Monetary Policy Under Fiscal Stress: A Forward-Looking Analysis of Fiscal Dominance

Donna Faye Bajaro, Jaqueson Galimberti and Irfan Qureshi
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Donna Faye Bajaro: Asian Development Bank
Jaqueson Galimberti: Asian Development Bank
Irfan Qureshi: Asian Development Bank

No 797, ADB Economics Working Paper Series from Asian Development Bank

Abstract: Subdued economic activity and low tax revenues, especially during crises, drive borrowing and increase public debt. During these periods, to ease the debt burden, central banks may face pressure to deviate from policy targets. Under fiscal dominance, debt sustainability relies on low interest rates and high inflation rather than consolidation. This paper empirically tests the presence of fiscal dominance using forward-looking Taylor rules and data from 52 economies over 3 decades. The results detect fiscal dominance, with stronger effects in de jure inflation-targeting emerging economies with low central bank independence, especially those without debt rules and with high debt-to-gross domestic product ratios. Emerging economies with high foreign currency-denominated debt are further affected by exchange rate debt valuation effects, and fiscal dominance leads their central banks to follow exchange rate stabilization policies. Since 2022–2023, interest rate responses to fiscal imbalances have strengthened, posing challenges for future policy.

Keywords: fiscal dominance; monetary policy; Taylor rule; consensus forecasts (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 E63 (search for similar items in EconPapers)
Pages: 43
Date: 2025-08-20
New Economics Papers: this item is included in nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ris:adbewp:021496

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