 1.8 (Year 2); 0.8 (Year 3)
  - Emerging Asia: stimulus in all regions: 3.4 (Year 1); 3.3 (Year 2); 1.4 (Year 3)
  - Latin America: stimulus in all regions: 2.4 (Year 1); 2.4 (Year 2); 1.1 (Year 3)
  - Remaining Countries: stimulus in all regions: 2.3 (Year 1); 2.3 (Year 2); 1.1 (Year 3)
- Spillovers and regional-only stimuli (Year 1 examples):
  - World: United States-only stimulus: 0.4; Euro Area-only: 0.3; Japan-only: 0.1; Emerging Asia-only: 0.8; Latin America-only: 0.2; Remaining Countries-only: 0.8
  - Emerging Asia-only domestic impact in Year 1: 2.0 (Emerging Asia)
  - Japan-only domestic impact in Year 1: 1.1 (Japan)
  - United States-only domestic impact in Year 1: 1.1 (United States)
- Coordinated global stimulus aggregate impact:
  - Coordinated stimulus applied in every region adds 2.4 percent to world GDP in years 1 and 2, and 1.1 percent in year 3.
  - The euro area and the United States would see an output boost of over 1½ percent, and Japan about 1.8 percent, in the coordinated scenario.
- Effects on Nominal GDP Level in Year 4 (percent deviation from baseline):
  - World: stimulus in all regions: 2.3
  - United States: stimulus in all regions: 1.6
  - Euro Area: stimulus in all regions: 1.0
  - Japan: stimulus in all regions: 1.8
  - Emerging Asia: stimulus in all regions: 3.3
  - Latin America: stimulus in all regions: 2.4
  - Remaining Countries: stimulus in all regions: 2.4
- Effects on Debt/GDP Ratio in Year 4 (percentage deviation from baseline):
  - World: stimulus in all regions: -0.7
  - United States: stimulus in all regions: -0.4
  - Euro Area: stimulus in all regions: -0.3
  - Japan: stimulus in all regions: -1.8
  - Emerging Asia: stimulus in all regions: -1.4
  - Latin America: stimulus in all regions: -0.6
  - Remaining Countries: stimulus in all regions: -0.7
- Fiscal dividend example:
  - Euro area debt ratio declines by 0.3 percentage point in year 4 under coordinated stimulus; a stimulus confined to the euro area alone would raise that area’s debt ratio by 0.9 percentage point—1.2 percentage points more than with an internationally coordinated stimulus.
- Positive financial-sector linkages:
  - With nominal policy rates held constant, real rates decline as stimulus raises inflation; lower real rates increase asset prices, strengthen balance sheets, reduce risk premiums, and ease credit conditions—propagated globally through trade integration.
- Caveat: model may understate longer-term benefits because it disregards negative effects of a prolonged slump on employment, productivity, confidence, and potential output.

---

### Policy conclusions and overarching messages
- A comprehensive, consistent, and coordinated approach—using monetary, fiscal, and structural policies in combination—can overcome apparent individual instrument constraints and move the global economy away from danger zones in a renewed global slowdown.
- Consistent policy frameworks provide space to deliver decisive short- to medium-term support by anchoring long-term inflation expectations and committing fiscal policy to an eventual sustainable downtrend in government debt-to-GDP ratios.
- Coordinated policies across major economies amplify individual policy effects through positive cross-border spillovers, boosting global nominal GDP and helping to keep debt-to-GDP ratios in check.
- The whole is greater than the sum of its parts: simulations suggest fiscal stimulus accommodated by monetary policy can mitigate negative shocks, help raise inflation to target levels, and improve debt-to-GDP dynamics—particularly when embedded in sound fiscal and credible monetary frameworks and when internationally coordinated through trade and financial channels.

*Source: IMF Staff Discussion Note — Macroeconomic Management When Policy Space Is Constrained (excerpted content unit _sdn1609).*

### EXECUTIVE SUMMARY _____________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Introduction and context
- Recovery in GDP growth since the global financial crisis has been halting and weak; an aggressive and internationally–coordinated policy stimulus in 2009–10 turned around a severe recession.
- Since the initial recovery, global output remains below potential, unemployment above its natural rate, and inflation below target.
- Since 2014, a renewed demand deceleration has been accompanied by a global decline in investment, trade, and manufacturing and by undesirably low inflation in much of the world.
- Downside risks are high; in 2016, inflation in the large advanced economies has remained below target, with several verging on deflation.
- Perceptions of limited policy space stem from:
  - the effective lower bound on policy interest rates limiting conventional monetary stimulus;
  - high peacetime public debt-to-GDP ratios and demographic pressures on public spending constraining fiscal policy and automatic stabilizers.

### The recommended approach: comprehensive, consistent, and coordinated
- Core idea: use a three-pronged policy approach—monetary, fiscal, and structural—implemented in a manner that is comprehensive, consistent, and coordinated across instruments, over time, and across countries.
- Benefits:
  - Exploits synergies so the whole is greater than the sum of parts.
  - Anchors long-term expectations while allowing decisive short- to medium-term accommodation when necessary.
  - Improves resilience and the ability to deal with shocks.
  - Amplifies positive cross-border spillovers when coordinated internationally.

### Why comprehensive
- Combine monetary, fiscal, structural, and financial-sector policies when single instruments are constrained.
- Examples noted:
  - When monetary policy is at the effective lower bound, fiscal policy should provide demand support.
  - Monetary accommodation prevents crowding out of fiscal stimulus.
  - Financial sector policies strengthen transmission of monetary policy and damp shocks.
  - Structural reforms raise potential growth and help reduce debt-to-GDP ratios.
  - Demand-management can offset short-term contractionary effects of structural reforms and ease implementation.

### Why consistent
- A consistent framework links instruments to objectives over time and anchors expectations.
- Operational prescriptions:
  - Monetary policy responsibility: achieve the inflation target while minimizing adverse output/employment effects.
  - Fiscal policy responsibility: prudent management of public sector balance sheet risks and discretionary countercyclical support in large shocks.
- Illustration: an inflation-forecast-targeting (IFT) framework can allow effective stimulus at the policy rate floor via a planned temporary overshoot of the inflation target.
- Credible medium-term fiscal frameworks broaden short- to medium-term scope for countercyclical policies and reassure markets that temporary above-target deficits or inflation will be contained.

### Why coordinated
- International coordination of fiscal and monetary stimulus can boost global GDP when interest rates are very low and output gaps are wide.
- Coordinated action generates positive spillovers that amplify individual country measures and help keep debt-to-GDP ratios under control through stronger nominal GDP.
- The G20 Brisbane Action Plan and IMF three-pronged advice reflect the value of coordination; coordinated active policy adds particular value if the current approach fails to revive growth or if a further downward shock occurs.

### Operational elements and policy tools
- Use of unconventional monetary tools (quantitative and qualitative easing, negative interest rates) when conventional policy is constrained, recognizing uncertain transmission and potential macro-financial side-effects.
- Fiscal policy should prioritize measures with high multipliers—e.g., government investment and transfers to cash-strapped households—especially when central banks plan to hold policy rates at or near the effective lower bound long enough to allow inflation to accelerate.
- Structural reforms to raise potential output, together with demand support to mitigate short-term costs and distributional impacts.
- Financial sector policies to bolster banking systems and markets and improve policy transmission.
- In some cases (example: Japan), incomes policies may be needed to help raise inflation expectations to target.

### Illustrations and country tailoring
- Framework must be tailored to country circumstances; illustrations provided for Canada and Japan:
  - Canada: long-term expectations firmly anchored; Canada has fiscal space and is using it. Strengthening the fiscal framework by establishing a credible medium-term fiscal consolidation plan would make current stimulus more credible.
  - Japan: much more limited policy space. A well-designed package of demand-management policies, structural reforms, and measures to strengthen the wage-setting process can create momentum for stronger growth and inflation closer to target.
- In simulations:
  - Central banks can plan to hold policy interest rates at or near the effective lower bound long enough for inflation to exceed the target of 2 percent for a while before returning to target.
  - Fiscal initiatives emphasized are those with high multiplier effects (investment and transfers to cash-strapped households).

### Framework mechanics (Box 1 summary)
- Analytical starting point: map instruments to objectives and make conditional commitments on instrument adjustment to achieve objectives.
- Monetary policy: responsible for inflation target; minimize adverse output/employment effects.
- Government objectives: manage public sector balance sheet risks and provide discretionary countercyclical support in large shocks.
- Combined application of available instruments—including unconventional measures—is preferable to instrument-by-instrument paralysis.
- Consistent communication and credible long-term frameworks reduce market volatility and allow temporary policy accommodation to be effective.
- International coordination is particularly valuable during global crises or prolonged slowdowns to restore confidence and generate reinforcing cross-border spillovers.

### Key implications for policy design
- Countries with fiscal space and anchored inflation expectations can deploy fiscal stimulus, supported by credible medium-term fiscal frameworks.
- Countries with limited fiscal space should focus on growth-friendly fiscal rebalancing, pace fiscal adjustment appropriately, and deploy structural and financial-sector measures to sustain demand and restore potential growth.
- Central banks operating near the effective lower bound should consider frameworks (e.g., IFT) that permit temporary overshoots of inflation targets to restore inflation expectations.
- Coordinated fiscal and monetary stimulus across major economies is especially valuable if growth revival falters or a large negative shock occurs.

_Italicized source: IMF Staff Discussion Note — Macroeconomic Management When Policy Space Is Constrained (Executive Summary)._

### 10.      Under current conditions—extremely low interest rates, high unemployment, below-

### 10.      Under current conditions—extremely low interest rates, high unemployment, below-target actual and expected inflation—a fiscal stimulus would effectively support output following a negative shock.

### Premise and context
- Under current conditions (extremely low interest rates, high unemployment, below-target actual and expected inflation), a fiscal stimulus would effectively support output following a negative shock because monetary policy would support the stimulus and the policy interest rate would stay at the effective lower bound for longer.
- The combined fiscal/monetary expansion of 2009–10 provides the best evidence that it would work during recessions.
- In contrast, in full employment periods, the short-term fiscal multiplier would be low or negligible because of crowding out as the central bank increases the policy interest rate to contain inflation.
- Public investment or assistance to cash-strapped households would likely have large multiplier effects.
- Conventional macro models do not account for positive effects on productivity from increased employment (on-the-job training) and technological advances embodied in new investment (hysteresis effects).

### Fiscal policy: effectiveness, design, and caveats
Findings
- A well-designed fiscal stimulus can effectively protect against persistent contractionary shocks, especially if conducted within a credible fiscal framework.
- Under certain conditions in which comprehensive, consistent, and coordinated policies raise nominal GDP sufficiently, fiscal stimulus can improve the debt ratio (relative to a scenario with no policy response following a contractionary shock) in the long term, and even in the near term.
- The size of the short-term multiplier effects on aggregate demand depends on:
  - the type of fiscal instrument (government investment, government consumption, transfers, taxes, and others);
  - the structure of the economy (households’ marginal propensity to consume, degree of openness, and others);
  - a sound and credible fiscal framework that manages risks to the public sector balance sheet—without such a framework, high existing debt or deficits could undermine the credibility of fiscal stimulus; and
  - the cyclical positions of the economy and the response of monetary policy.
- Credibility is critical. Fiscal stimulus lacking a credible fiscal framework may widen sovereign spreads and undermine confidence.
- Where government debt-to-GDP is high and a credible long-term fiscal strategy is absent, a fiscal expansion today may be expected to be reversed, leaving negligible effects on output and inflation and potentially increasing risk premiums sharply.
- With long-term nominal bond rates at extremely low levels, and with the boost to nominal GDP growth, a short-term fiscal stimulus need not weaken the public balance sheet.
- When economic slack is substantial, multiplier effects raise incomes and tax revenues such that over the medium term the government debt-to-GDP ratio does not necessarily rise relative to a scenario with no policy response following a negative shock.
- Many infrastructure projects would pass a cost test given low real rates: “the present value of the increase in future potential output would exceed the consumption sacrifice today.”

Policy recommendations / design principles
- Implement fiscal stimulus within a credible long-term fiscal framework that commits to managing public sector balance sheet risks, taking into account both assets and liabilities.
- Articulate a clearly defined long-term fiscal anchor (stock or combination of stock and flow variables) and adopt a systematic behavioral rule for fiscal policy relative to deviations from the anchor.
- Embed a strong fiscal risk-management component: identify and quantify fiscal risks, develop mitigating strategies, and provision for residual risks.
- Prioritize high-return public investment projects and ensure efficient project selection and management (to avoid poor productivity, cost overruns, and delays).
- Include well-designed escape clauses in fiscal frameworks to allow adequate fiscal responses in exceptional circumstances.
- Where fiscal space is perceived limited, maximize output effect per unit of deficit by focusing on instruments with larger multipliers (notably government investment).

### Fiscal multipliers and model evidence (GIMF simulations)
Key simulation setup and assumptions
- Simulations use the Global Integrated Monetary and Fiscal (GIMF) Model for a generic large open economy; shocks are to government investment, government consumption, and transfer payments, with varying degrees of monetary accommodation.
- In the baseline case, monetary policy follows an inflation-forecast-based reaction function.
- Temporary shock specification: deficit-financed government spending equal in value to 1 percent of baseline GDP in years 1 and 2, 0.5 percent in year 3, and zero thereafter.

Findings from GIMF simulations
- Efficiently managed government investment has a stronger, longer-lasting effect on real GDP than government consumption because it increases potential output.
- Government investment increases the public sector capital stock and raises the private sector’s desired capital stock, boosting potential output and stimulating consumption and private investment.
- Ranking of impacts on GDP: government investment > government consumption > targeted transfers > general transfers.
- Transfers have the smallest effect due to larger leakages (taxes, savings, imports); general transfers especially may have low multipliers if recipients have lower marginal propensities to consume.
- Transfers targeted to cash-strapped groups have substantially larger multipliers than general transfers, but still only about half of those for government investment.
- Multipliers are larger if monetary policy keeps interest rates lower for longer (example: central bank holds policy rate flat for one or two years). The resulting higher inflation reduces real interest rates, eases financial conditions, and raises asset prices, stimulating private consumption and investment.
- Over the long term, with a regular reaction function, inflation stabilizes at the official target rate.
- Coordinated fiscal, monetary, and structural policies can raise nominal GDP enough that the debt-to-GDP ratio declines even though the deficit rises temporarily because higher nominal income raises tax revenues and the denominator in the debt ratio.

### Public investment: structural case and efficiency
Findings and recommendations
- The structural, productivity-enhancing case for a permanent increase in government investment is strong given very low long-term borrowing costs and substantial infrastructure deficiencies in many countries.
- A permanent increase in government investment equal to 1 percent of baseline GDP leads to higher productivity in the private sector, permanently higher private investment and consumption, and higher imports (positive spillovers).
- Increased growth of potential output creates future policy space by raising government revenues, reducing debt-to-GDP ratios, and raising the neutral interest rate.
- The growth dividends of public investment critically depend on its efficiency: the most efficient public investors get twice the growth impact from their public investment than the least efficient.
- An alternative policy of shifting spending from general consumption to investment (no net change in outlays) yields smaller but still sizable gains.
Caveat
- Infrastructure development biased toward sectors with chronic and growing excess capacity may delay necessary adjustments and provide only short-term boosts to output.

### Monetary policy within the coordinated approach
Findings and role
- Monetary policy should strengthen the nominal anchor provided by the official inflation target by raising actual and expected inflation in a controlled manner to the target and moving output closer to potential.
- Monetary and fiscal policy acting together can always raise the rate of inflation.
- Institutional constraints (restrictions on direct lending to government, measures to prevent fiscal dominance) are important to maintain central bank independence while allowing short- to medium-term discretion to act against shocks to output and employment.
- When the main danger is recession and low inflation, the central bank would accommodate fiscal stimulus by holding the policy interest rate constant, or even cutting policy rates, to boost aggregate demand further.
- When near full employment, the central bank would raise policy rates in response to fiscal expansion to defend its inflation objective, causing crowding out and reducing the multiplier.

### Risks, implementation challenges, and country-specific issues
- Governments need to manage spending carefully; infrastructure projects often suffer poor productivity, cost overruns, and delays.
- Failure to establish credible long-term fiscal plans can lead to sudden and severe public sector balance sheet difficulties.
- In smaller or less-advanced economies, perceptions of unstable fiscal dynamics at high debt levels could abruptly cut off access to international financial markets.
- The diminishing usefulness of each policy measure instrument-by-instrument and country-by-country risks policy paralysis if growth slows again; coordinated actions across structural, fiscal, and monetary prongs are recommended.

*Source: IMF staff discussion in “MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED,” excerpted from the supplied content unit.*

### 29.      In addition to its impact on the short-term fiscal multiplier, monetary policy has an

### _sdn1609 - 29.      In addition to its impact on the short-term fiscal multiplier, monetary policy has an

### Monetary policy role at the effective lower bound (ELB)
- Where central banks operate at the effective lower bound, strategies aiming for a slow and monotonic return to the inflation target over the medium term may not provide sufficient demand support to anchor long-term inflation expectations to the target while restoring the economy to full employment (see Online Appendix 2).
- One option is for monetary policy to aim for a faster increase in the inflation rate, with the expectation that this will imply a modest overshooting of inflation; the target would then eventually be approached from above (the Bank of Japan has just explicitly embraced this approach).
- As shown in section III, a faster-than-usual increase in inflation would also improve debt dynamics by increasing nominal GDP and reducing debt-to-GDP ratios.
- Section III considers the case of Japan where the policy rate is expected to remain at the effective lower bound for years; in such cases, other policies must be used aggressively to stimulate aggregate demand and raise inflation expectations to avoid getting stuck in a deflation or low-inflation trap. (footnote 21)

### Inflation-Forecast-Targeting (IFT) framework: purpose and mechanics
- IFT can make a difference when ELB constraints and risks of downward-ratcheting long-term inflation expectations exist.
- IFT central banks have either explicit or implicit dual mandates (Clinton and others 2015); while inflation control is the primary objective, output stability is also an important goal—especially when the policy rate is at the ELB and long-term inflation expectations risk ratcheting downward. (footnote 19, footnote 20)
- Targeting of inflation under IFT is symmetric around a point target; over time, undershoots and overshoots should be about equally frequent.
- In economies with material slack and inflation expectations below target, a risk-avoidance strategy under IFT would call for an aggressive monetary expansion. (footnote 21, footnote 22)
- Under IFT, monetary policy can credibly commit to a temporary period of inflation somewhat above target without undermining its medium-term goal of price stability.
- A strategy involving planned temporary and modest overshoots (and undershoots) could:
  - enhance inflation-target credibility;
  - increase confidence in the economy’s stability;
  - induce a faster convergence of output and the unemployment rate to their natural levels (Online Appendix 3).
- Credibility ultimately comes from satisfying the mandate within an explicit framework; IFT gives monetary policy scope to act as an effective buffer against cyclical shocks without undermining inflation-control credibility. (footnote 23)

### Transparency, communications, and forward guidance under IFT
- Successful IFT implementation depends on a high degree of monetary policy transparency.
- Inflation-targeting central banks typically publish inflation forecasts and the outlook for the output gap; some also release the forecast interest rate path with confidence bands.
- Publishing a model-consistent policy-rate path helps align the yield curve with policy objectives and clarifies the implications of “data dependent” policy (Clinton and others 2015). (footnote 24)
- Over time, a central bank would establish an open public record of how it manages the short-term trade-off between output and inflation, revealing the relative weights placed on deviations from potential output and the inflation target.
- IFT provides a more robust form of forward guidance by communicating how the interest rate path might change in response to various developments; the central bank need not give special guidance about switching particular policy approaches on and off. (references: Svensson 1997, Svensson 2002, Qvigstad 2005)

### Empirical evidence on IFT and inflation expectations
- Surveys conducted in 2015 and 2016 compare a group of inflation-forecast targeters with non-IFT advanced economies.
- Findings summarized (Figure 4):
  - In almost all economies covered, expected inflation is below target, largely because of known factors at the time of the survey (such as low energy prices and economic slack).
  - Non-IFT advanced-economy group: expectations for a negative deviation persist at least until the third year ahead, with a distinct positive correlation between expected deviation this year and in three years’ time.
  - IFT group: the expected three-year-ahead deviation from target is near zero, with no such correlation.
  - Conclusion: in non-IFT economies negative inflation shocks tend to shift medium-term inflation expectations downward; in IFT economies medium-term expectations remain stable at the target rate.
- IFT regimes represent the highest levels of transparency (Dincer and Eichengreen 2014; Obstfeld and others 2016). (footnote 25)
- All IFT central banks publish forecasts for inflation and output; some publish the full forecast including the short-term interest rate path and where relevant, forecasts for less conventional policy instruments.

### Adoption and credibility build-up
- Inflation targeting can be adopted quickly, often after a crisis or a history of unsatisfactory inflation; it has not typically required statutory changes to central banking law but a reinterpretation of existing mandates.
- Example: the United States adopted flexible inflation targeting in 2012 with an announced explicit numerical objective accompanied by a clear statement of the dual mandate (FOMC 2012).
- Anchoring long-term inflation expectations and establishing full credibility can take time and requires a comprehensive suite of policies, including assurances against fiscal dominance, for example. (section II.C transition)

### Synergies between demand management, structural policies, and fiscal space
- Fiscal, monetary, and structural policies can have mutually supportive macroeconomic effects; reforms addressing the decline in potential growth and the global equilibrium rate of interest since the early 2000s can revive investment demand and raise the neutral interest rate (Figure 5).
- Revived investment and higher potential output raise fiscal space by increasing nominal GDP and broadening the tax base, thereby reducing debt-to-GDP ratios.
- Product market reforms can deliver sizable medium-term output gains and pay off fairly quickly; however, such reforms might be deflationary in the short term when monetary policy is constrained (Eggertsson, Ferrero, and Raffo 2014), though they may also have inflationary effects via firm entry increasing demand for capital and labor (Cacciatore and others 2016b). Monetary policymakers should be ready to ease further if reforms cause noticeable short-term deflationary effects.
- Labor market participation measures (education, training, day care availability, reductions in marginal taxes on second earners) have immediate budget costs and may benefit from using some fiscal space; these costs are at least partially offset over time by a broader tax base and accumulation of on-the-job human capital.
- Fiscal stimulus can enhance the short-term macroeconomic effects of labor market reforms; estimated average outcomes for major past legislative reforms relaxing employment protection for regular workers show:
  - A significant decline in unemployment when reforms were accompanied by a large fiscal expansion;
  - An increase in unemployment when reforms were implemented together with a major fiscal contraction (Figure 7).
- Fiscal policy can mitigate distributive effects of reforms to ease resistance (examples include bundling relaxation of employment protection with more generous unemployment benefits, higher spending on active labor market policies, and labor tax cuts). (section II.C, footnote 27)
- Fiscal structural reform (tax policy and administration reform, strengthening fiscal institutions, expenditure reform) can create fiscal space that can be used to stimulate the economy where needed in the short term.

### Financial sector policy and monetary transmission
- Monetary policy effects on the real economy are transmitted through channels that require a healthy financial system; well-functioning markets allow monetary policy to affect a wide array of market prices (Online Appendix 4).
- Banks play a critical role in extending credit; micro- and macroprudential policies that enhance financial sector resilience and decisive actions on nonperforming loans reduce the risk that the financial system becomes a source or amplifier of shocks, leaving more room for monetary policy to maneuver.
- A weak banking sector can impede monetary policy transmission:
  - Banks overly exposed to troubled assets or with capital shortages will cut back on lending and attempt to keep lending rates high to rebuild equity through retained earnings. (footnote 28)
  - Banks may limit risk-taking and face funding premia over the policy rate unless central banks provide generous funding against wide collateral.
- Overstretched non-financial-sector balance sheets can limit monetary policy effects: borrowers at borrowing constraints become less sensitive to monetary policy and will not engage in new borrowing.
- Accommodative monetary policy can build financial imbalances in some sectors; macroprudential policy can address vulnerabilities across time and structural dimensions:
  - Time-dimension tools: build buffers as systemic risk accumulates to be drawn down in stress periods, constraining boom/bust credit cycles.
  - Structural-dimension tools: address externalities of systematically important financial institutions via capital surcharges and additional loss absorbency requirements to enhance resilience and facilitate orderly resolution (IMF/FSB/BIS 2016).

*Source: Excerpt from IMF chapter "MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED" (sections 29–48, footnotes 19–28, Figures and Online Appendices referenced).*

### 49.      Active use of macroprudential policies can help support the room for maneuver for

### _sdn1609 - 49.      Active use of macroprudential policies can help support the room for maneuver for

### Macroprudential policies and monetary policy room for maneuver
- Low interest rates combined with limited elasticity of housing supply have contributed to increases in house prices and a run-up in household debt and leverage.
- Targeted macroprudential policies (for example, tightening of caps on loan-to-value and debt-service-to-income ratios) can:
  - help contain these dynamics;
  - increase the system’s resilience to shocks to asset prices or household incomes.
- When macroprudential buffers have been built up, some can be relaxed when systemic risks materialize and financial shocks lead banks to pull back credit, which can help sustain the flow of credit through adverse financial conditions (IMF 2013; Nier and Kang 2016).

### Crisis responses to restore monetary policy transmission and financial health
- In acute financial crises, swift and decisive policy action to restore the health of the financial system is essential to support monetary policy transmission.
- Policies must give incentives to both lenders and borrowers to address balance sheet weaknesses; otherwise, waiting to “grow out” of the crisis leads to costly misallocation of resources, slow credit growth, and weak recovery.
- Restoring financial-sector health often translates into higher public debt ratios as contingent financial liabilities migrate to the public sector balance sheet—making management of public sector balance sheet risks important, including building policy space in good times.

### Supply-side and demand-side measures to strengthen transmission
- Supply-side measures:
  - Supervisory action to incentivize prompt loss recognition on troubled assets.
  - Asset quality reviews to ensure balance sheets reflect actual economic valuations.
  - Stress tests to reassure investors about capital buffers and viability.
  - Strengthening banks’ capital bases where possible so banks can continue lending during downturns.
  - Well-designed bank resolution frameworks ex ante to reduce moral hazard and minimize public cost.
  - State solvency support for recapitalizations as a last resort; private sector bail-ins possible but require careful management.
  - Asset management companies can relieve banks of troubled assets, but raise issues of moral hazard, budgetary costs, public debt, and contingent liabilities.
  - Central bank liquidity lines can restore market functioning but should be used only to address temporary market distortions.
- Demand-side measures:
  - Overindebtedness in households and firms impedes new lending.
  - Swift restructuring of distressed loans is vital to clean private sector balance sheets and jump-start credit demand.

### Interaction with accommodative monetary policy
- Accommodative monetary policy helps both supply and demand factors by:
  - boosting growth, decreasing nonperforming loans, improving valuations, strengthening balance sheets, and decreasing borrower riskiness.
- But cheap funding can postpone recognition of losses and restructuring of loans (the evergreening issue noted in the October 2013 Global Financial Stability Report).

### Country examples: Canada and Japan—tailoring comprehensive, consistent, and coordinated policies
- Canada:
  - Substantial fiscal space (variable by province) and room for further monetary stimulus, subject to regulatory measures to cool overheated housing markets.
  - Long-term inflation expectations firmly anchored at the 2 percent target rate.
  - Model simulations show fiscal support complemented by monetary accommodation can close the output gap, raise inflation quickly, raise nominal interest rates away from the effective lower bound over the medium term, reinforce the inflation target, boost nominal GDP, and help stabilize government finances while lowering short-term debt service cost.
- Japan:
  - More challenging conditions: low growth and inflation expectations below target after decades of deflation; expansionary macroeconomic policies pushed toward perceived limits.
  - Recommendation of a “Three-Arrows-Plus” package building on the “Three Arrows”:
    - Fiscal policy: gradual increase in the value-added tax (VAT) to manage public sector balance sheet risks; VAT chosen for low macroeconomic multiplier and low allocative distortions; gradual increases avoid abrupt consumption reallocations associated with the pre-announced VAT hike of 2014.
    - Monetary policy: Bank of Japan could adopt a transparent IFT regime to strengthen its inflation-targeting approach.
    - Structural policies: growth-enhancing reforms—labor market reform to offset declining workforce and reduce labor-market dualism; ease barriers that exclude workers from protected sectors; investment in human capital; consider special measures (for example, an incomes policy) to support nominal wage growth and help reach the 2 percent inflation objective.
  - Model simulations indicate the Three-Arrows-Plus package could deliver the ambitious targets of Abenomics.

### International policy coordination and model simulation findings
- A large global contractionary shock could raise the risk of a deflation (or low-inflation) trap; timely and coordinated policy response can jump-start a permanent offsetting increase in employment and output.
- Historical example: G20 stimulus after the global financial crisis called for tax cuts and discretionary spending increases equivalent to 2 percent of GDP in both 2009 and 2010.
- GIMF simulation of a hypothetical coordinated fiscal stimulus:
  - Stimulus composition: raising government investment, government consumption, and targeted transfers.
  - Size and timing: 1 percent of each region’s baseline GDP in year 1, 1 percent in year 2, and 0.5 percent in year 3, with instruments returning to baseline thereafter.
  - Monetary accommodation: nominal policy interest rates kept unchanged for two years.
- Key quantitative and qualitative results from simulations:
  - Estimated domestic multipliers exceed unity for almost all regions; greatest for emerging Asia, Latin America, and the remaining countries group (high shares of liquidity-constrained households); short-term multipliers for the euro area, the United States, and Japan are about unity.
  - Large international spillover effects arise because of region size, domestic output effects, and openness; fiscal stimulus in emerging Asia or the remaining countries produces especially powerful spillovers.
  - Coordinated stimulus applied simultaneously in every region adds 2.4 percent to world GDP in years 1 and 2, and 1.1 percent in year 3.
  - The euro area and the United States would see an output boost of over 1½ percent, and Japan about 1.8 percent, in the coordinated scenario.
  - Positive financial-sector linkages: with nominal policy rates held constant, real rates decline as stimulus raises inflation; lower real rates increase asset prices, strengthen balance sheets, reduce risk premiums, and ease credit conditions—propagated globally through trade integration.
  - Coordination yields a “fiscal dividend”: as global fiscal and monetary coordination raises nominal GDP, the debt-to-GDP ratio is eventually lower for all regions despite initial deficit increases (Table 3 results referenced). Example: euro area debt ratio declines by 0.3 percentage point in year 4 under coordinated stimulus; by contrast, a stimulus confined to the euro area alone would raise that area’s debt ratio by 0.9 percentage point—1.2 percentage points more than with an internationally coordinated stimulus.
  - Model may understate longer-term benefits because it disregards negative effects of a prolonged slump on employment, productivity, confidence, and potential output.

### Policy conclusions and overarching messages
- A comprehensive, consistent, and coordinated policy approach—using monetary, fiscal, and structural policies in combination—can overcome apparent individual constraints on instruments and move the global economy away from danger zones in a renewed global slowdown.
- Consistent policy frameworks provide policy space to deliver decisive short- to medium-term support (for example, by anchoring long-term inflation expectations and committing fiscal policy to an eventual sustainable downtrend in government debt-to-GDP ratios).
- Coordinated policies across major economies amplify individual policy effects through positive cross-border spillovers, boosting global nominal GDP and helping to keep debt-to-GDP ratios in check.
- The whole is greater than the sum of its parts: model simulations suggest that fiscal stimulus accommodated by monetary policy can mitigate negative shocks, help raise inflation to target levels, and improve debt-to-GDP dynamics—particularly when embedded in sound fiscal and credible monetary frameworks and when internationally coordinated through trade and financial channels.

*MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED, INTERNATIONAL MONETARY FUND*

### 66.      This approach also encompasses financial sector policies and structural reforms that

### MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED

### Strengthening monetary transmission and financial sector policies
- Financial sector policies can improve the transmission of monetary policy by strengthening banking systems and markets through prudential policy, resolution of legacy loan issues, and stronger bank capital bases.
- Macroprudential policy can contain unintended side effects of monetary accommodation.
- Structural reforms in labor, product, and services markets can increase potential growth; higher nominal GDP growth reduces the debt-to-GDP ratio and strengthens the budget by expanding the tax base and/or lowering transfers.
- Caveat: Some sound structural reforms can have short-term negative impacts on aggregate output; a comprehensive policy mix should use monetary and fiscal instruments to offset such impacts.

### Coordinated policy framework and the Japan case
- A comprehensive, consistent, and coordinated approach relates policy objectives and instruments over time and offers the best chance to deal with negative shocks.
- Model simulations for Japan—where perceived macroeconomic policy space is very limited—suggest that supplementing the “Three Arrows” of Abenomics with an incomes policy to raise expectations of inflation could help achieve that program’s ambitious objectives on a timely schedule.

### Relevance for emerging market economies
- Insights are relevant for emerging market economies recovering from recession and falling commodity prices.
- Preconditions: establishing sound consistent fiscal frameworks that successfully manage fiscal balance sheet risks over time.
- Reforms of the monetary framework can establish clarity on monetary policy objectives and targets.
- Stronger governance arrangements would gradually entrench greater monetary policy credibility, enabling more flexible use of monetary and fiscal tools to manage aggregate demand.
- For countries with limited room for maneuver (for example, commodity exporting countries), this approach can help determine the pace of necessary fiscal adjustment and implement growth-friendly fiscal rebalancing.

### Macro risks, potential payoffs, and long-term gains
- The global macroeconomic risks of 2016 are characterized as one-sided, with output in major advanced economies and many emerging market economies remaining short of potential—well short in many cases.
- Inflation is below target in many regions, and below zero in some.
- Geopolitical frictions and economic imbalances encourage isolationist policies and tilt the balance of risks toward further negative shocks to global output.
- A major downdraft would push the global economy closer toward, and in some regions definitively into, a low-inflation quagmire.
- The payoff from a successful policy strategy outlined in the note would be large—probably even larger than suggested by macroeconomic models, which do not account for lasting productivity gains from higher employment (through acquisition of skills and know-how) and increased investment (through a larger, newer capital stock and embodied technical advances).

*Source: MACROECONOMIC MANAGEMENT WHEN POLICY SPACE IS CONSTRAINED, INTERNATIONAL MONETARY FUND*

### 6. Inflation and Output Gap

### 6. Inflation and Output Gap

### Illustrative Discretionary Fiscal Multipliers with Monetary Policy Accommodation
- Real GDP (Percent deviation from baseline)
  - Government investment: Year 1: 1.2; Year 2: 1.1; Year 3: 0.5
  - Government investment with one-year monetary accommodation: Year 1: 1.3; Year 2: 1.3; Year 3: 0.6
  - Government investment with two-year monetary accommodation: Year 1: 1.7; Year 2: 1.7; Year 3: 0.8
  - Government consumption: Year 1: 0.9; Year 2: 0.8; Year 3: 0.2
  - Government consumption with one-year monetary accommodation: Year 1: 1.1; Year 2: 0.9; Year 3: 0.2
  - Government consumption with two-year monetary accommodation: Year 1: 1.4; Year 2: 1.3; Year 3: 0.4
  - Targeted transfers: Year 1: 0.5; Year 2: 0.5; Year 3: 0.2
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.6; Year 2: 0.6; Year 3: 0.2
  - Targeted transfers with two-year monetary accommodation: Year 1: 0.8; Year 2: 0.8; Year 3: 0.3
  - General transfers: Year 1: 0.1; Year 2: 0.1; Year 3: 0.0
  - General transfers with one-year monetary accommodation: Year 1: 0.2; Year 2: 0.1; Year 3: 0.0
  - General transfers with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.2; Year 3: 0.1
- Government Debt (Percent of GDP deviation from baseline)
  - Government investment: Year 1: -0.9; Year 2: -0.2; Year 3: 0.8
  - Government investment with one-year monetary accommodation: Year 1: -1.2; Year 2: -0.5; Year 3: 0.5
  - Government investment with two-year monetary accommodation: Year 1: -1.8; Year 2: -1.4; Year 3: -0.2
  - Government consumption: Year 1: -0.5; Year 2: 0.2; Year 3: 1.3
  - Government consumption with one-year monetary accommodation: Year 1: -0.8; Year 2: -0.0; Year 3: 1.1
  - Government consumption with two-year monetary accommodation: Year 1: -1.4; Year 2: -0.8; Year 3: 0.3
  - Targeted transfers: Year 1: 0.2; Year 2: 0.9; Year 3: 1.6
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.0; Year 2: 0.7; Year 3: 1.5
  - Targeted transfers with two-year monetary accommodation: Year 1: -0.4; Year 2: 0.2; Year 3: 1.0
  - General transfers: Year 1: 0.8; Year 2: 1.7; Year 3: 2.1
  - General transfers with one-year monetary accommodation: Year 1: 0.7; Year 2: 1.6; Year 3: 2.1
  - General transfers with two-year monetary accommodation: Year 1: 0.6; Year 2: 1.4; Year 3: 2.0
- Inflation (Percentage point deviation from baseline)
  - Government investment: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government investment with one-year monetary accommodation: Year 1: 0.2; Year 2: 0.2; Year 3: 0.2
  - Government investment with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.4; Year 3: 0.4
  - Government consumption: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government consumption with one-year monetary accommodation: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - Government consumption with two-year monetary accommodation: Year 1: 0.2; Year 2: 0.3; Year 3: 0.3
  - Targeted transfers: Year 1: 0.1; Year 2: 0.1; Year 3: 0.1
  - Targeted transfers with one-year monetary accommodation: Year 1: 0.1; Year 2: 0.1; Year 3: 0.1
  - Targeted transfers with two-year monetary accommodation: Year 1: 0.1; Year 2: 0.2; Year 3: 0.2
  - General transfers: Year 1: 0.0; Year 2: 0.0; Year 3: 0.0
  - General transfers with one-year monetary accommodation: Year 1: 0.0; Year 2: 0.0; Year 3: 0.0
  - General transfers with two-year monetary accommodation: Year 1: 0.0; Year 2: 0.1; Year 3: 0.1
- Source of simulations: Authors’ simulations.

### Estimates of the Effects of a Coordinated Fiscal Stimulus after a Hypothetical Negative Global Demand Shock (Part I) — Effects on Real GDP Level
- Note on stimulus design:
  - The size of the fiscal stimulus is equal to 1 percent, 1 percent, and 0.5 percent of each region’s baseline GDP, respectively.
  - It consists of government investment, government consumption, and targeted transfers, with their respective share being 1/4, 1/4, and 1/2 of the total stimulus.
  - Monetary policy in all regions accommodates the fiscal expansion by keeping nominal policy interest rate unchanged for two years.
- Effects on Real GDP Level in Year 1 (Percent deviation from baseline)
  - World: When stimulus in all regions: 2.4; When stimulus in United States only: 0.4; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.8; Latin America only: 0.2; Remaining Countries only: 0.8
  - United States: When stimulus in all regions: 1.6; When stimulus in United States only: 1.1; Euro Area only: 0.1; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.1; Remaining Countries only: 0.2
  - Euro Area: When stimulus in all regions: 1.5; When stimulus in United States only: 0.1; Euro Area only: 0.9; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.0; Remaining Countries only: 0.3
  - Japan: When stimulus in all regions: 1.8; When stimulus in United States only: 0.1; Euro Area only: 0.1; Japan only: 1.1; Emerging Asia only: 0.4; Latin America only: 0.0; Remaining Countries only: 0.2
  - Emerging Asia: When stimulus in all regions: 3.4; When stimulus in United States only: 0.4; Euro Area only: 0.3; Japan only: 0.2; Emerging Asia only: 2.0; Latin America only: 0.2; Remaining Countries only: 0.8
  - Latin America: When stimulus in all regions: 2.4; When stimulus in United States only: 0.3; Euro Area only: 0.2; Japan only: 0.1; Emerging Asia only: 0.3; Latin America only: 1.5; Remaining Countries only: 0.3
  - Remaining Countries: When stimulus in all regions: 2.3; When stimulus in United States only: 0.2; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.5; Latin America only: 0.1; Remaining Countries only: 1.4
- Effects on Real GDP Level in Year 2 (Percent deviation from baseline)
  - World: When stimulus in all regions: 2.4; When stimulus in United States only: 0.4; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.8; Latin America only: 0.2; Remaining Countries only: 0.8
  - United States: When stimulus in all regions: 1.6; When stimulus in United States only: 1.1; Euro Area only: 0.1; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.1; Remaining Countries only: 0.3
  - Euro Area: When stimulus in all regions: 1.6; When stimulus in United States only: 0.1; Euro Area only: 1.0; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.0; Remaining Countries only: 0.3
  - Japan: When stimulus in all regions: 1.8; When stimulus in United States only: 0.1; Euro Area only: 0.1; Japan only: 1.1; Emerging Asia only: 0.4; Latin America only: 0.1; Remaining Countries only: 0.2
  - Emerging Asia: When stimulus in all regions: 3.3; When stimulus in United States only: 0.4; Euro Area only: 0.3; Japan only: 0.2; Emerging Asia only: 1.9; Latin America only: 0.2; Remaining Countries only: 0.8
  - Latin America: When stimulus in all regions: 2.4; When stimulus in United States only: 0.3; Euro Area only: 0.2; Japan only: 0.1; Emerging Asia only: 0.3; Latin America only: 1.5; Remaining Countries only: 0.3
  - Remaining Countries: When stimulus in all regions: 2.3; When stimulus in United States only: 0.2; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.5; Latin America only: 0.1; Remaining Countries only: 1.4
- Effects on Real GDP Level in Year 3 (Percent deviation from baseline)
  - World: When stimulus in all regions: 1.1; When stimulus in United States only: 0.2; Euro Area only: 0.2; Japan only: 0.1; Emerging Asia only: 0.4; Latin America only: 0.1; Remaining Countries only: 0.4
  - United States: When stimulus in all regions: 0.8; When stimulus in United States only: 0.4; Euro Area only: 0.1; Japan only: 0.0; Emerging Asia only: 0.1; Latin America only: 0.0; Remaining Countries only: 0.1
  - Euro Area: When stimulus in all regions: 0.9; When stimulus in United States only: 0.1; Euro Area only: 0.5; Japan only: 0.0; Emerging Asia only: 0.1; Latin America only: 0.0; Remaining Countries only: 0.2
  - Japan: When stimulus in all regions: 0.8; When stimulus in United States only: 0.1; Euro Area only: 0.1; Japan only: 0.4; Emerging Asia only: 0.2; Latin America only: 0.0; Remaining Countries only: 0.2
  - Emerging Asia: When stimulus in all regions: 1.4; When stimulus in United States only: 0.2; Euro Area only: 0.2; Japan only: 0.1; Emerging Asia only: 0.8; Latin America only: 0.1; Remaining Countries only: 0.4
  - Latin America: When stimulus in all regions: 1.1; When stimulus in United States only: 0.2; Euro Area only: 0.1; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.6; Remaining Countries only: 0.2
  - Remaining Countries: When stimulus in all regions: 1.1; When stimulus in United States only: 0.1; Euro Area only: 0.1; Japan only: 0.1; Emerging Asia only: 0.3; Latin America only: 0.0; Remaining Countries only: 0.7

### Estimates of the Effects of a Coordinated Fiscal Stimulus after a Hypothetical Negative Global Demand Shock (Part II) — Effects on Nominal GDP and Debt/GDP
- Effects on Nominal GDP Level in Year 4 (Percent deviation from baseline)
  - World: When stimulus in all regions: 2.3; When stimulus in United States only: 0.4; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.8; Latin America only: 0.2; Remaining Countries only: 0.8
  - United States: When stimulus in all regions: 1.6; When stimulus in United States only: 0.9; Euro Area only: 0.1; Japan only: 0.1; Emerging Asia only: 0.3; Latin America only: 0.1; Remaining Countries only: 0.3
  - Euro Area: When stimulus in all regions: 1.0; When stimulus in United States only: 0.1; Euro Area only: 0.4; Japan only: 0.0; Emerging Asia only: 0.2; Latin America only: 0.0; Remaining Countries only: 0.3
  - Japan: When stimulus in all regions: 1.8; When stimulus in United States only: 0.2; Euro Area only: 0.2; Japan only: 0.8; Emerging Asia only: 0.5; Latin America only: 0.1; Remaining Countries only: 0.3
  - Emerging Asia: When stimulus in all regions: 3.3; When stimulus in United States only: 0.4; Euro Area only: 0.4; Japan only: 0.2; Emerging Asia only: 1.8; Latin America only: 0.2; Remaining Countries only: 0.9
  - Latin America: When stimulus in all regions: 2.4; When stimulus in United States only: 0.4; Euro Area only: 0.2; Japan only: 0.1; Emerging Asia only: 0.4; Latin America only: 1.1; Remaining Countries only: 0.4
  - Remaining Countries: When stimulus in all regions: 2.4; When stimulus in United States only: 0.3; Euro Area only: 0.3; Japan only: 0.1; Emerging Asia only: 0.6; Latin America only: 0.1; Remaining Countries only: 1.3
- Effects on Debt/GDP Ratio in Year 4 (Percentage deviation from baseline)
  - World: When stimulus in all regions: -0.7; When stimulus in United States only: 0.0; Euro Area only: 0.0; Japan only: -0.0; Emerging Asia only: -0.2; Latin America only: -0.0; Remaining Countries only: -0.1
  - United States: When stimulus in all regions: -0.4; When stimulus in United States only: 0.8; Euro Area only: -0.1; Japan only: -0.1; Emerging Asia only: -0.3; Latin America only: -0.1; Remaining Countries only: -0.3
  - Euro Area: When stimulus in all regions: -0.3; When stimulus in United States only: -0.1; Euro Area only: 0.9; Japan only: -0.0; Emerging Asia only: -0.2; Latin America only: -0.0; Remaining Countries only: -0.3
  - Japan: When stimulus in all regions: -1.8; When stimulus in United States only: -0.3; Euro Area only: -0.2; Japan only: 0.2; Emerging Asia only: -0.6; Latin America only: -0.1; Remaining Countries only: -0.5
  - Emerging Asia: When stimulus in all regions: -1.4; When stimulus in United States only: -0.2; Euro Area only: -0.2; Japan only: -0.1; Emerging Asia only: 0.2; Latin America only: -0.1; Remaining Countries only: -0.5
  - Latin America: When stimulus in all regions: -0.6; When stimulus in United States only: -0.2; Euro Area only: -0.1; Japan only: -0.0; Emerging Asia only: -0.2; Latin America only: 0.7; Remaining Countries only: -0.2
  - Remaining Countries: When stimulus in all regions: -0.7; When stimulus in United States only: -0.1; Euro Area only: -0.2; Japan only: -0.0; Emerging Asia only: -0.3; Latin America only: -0.0; Remaining Countries only: 0.5

*Source: Authors’ simulations.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2016/_sdn1609.pdf_