Monetary policy surprise shocks under different fiscal regimes: A panel analysis of the Euro Area

We examine the impact of surprise shocks on real output and price levels, conditioned on different fiscal stances, using quarterly data from 2001Q4 to 2021Q4 for 19 Euro Area countries. Employing local projection methods, we find that the influence of monetary shocks depends on each country’s fiscal position. Specifically, while high debt amplifies monetary policy’s contractionary effect on output, the “Ricardian" nature of fiscal policy plays a pivotal role in price responses. Notably, in the high-debt and low-sustainability regime, we observe “fiscal inflation" where monetary tightening raises prices instead of containing them. Consistent with the Fiscal Theory of Price Level, this occurs when agents anticipate insufficient fiscal adjustments to offset the debt burden, creating inflationary pressures. Our study introduces a novel approach by integrating Bohn’s fiscal reaction function within a time-varying framework and analyzing interactions between fiscal stances and monetary shocks in the Euro Area. These findings carry significant policy implications, suggesting monetary authorities should consider fiscal conditions when implementing policy measures.