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

Abstract

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.