Fiscal Policy and Macroeconomic Stability in Mediterranean Countries

This chapter reviews fiscal developments and policy issues in Mediterranean countries1 and their implications for macroeconomic stability and the conduct of monetary policy. Some references are made to oil-centred economies in the Gulf region that face similar issues to those faced by oil-exporters in the Mediterranean region. Fiscal policy is a crucial factor in determining a country’s overall economic performance via its effects on allocation, stabilisation and distribution, and constitutes a key component of macroeconomic policies alongside monetary and exchange rate policy. There are at least two reasons why fiscal developments are of great relevance from the perspective of monetary policy. 1) Governments may resort to the central bank for the financing of public deficits rather than borrowing in capital markets and thus fuel inflation. This is more likely the less developed the domestic capital markets, the more severe the impediments and disruptions in accessing international capital markets and the less independent central banks are, and thus appears particularly relevant for developing and emerging market economies. 2) Even in the absence of monetary financing, fiscal policy can have a large impact on the economy via its effects on interest rates, the exchange rate and aggregate demand, as well as on expectations, in particular as regards the sustainability of public debt. Perceptions of the sustainability of fiscal policy can have an impact on financial markets and, if negative, can interfere with the objectives of monetary and exchange rate policy, such as achieving and preserving price stability, financial stability or maintaining an exchange rate peg. In the extreme case, fiscal dominance of monetary policy can lead to a situation in which a central bank is no longer able to use its instruments effectively in order to achieve its objectives.