How Would A Fiscal Policy Rule That Incorporates A Debt-to-GDP Ratio Feedback Mechanism, Similar To The One Implemented In Sweden, Affect The Transmission Of Monetary Policy Shocks To The Real Economy In A Small Open Economy With A High Level Of Public Debt, Such As Portugal?

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Implementing a fiscal policy rule that incorporates a debt-to-GDP ratio feedback mechanism in a high-debt, small open economy like Portugal would have a dual impact on the transmission of monetary policy shocks, balancing both stabilizing and constraining effects. Here's a structured analysis:

Stabilizing Effects:

  1. Enhanced Credibility and Investor Confidence: A credible fiscal rule, akin to Sweden's, can improve investor confidence, reducing borrowing costs and enhancing monetary policy effectiveness. Lower long-term interest rates stimulate investment and consumption, supporting the economy during shocks.

  2. Predictable Policy Environment: By providing a stable fiscal backdrop, the rule allows monetary policy to operate more effectively, as households and businesses can make decisions with greater certainty about future fiscal conditions.

  3. Exchange Rate Stability: A credible rule might lead to a more stable exchange rate, reducing volatility and enhancing the transmission of monetary policy through trade and price channels.

  4. Interest Rate Channel: A sustainable debt path can lower long-term interest rates, making monetary policy more effective in stimulating the economy through reduced borrowing costs.

Constraining Effects:

  1. Reduced Fiscal Space: In a high-debt scenario, the government might have limited ability to implement fiscal stimulus, relying more on monetary policy, which could be constrained in a monetary union like the Eurozone.

  2. Potential for Pro-cyclical Policies: A rigid fiscal rule might force austerity during downturns, deepening recessions and reducing the effectiveness of expansionary monetary policy.

  3. Interaction with Automatic Stabilizers: If the rule limits the use of automatic stabilizers, it could reduce fiscal policy's ability to cushion the economy, potentially muting the impact of monetary policy.

  4. Policy Mix Dynamics: While a rule-based fiscal policy can complement monetary policy, it might also lead to situations where fiscal and monetary policies work at cross-purposes, especially if the rule is too strict.

Conclusion:

The implementation of a debt-to-GDP feedback mechanism in Portugal's fiscal policy could enhance the effectiveness of monetary policy through increased credibility and stability. However, it also poses risks of reduced fiscal flexibility and potential pro-cyclical outcomes. The balance depends on the rule's design, particularly its flexibility to accommodate economic shocks while maintaining long-term debt sustainability.