Terms-of-trade-driven inflation and monetary-fiscal policie

Gergő Motyovszki

Quarterly Report on the Euro Area (QREA), 2024, vol. 23, issue 1, 7-22

Abstract: This chapter looks at whether the recent sharp spike in inflation can be beneficial for public debt sustainability by eroding the real value of nominal debt. Simulations with the European Commission's QUEST model suggest that, if the source of inflation is an adverse terms-of-trade shock, then it leads to a rising public debt-to-GDP ratio instead. In this case, the debt-reducing effect of higher inflation is outweighed by the adverse effects of slower real growth, a declining primary budget balance, and higher interest rates as an active monetary policy tightens to fight inflationary pressures. The results are policy-dependent: shorter debt maturity (e.g. as brought about by past QE programs) would speed up the rise in interest expenditures, while a more accommodative monetary policy would delay them, also supporting nominal growth. The initial terms-of-trade loss triggers second round domestic price pressures as economic agents strive to recover their purchasing power, and the emergence of such wage-price spirals is found to interact strongly with the reaction of monetary policy. The reaction of the primary fiscal balance (via automatic stabilisers, inflation indexation and debt-stabilisation rules) also matters. However, the baseline result that the debt-to-GDP ratio rises in response to an adverse termsof-trade shock is fairly robust across all but the most extreme alternative policy scenarios. The source of the inflationary shock is crucial for these results as demand-driven inflation would have opposite fiscal implications. The results of the chapter should not be blindly applied to the observed inflation development, which was driven by a combination of different economic shocks.

Keywords: fiscal policy; inflation; monetary policy; terms-of-trade (search for similar items in EconPapers)
Date: 2024
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