U.S. and Euro Area Monetary and Fiscal Interactions During the Pandemic: A Structural Analysis

IMF Working Papers, November 11, 2022

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The paper employs a two-country New Keynesian DSGE model to assess macroeconomic impacts of changes in monetary policy frameworks and fiscal support in the U.S. and euro area during the pandemic.
Moving from a previous target of “below, but close to 2 percent” to a formal symmetric inflation targeting regime in the euro area boosts output and inflation in both regions.
Moving from flexible to average inflation targeting in the U.S. boosts output and inflation in both regions.
The fiscal packages approved in the U.S. and the euro area, and a slower withdrawal of fiscal support in the euro area, have a similar impact on output and inflation as changing the monetary policy frameworks.
Simultaneously implementing these monetary and fiscal policies is mutually reinforcing.
These combined policy changes are insufficient to fully explain the unexpected increase in core inflation during 2021.

Model: two-country New Keynesian DSGE model.
Policy scenarios analyzed:
- Change in euro area monetary policy from “below, but close to 2 percent” to a formal symmetric inflation targeting regime.
- Change in U.S. monetary policy from flexible inflation targeting to average inflation targeting.
- Fiscal packages in the U.S. and the euro area and pace of fiscal withdrawal in the euro area.
- Simultaneous implementation of monetary framework changes and fiscal support.
Mechanisms emphasized:
- Monetary regime shifts raise expected inflation and stimulate output in both regions.
- Fiscal stimulus and slower fiscal withdrawal operate through demand channels and produce effects comparable to monetary framework changes.
- Interactions between monetary and fiscal policies are mutually reinforcing but do not fully account for the 2021 core inflation rise.

Monetary-policy-framework changes (formal symmetric inflation targeting in the euro area; average inflation targeting in the U.S.) can be effective at raising output and inflation across regions.
Fiscal stimulus and the timing of fiscal withdrawal are powerful tools with effects comparable to monetary-framework changes.
Coordinated monetary and fiscal action is mutually reinforcing and can amplify macroeconomic stabilization effects.
Additional factors beyond the considered monetary and fiscal adjustments are needed to fully account for the unexpected rise in core inflation in 2021; policymakers should investigate supplementary drivers.

IMF Working Paper: U.S. and Euro Area Monetary and Fiscal Interactions During the Pandemic: A Structural Analysis (Working Paper No. 2022/222).