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Monetary Policy Under Fiscal Stress: A Forward-Looking Analysis of Fiscal Dominance

Author

Listed:
  • Donna Faye Bajaro

    (Asian Development Bank)

  • Jaqueson Galimberti

    (Asian Development Bank)

  • Irfan Qureshi

    (Asian Development Bank)

Abstract

Subdued economic activity and low tax revenues, especially during crises, drive borrowing and increase public debt. During these periods, to ease the debt burden, central banks may face pressure to deviate from policy targets. Under fiscal dominance, debt sustainability relies on low interest rates and high inflation rather than consolidation. This paper empirically tests the presence of fiscal dominance using forward-looking Taylor rules and data from 52 economies over 3 decades. The results detect fiscal dominance, with stronger effects in de jure inflation-targeting emerging economies with low central bank independence, especially those without debt rules and with high debt-to-gross domestic product ratios. Emerging economies with high foreign currency-denominated debt are further affected by exchange rate debt valuation effects, and fiscal dominance leads their central banks to follow exchange rate stabilization policies. Since 2022–2023, interest rate responses to fiscal imbalances have strengthened, posing challenges for future policy.

Suggested Citation

  • Donna Faye Bajaro & Jaqueson Galimberti & Irfan Qureshi, 2025. "Monetary Policy Under Fiscal Stress: A Forward-Looking Analysis of Fiscal Dominance," ADB Economics Working Paper Series 797, Asian Development Bank.
    • Handle: RePEc:ris:adbewp:021496
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    Keywords

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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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