Taming supply-driven inflation: Why smart monetary–fiscal responses matter

Abstract
The recent euro area inflation surge uncovered the trade-offs facing policymakers following supply-driven shocks. In this Policy Brief we summarize the findings in Campos et al. (2025) which shows that, in face of an inflationary shock, an appropriate mix of monetary and fiscal policies may be needed to ensure a swift return of inflation to target while mitigating the real impact. Monetary tightening is more effective at restoring price stability but deepens the output contraction and worsens public debt dynamics, especially in high-debt countries. Fiscal policy can cushion the downturn, but, depending on the composition of the fiscal support, the ultimate impact on inflation and debt dynamics varies greatly. Broad-based measures risk fuelling inflation and excessively strain public finances, whereas targeted transfers or higher government investment support the economy without prompting additional monetary tightening and with milder fiscal costs.

Inflation shocks require an appropriate mix of responses from monetary and fiscal authorities

When inflation surges due to a global cost-push shock – such as those driven by energy disruptions, supply bottlenecks, or geopolitical tensions – policymaking faces a dilemma: central banks  must act decisively to prevent inflation from becoming entrenched, but this weighs on the real economy; fiscal authorities may try to smooth activity through automatic stabilisers and discretionary measures to support households and firms while ensuring redistribution and fiscal sustainability. Thus, the goals of the monetary authority and those of national fiscal authorities are not always aligned, and trade-offs can emerge. Recent work exploring this complex interplay in the context of the 2021-2022 inflation surge in the euro area include Bonam et al. (2024), Dao et al. (2023) and Motyovszki (2023).

In Campos et al. (2025), we add to the existing literature by simulating a worldwide supply shock that drives consumer price inflation up, prompting an interest rate response by the monetary authority. Economic activity significantly falls while the public debt-to-GDP ratio gradually increases. Following this shock, we first analyse the different effects of alternative monetary policy responses and, second, we study how outcomes differ depending on the design of the fiscal policy response and on the level of government debt (low- vs. high-debt countries).

The analysis is conducted through the lens of a version of the EAGLE (Euro Area and Global Economy) model (Gomes et al., 2012) that includes an enhanced fiscal block allowing for a richer set of fiscal policy instruments. The model splits the euro area into three blocs – a high public debt bloc, a low-debt bloc, and the rest of the euro area. We show that, in face of an inflationary shock, the effectiveness of monetary and fiscal policies critically depends on the decisions taken by each other. In isolation, decisions on each front have benefits and costs that, in combination, can either reinforce or undermine one another.

Monetary policy tightening pushes down inflation, but there is a catch for the real economy

Figure 1 shows that a decisive rise in interest rates is most successful in taming inflation. However, output declines more sharply than in a scenario with delayed and lighter tightening. Higher interest rates increase debt-servicing costs while recessionary dynamics erode tax revenues, thereby raising the public debt-to-GDP ratio and reducing governments’ leeway to support vulnerable agents, exactly when such support is needed the most.

This interplay underscores the trade-offs emerging when monetary policy is required to tighten to tackle supply-driven inflation. The trade-off is starker in high-debt countries, as the snowball effect of aggressive monetary tightening implies a stronger increase in the debt-to-GDP ratio and hence further restricts the fiscal space. The trade-off is weaker when price changes are more frequent, which is typically the case after larger inflationary shocks, highlighting the presence of possible nonlinearities. This would likely call for a stronger monetary tightening to minimise risks of inflation becoming entrenched through higher inflation expectations.

Figure 1. Macroeconomic impact of a worldwide supply shock under alternative monetary policy responses

Fiscal policy: composition matters

Fiscal authorities have several instruments that can be used to cushion the effects of inflation and recession on households and firms, each with different implications for the interplay between fiscal and monetary policies. We compare three possible fiscal measures:

1. Consumption tax cuts – such as lowering VAT or excise duties. These bring prices down immediately, but their effect is short lived. Once the measure unwinds there is the opposite effect on inflation. Moreover, such broad-based measures put unnecessary strain on public revenues as they benefit all agents, including those who least need it.
2. Transfers to households and firms, which are effective in stabilizing real incomes but boost demand and can fuel inflation, especially if broad-based. The likelihood of creating upward price pressure is lower in the case of transfers targeting more vulnerable agents, in which case the fiscal costs are also more contained.
3. Increases in public investment have positive effects on activity but also imply higher inflation in the short-term. However, if it expands productive capacity in the medium-run, higher investment exerts negative pressure on inflation, allowing for a quicker reversal of monetary tightening, as interest rates decline rapidly in this case.

Figure 2 highlights that fiscal policy can cushion the economic fallout but has an overall limited direct contribution for the disinflationary process. However, it also shows that, because different fiscal measures yield different impacts on inflation, the design and composition of the fiscal support have important implications for the response required from the monetary authority, ultimately shaping how the inflationary episode unfolds.

Out of the fiscal measures we analyse, targeted transfers directed to low-income or liquidity-constrained agents offer the most balanced results. Moreover, because the implied fiscal costs are comparatively milder, targeted measures are also less detrimental for debt sustainability, which is particularly relevant when necessary monetary tightening puts upward pressure on interest payments.

Promoting productive government investment also stands out as a balanced alternative. It mitigates the short-term fallout in aggregate demand, inducing a stronger initial response by the monetary authority. However, inflation drops faster than in other scenarios allowing for a quicker unwinding of monetary tightening. Together with a favourable denominator effect, this results in a milder increase in the debt-to-GDP ratio.

Figure 2. Macroeconomic impact of a worldwide supply shock under different fiscal policy measures

Conclusion: an appropriate policy mix is key

Monetary and fiscal policies interact though different channels. Whereas in a low inflation and low interest rate environment they may naturally align, in a high inflation environment new challenges may arise, in particular when shocks generate a trade-off between stabilising inflation and economic activity. Our simulation exercises illustrate several policy-relevant results:

1. In face of a cost-push inflation surge, monetary policy may need to tighten enough to re-establish price stability, which contributes to anchor expectations, but implies short-term costs on economy activity.

1. Temporary and targeted fiscal support cushions the economic fallout – particularly as regards vulnerable households and firms – without undermining the central bank’s disinflationary efforts. Productive public investments may also do so.
2. Debt sustainability must remain in focus. An appropriate policy mix can limit the increase in the debt-to-GDP ratio during monetary tightening, but high-debt countries remain particularly vulnerable to shocks.

Not all inflation surges are alike, and policy responses must be tailored accordingly. When inflation is driven by supply-side disturbances, balancing price and output stabilisation with fiscal sustainability may be achieved through an appropriate mix of a monetary policy stance that credibly restores price stability and fiscal measures that directly support vulnerable agents and productive public investment.