Euro Area Monetary and Fiscal Dominance: The Cases of France and Italy

In most Euro Area countries, fiscal and inflation dynamics arise from the history of recurrent monetary and fiscal dominance regimes. We consider France and Italy as illustrative cases for revising price and debt relationship (1955-2019 and 1950-2019, respectively) and estimate a Dynamic Stochastic General Equilibrium model where monetary/fiscal policy regimes emerge owing to Markov-switching policy rules. We find that fiscal dominance prevailed until the late 80s/early 90s, before switching to monetary dominance driven by central bank independence, fiscal backing and EMU convergence. The effective lower bound combined with a contemporaneous switch into fiscal easing in France, shared by Italy only after consolidating finances under Monti’s government. Simulations for France explain price volatility and debt stabilisation under fiscal dominance, deflation and explosive debt paths under monetary dominance. In Italy, a procyclical fiscal policy in downturns due to limited fiscal space explains the increasing and persisting imbalances, high aggregate volatility and low growth.