European Central Bank can bring inflation down faster if governments move along

he European Central Bank can bring inflation down faster with an interest rate hike if governments move in the same direction in their fiscal policy. This is according to a study by economist and junior lecturer Roben Kloosterman and senior lecturer in Monetary and Financial Policy Koen van der Veer. In collaboration with Dennis Bonam of De Nederlandsche Bank (DNB), they investigated how effective the instrument of raising interest rates is at lowering inflation and what influence simultaneous government revenue and expenditure have on this.

The results show that inflation falls more sharply when governments implement spending cuts or tax increases when interest rates are raised than when they take measures that actually stimulate the economy. In the latter case, the central bank will have to keep interest rates high for longer to maintain inflation, which can be detrimental to the economy. Thus, in the event of a recession, unemployment may rise, house prices fall and people may have less to spend for a long time. Similar policies by both central banks and governments on the amount of money in the economy could prevent these negative consequences.

Targeted subsidy programmes

Roben Kloosterman: 'Central bank and government policies are often out of sync. Even now we see the central bank raising interest rates to reduce consumption, while the government is spending money to restore purchasing power for consumers. And if the government continues to stimulate on balance, the European Central Bank will have to keep interest rates higher for longer. It will eventually be effective, but the cost to the economy is greater this way. For inflation to fall quickly, it is therefore important that the government both moves with the central bank and sets up targeted subsidy programmes to protect only the most vulnerable households from high inflation. Then working together can be very effective.'

DNB recently published its semi-annual estimates for the Dutch economy and discussed this with, among others, Prime Minister Rutte and Minister Kaag. The findings from this research were included in this. The survey results underline the importance of engaging with European governments on effective fiscal policy in relation to central bank policy.

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