Monetary policy under fiscal stress: A forward-looking analysis of fiscal dominance
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Date
2025-12
Publication Type
Journal Article
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yes
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Abstract
Subdued economic activity and low tax revenues, especially during crises, drive borrowing and increase public debt. Central banks may face pressure to deviate from policy targets during these periods to ease the debt burden. 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 countries over three 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-GDP 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 202223, interest rate responses to fiscal imbalances have strengthened, posing challenges for future policy.
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published
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Journal / series
Volume
86
Pages / Article No.
103701
Publisher
Elsevier
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Edition / version
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Date collected
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Subject
Fiscal dominance; Monetary policy; Taylor rule; Consensus forecasts