Debt, Deficits, and Central Bank Independence: A Cross-Country Analysis of the Monetary Transmission Mechanism

Abstract

This paper examines the effects of fiscal policy, in the form of debt and deficits, on the transmission and efficacy of monetary policy. With debt-to-gdp levels forecasted to rise indefinitely in many advanced economies, fiscal and monetary interactions have returned as an area of great concern and focus. I contribute to the recent literature on the topic by analyzing this relationship across countries and by studying the role of central bank independence (CBI), which has been under threat recently as well. In the first part of this paper, I extend the analysis of Laubach (2009) and Plante et al. (2025) to a large group of countries, centered on the time period of 2011-2024. I find that in times of crisis, larger deficits may lower yields under either a recovery or stress regime, a result contrary to prior studies. I also find little to no econometric relationship between these results and CBI, however, I find qualitatively that low CBI may contribute to the classic positive relationship between deficits and yields. In the second part of my paper, I identify monetary policy shocks through a Fiscal FAVAR model, comparing impulse response functions for several advanced economies over the period of 1984-2019 and subsamples. I find that including fiscal information may amplify, dampen, or even overturn impulse responses in different subsamples, and that the Global Financial Crisis has an outsized effect on recent samples. I also find that there is some parameter instability before and after the introduction of CBI, but not enough evidence to pinpoint the casual effect. These results suggest three main implications: the relationship between fiscal policy and yields changes in times of crisis, the interaction between fiscal and monetary policy matters for monetary transmission, and more research is necessary to quantify the role of CBI in such interactions.