Diminishing Monetary Potency under Fiscal Dominance: A Bayesian Local Projections Analysis

Naveed Javed and James Morley

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: We consider empirically how fiscal stance influences the potency of monetary policy. New Zealand provides a compelling laboratory to study this form of monetary-fiscal interaction given its stable history of inflation targeting and substantial changes in its fiscal stance due to global forces acting on a small open economy (SOE). A simulation-based Bayesian Local Projection (BLP) framework is developed to estimate the macroeconomic effects of a narrative measure of monetary policy shocks when there are many possible omitted variables, especially in this SOE setting. Our BLP approach incorporates a novel shape prior on impulse response functions to help manage the substantial bias-efficiency tradeoffs given the relatively small effective sample sizes when considering nonlinearities inherent in policy interactions. For a smooth-transition regime-switching model with an endogenously-estimated threshold parameter, we find that monetary policy is clearly more potent, especially in terms of out-put and inflation, when there is a high degree of fiscal consolidation. Consistent with the fiscal theory of the price level, our results for a more general model that also allows for sign asymmetries suggest the effects of expansionary versus contractionary monetary policy shocks on output, inflation, and the exchange rate are actually reasonably symmetric, implying that the potency of monetary policy is more related to monetary-fiscal dominance than coordination.

Keywords: monetary-fiscal interactions; Bayesian local projections; fiscal theory of the price level (search for similar items in EconPapers)
JEL-codes: C32 E52 E58 E63 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2026-09
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2026-75

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