ECB Interest Rate Hikes Have a Greater Impact in Euro Area Countries with Restrictive Fiscal Policies

Alexander Kriwoluzky and Frederik Kurcz

DIW Weekly Report, 2026, vol. 16, issue 39-41, 295-301

Abstract: The war in Iran has once again driven up energy prices and, as a result, inflation in the euro area. The European Central Bank (ECB) has responded with two interest rate hikes, and more could follow. It is easy to lose sight of the fact that higher interest rates place a burden not only on businesses and households but also on government budgets as interest expenses rise. In addition, the weaker economy depresses tax revenues and drives up transfer payments. Using time-series models for each euro area country, this Weekly Report examines how debt levels, government spending, economic output, and inflation react to an interest rate hike by the ECB. The results show that these outcomes vary greatly depending on the fiscal policy response of each respective member state. Countries that offset their budget shortfall through spending cuts— including Germany through 2025—lose significantly more economic output following an interest rate hike than countries that temporarily take on additional debt. For the ECB, this implies that the impact of its interest rate policy depends on the fiscal policies of member states. With the fiscal policy reversal initiated in Germany in 2025, the impact of interest rate hikes in the largest euro area country is likely to weaken in the future. Accordingly, the ECB may need to raise interest rates more sharply to sufficiently curb inflation.

Keywords: Monetary policy; fiscal policy; monetary-fiscal interaction; public debt; euro area; Bayesian VAR (search for similar items in EconPapers)
JEL-codes: C32 E52 E62 E63 H63 (search for similar items in EconPapers)
Date: 2026
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DIW Weekly Report is currently edited by Anna Bindler, Tomaso Duso, Sabine Fiedler, Marcel Fratzscher, Peter Haan, Claudia Kemfert, Alexander Kritikos, Alexander Kriwoluzky, Karsten Neuhoff and Sabine Zinn

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