Abstract
The euro area recently experienced a prolonged period of weak economic activity and very low inflation. This paper reviews models of business cycle stabilization with an eye to formulating lessons for policy in the euro area. According to standard models, after a large recessionary shock accommodative monetary and fiscal policy together may be necessary to stabilize economic activity and inflation. The paper describes practical ways for the euro area to be able to implement an effective monetary-fiscal policy mix.
Highlights
Standard macroeconomic models explain why fluctuations in aggregate economic activity can be excessive and suggest that appropriate stabilization policy can dampen the undesirable variability.The member states of the euro have been experiencing a prolonged period of weak economic activity and very low inflation
The euro area has been going through a prolonged period of weak economic activity and very low inflation
Standard models and the recent experience of a number of advanced economies suggest that monetary policy alone may fail to stabilize economic activity and inflation satisfactorily due to the lower bound on nominal interest rates
Summary
The euro area has been going through a prolonged period of weak economic activity and very low inflation. Unconventional monetary policy, while helpful, may turn out to be indecisive, especially if long-term interest rates are low to begin with and financial markets are undisrupted Another takeaway is that at a time when the central bank’s policy rates are at or close to their lower bound, one can expect accommodative fiscal policy to have sizable effects. A policy mix consisting of the ECB keeping its interest rates low and expanding the monetary base in order to purchase national public debt – as implemented in the Public Sector Purchase Program – together with fiscal accommodation by the member states would have had sizable effects on the economy and remains a sensible short-term option. In the paper we explain why the institutional structure including the fund, outlined here, appears preferable in the medium and long run
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