Can Fiscal Consolidation help Central Banks Fight Inflation?

This paper argues case that a tighter fiscal policy stance can meaningfully support central banks in fighting inflation in both advanced and emerging market economies. While the standard textbook result suggest that monetary policy is much more effective than fiscal policy in battling inflation in open economies due to the exchange rate channel, we show that a tighter fiscal stance is notably more effective in the current situation. This is so because when many countries currently need to tighten the policy stance simultaneously, the exchange rate channel does not provide monetary policy with an edge over fiscal policy. We also show that fiscal consolidation can be helpful in small open emerging markets and developing economies by reaffirming their commitment to price stability, and by putting the fiscal house in order which reduces risk premiums and strengthens the currency. Furthermore, we show that spillovers from major economies can be more adverse from tighter monetary policy. By applying a two-agent New Keynesian modeling framework with unconstrained and hand-to-mouth households, we show that any adverse effects of tighter fiscal policy (relative to tighter monetary policy) on consumption inequality can be handled with a combination of general spending cuts and targeted transfers to vulnerable households.