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Fiscal policy and high inflation

Krzysztof Bańkowski, Othman Bouabdallah, Cristina Checherita-Westphal, Maximilian Freier, Pascal Jacquinot and Philip Muggenthaler

Economic Bulletin Articles, 2023, vol. 2

Abstract: This article assesses the relation between fiscal policy and inflation, with a focus on the euro area and the period 2022-25 (corresponding to the horizon of the December 2022 Eurosystem staff macroeconomic projections for the euro area). Overall, the article concludes that, even without the discretionary policy response to the high energy prices and inflation (assessed at close to 2% of GDP over the 2022-23 period), the euro area budget balance could be negatively affected by the current high inflation beyond the short term. This is primarily explained by the nature of the inflation shock, which has a substantial external, energy-driven component, and its large size. Such factors lead to more limited gains on the revenue side of the budget, which in turn can easily be outweighed in the following years by extra spending pressures. In terms of the euro area debt-to-GDP ratio, the analysis shows that a negative impact on economic activity from an adverse supply shock, given the monetary policy reaction, may outweigh the positive initial impact of higher inflation through the denominator effect. The discretionary fiscal policy measures that have so far been adopted to shield the economy from the impact of high inflation in turn lower the inflationary pressures over the 2022-23 period, with a broad estimated reversal of the effect afterwards. The degree to which these fiscal measures will influence price dynamics is highly uncertain. JEL Classification: E31, E37, E62, E63

Keywords: fiscal-monetary interactions; Fiscal policy; inflation; model simulations (search for similar items in EconPapers)
Date: 2023-02
Note: 2648110
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