Inflationary oil shocks, fiscal policy, and debt dynamics: New evidence from oil-importing OECD economies

Abstract

Appropriate fiscal and monetary policies are essential for mitigating the surging inflation caused by post-Covid 19 commodity price shocks, whilst minimizing real output losses. Considerable attention, however, has focused on the implications for monetary policy but somewhat neglected the fiscal dimension. By estimating Proxy-VARs we study the impact of inflationary oil supply and demand shocks on the dynamics of the fiscal balance and public debt in seven oil-importing OECD economies and the Eurozone bloc. The results indicate that fiscal balances actually increase in the medium-term following an inflationary oil shock, and public debt-to-GDP ratios fall. A key implication is that policy makers have more fiscal space than typically assumed, and will run the risk of an excessively contractionary macroeconomic policy stance if they do not account for this increase in the fiscal balance following inflationary oil shocks.