Fiscal sustainability and its implications for monetary policy

• Applicant: Professor Dr. Olaf Posch
• Subject Area: Economic Theory ; Economic Policy, Applied Economics
• Term: since 2020
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 446166239

Fiscal sustainability is one of the most important macroeconomic issues of our time. This topic has recently become even more prominent due to the rapid increase in public debt in the wake of the COVID-19 pandemic. In this context, the explosion in debt ratios is primarily due to the implementation of government bailout programs and stimulus packages of unprecedented magnitude. Current research is still in the process of understanding and classifying the COVID-19 pandemic from a variety of perspectives. Ultimately, the success of an economic theory is measured by how well it can conceptualize, map, and explain economic development. The New Keynesian (NK) modelling framework is one of the most important and widely used approaches to study business cycles as well as monetary and fiscal policy. However, the simple NK model framework has significant weaknesses when studying debt ratios and the impact of sustainable fiscal policy. This is mainly because debt and fiscal policy are basically irrelevant for model dynamics and model forecasts. With reference to the open questions and points of criticism, we want to develop solutions in this project. The FTPL-NK reference model developed during the first funding phase shows that the consequences of large-scale stimulus packages and high debt ratios can be explained consistently with empirical developments. The consideration of risk premiums opens up the possibility of gaining new insights into transmission channels of sustainable fiscal policy, estimating parameters and comparing model forecasts with empirical data. In particular, we want to investigate the influence on the design of monetary policy and develop new strategies to manage or even avoid debt crises. The period between the financial crisis and the COVID-19 pandemic was characterized by a sustained period of low real interest rates and high economic growth in most developed economies. This raises the question of whether debt has fiscal costs in this situation, what this means for monetary policy, and to what extent maintaining sustainability requires that high debt ratios be ultimately reduced through higher taxes or lower spending. Sustainability is an omnipresent challenge for any country, regardless of its level of development. Especially in small economies, which cannot pursue a completely independent monetary policy due to fixed exchange rates, fiscal policy instruments take on an integral importance. However, this can also be limited by the preservation of sustainability. Against this background, we want to examine the influence on the design of monetary policy and develop new economic policy strategies in a way that leaves the greatest possible room for maneuver for coping with future debt and currency crises and are optimal from a welfare economics perspective.

• DFG Programme: Research Grants