Can Fiscal Consolidation help Central Banks Fight Inflation?

IMF Working Papers, December 15, 2023

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Authors: Jiaqian Chen, Era Dabla-Norris, Carlos Goncalves, Zoltan Jakab, Jesper Lindé
Published: December 15, 2023
Series: IMF Working Papers
DOI: https://doi.org/10.5089/9798400262906.001

The paper argues that a tighter fiscal policy stance can meaningfully support central banks in fighting inflation in both advanced and emerging market economies.
While the standard textbook result suggests that monetary policy is much more effective than fiscal policy in battling inflation in open economies due to the exchange rate channel, the paper shows that a tighter fiscal stance is notably more effective in the current situation.
Reason: when many countries currently need to tighten the policy stance simultaneously, the exchange rate channel does not provide monetary policy with an edge over fiscal policy.
Fiscal consolidation can be helpful in small open emerging markets and developing economies by:
- reaffirming their commitment to price stability, and
- putting the fiscal house in order which reduces risk premiums and strengthens the currency.
Spillovers from major economies can be more adverse from tighter monetary policy than from tighter fiscal policy.
Any adverse effects of tighter fiscal policy (relative to tighter monetary policy) on consumption inequality can be handled with a combination of general spending cuts and targeted transfers to vulnerable households.

Tighter fiscal policy can meaningfully support central banks in fighting inflation in both advanced and emerging market economies.
The exchange rate channel advantage for monetary policy is weakened when many countries tighten simultaneously.
Fiscal consolidation can strengthen price stability commitment and reduce risk premiums in small open emerging markets and developing economies.
Spillover effects from major economies are potentially more adverse under tighter monetary policy than under tighter fiscal policy.
Distributional concerns from fiscal tightening can be mitigated by combining general spending cuts with targeted transfers to vulnerable households.

The analysis applies a two-agent New Keynesian modeling framework with unconstrained and hand-to-mouth households to compare tighter fiscal policy versus tighter monetary policy and to evaluate distributional consequences.

Consider using fiscal consolidation as a complement to monetary tightening to fight inflation, particularly when many countries are tightening policy simultaneously.
For small open emerging markets and developing economies, emphasize fiscal consolidation to:
- reaffirm commitment to price stability, and
- reduce risk premiums and strengthen the currency.
Address potential consumption-inequality effects of fiscal consolidation with:
- general spending cuts where appropriate, and
- targeted transfers to vulnerable households.