Inflation and Fiscal Policy: Is There a Threshold Effect in the Fiscal Reaction Function?

Clémence Briodeau; Cristina Checherita-Westphal

doi:10.1515/ev-2024-0048

Article

Inflation and Fiscal Policy: Is There a Threshold Effect in the Fiscal Reaction Function?

Clémence Briodeau and Cristina Checherita-Westphal

Published/Copyright: August 15, 2024

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From the journal The Economists’ Voice Volume 21 Issue 2

Abstract

The euro area, like other advanced economies, faced high inflation over the past years. We analyse empirically the impact of inflation on public finances in the euro area, focusing on the question of whether at such high levels, inflation could have a different impact on the primary budget balance. To this end, we estimate a fiscal reaction function for euro area countries and find evidence of non-linear short-term effects of HICP inflation on the primary balance. Over the period 1999–2022, we unveil an inverse U-turn relationship and an inflation turning point – beyond which its short-term (contemporaneous) impact on the primary balance starts being negative. These results reflect primarily the most recent high inflation episode and indicate that in such conditions inflation can be costly for public finance flows even in the shorter run.

Keywords: fiscal reaction function; inflation; euro area; panel models

JEL Classification: H60; E62; E31; C33

Corresponding author: Cristina Checherita-Westphal, DG Economics, Fiscal Policies Division, European Central Bank, Frankfurt am Main, Germany, E-mail: Cristina.Checherita-Westphal@ecb.europa.eu

This article is a shortened version of Briodeau and Checherita-Westphal (2023), ECB Working Paper no. 2880. The views expressed herein are those of the authors and do not necessarily reflect those of the European Central Bank (ECB). We are very grateful for useful suggestions to two anonymous reviewers before publication of the manuscript in the ECB Working papers’ series, as well as to our discussants, Luca Marchiori and Paolo Guarda, and other participants to the WGPF Public Finance Workshop, Luxembourg, June 27, 2023. All remaining errors and omissions are solely our responsibility.

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Received: 2024-07-31

Accepted: 2024-08-01

Published Online: 2024-08-15

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https://doi.org/10.1515/ev-2024-0048

Keywords for this article

fiscal reaction function; inflation; euro area; panel models