Does monetary policy influence euro area fiscal sustainability?

This paper studies the impact of monetary policy on fiscal sustainability in the euro area. We extend a standard fiscal reaction function by introducing a monetary policy stance variable as an interaction term, allowing us to assess how monetary policy influenced fiscal dynamics. Our study yields two main findings. First, an expansionary monetary policy stance in response to rising debt-to-GDP levels is associated with lower primary balance changes, potentially supporting fiscal sustainability in the short term. Second, when considering exogenous monetary policy shocks, a monetary tightening significantly deteriorates primary balances, potentially straining fiscal sustainability. These results highlight the importance of monetary-fiscal interactions for fiscal sustainability in the euro area. • This paper studies the effects of the ECB’s monetary policy on fiscal sustainability in the euro area. • An expansionary monetary policy stance, following an increase in debt-to-GDP, leads to lower primary balances. • An exogenous monetary policy tightening significantly deteriorates the primary balance. • Periphery countries’ primary balances are more reactive to monetary policy shocks. • Expansionary monetary policy can reduce the fiscal effort needed to achieve fiscal sustainability.