Monetary financing and fiscal discipline

Abstract

Rules governing monetary state financing vary across jurisdictions. The mainstream rationale for bans of state financing rests on the empirical assumption that monetary financing undermines fiscal discipline. We address the plausibility of this assumption by estimating local projection models for a panel of euro area countries to explore the reaction of the sovereigns’ fiscal position to a monetary policy shock. Our results suggest that fiscal discipline is not waning after an expansionary monetary policy innovation that can be related to non-standard policy interventions, as expressed through an improvement of the primary balance despite declining borrowing costs. While no compelling inferences can be made as to the driving force of this improvement – political pressure channeled through conditionality may be a plausible explanation – our results suggest that empirical claims on the adverse effect of unconventional monetary policy on fiscal discipline are ill-founded.