Fiscal and monetary policy interactions in a low interest rate world

BIS Working Papers  |  No 954  | 
22 July 2021



Equilibrium real interest rates have declined significantly over recent decades. As a consequence, the zero lower bound (ZLB) on policy rates has become a more binding constraint for conventional monetary policy. This paper analyses the implications of the ZLB under low equilibrium interest rates for macroeconomic and public debt stability. It zooms in on the role of quantitative easing (QE) as a monetary policy instrument and on the interaction between fiscal rules and monetary policy in a low interest rate world.


We develop a small-scale model of the economy with the aim of studying fiscal-monetary interactions at the ZLB. The model extends previous analysis of robust interest rate policy to account for QE policies, fiscal policy and government debt dynamics. It acknowledges imperfect knowledge of the structure of the economy by incorporating expectations formation based on perpetual learning. The model is used to simulate the implications of the ZLB, QE policy and fiscal rules for macroeconomic and public debt dynamics.


First, we find that a low equilibrium rate of interest gives rise to a frequently binding ZLB constraint and worse macroeconomic outcomes. Fiscal policy has to intervene more aggressively to compensate for less potent monetary policy, leading to higher and more volatile public debt. Second, the systematic use of countercyclical QE by the central bank can mitigate the ZLB constraint, yielding more stable inflation, unemployment and public debt. Third, debt-averse fiscal policy harms economic stability, while a more aggressive countercyclical fiscal policy at the ZLB in combination with QE policy can enhance it. Fourth, combining moderately negative policy rates with QE appears to improve economic stability. Finally, a credible inflation goal anchoring long-run inflation expectations can mitigate the stabilisation costs associated with the ZLB and reduce the need for aggressive QE.


We analyse fiscal and monetary policy interactions when interest rate policy is hampered by the zero lower bound (ZLB) in an environment where expectations are formed with perpetual learning. The ZLB induces a deterioration of economic performance and raises the risk of persistent low ation that can disanchor in ation expectations and lead to debt de ation. Systematic use of quantitative easing (QE) can partially substitute for interest rate easing and, if sufficiently aggressive, can maintain average in ation in line with the central bank's goal. By compressing term premia on longterm interest rates, QE creates fiscal space that facilitates expansionary fiscal policy and reduces debt-de ation risk. The ZLB can be counteracted with less aggressive QE if mildly negative policy rates are feasible, if more countercyclical fiscal policy can be activated, or if the central bank can credibly communicate a clear in ation goal. Timidity in implementing QE and excessively debt-averse fiscal policies are counterproductive.

JEL classification: E52, E58, E62, E63

Keywords: zero lower bound, fiscal policy, debt de ation, quantitative easing, perpetual learning.