profitability and competitiveness and leads to stronger internal and external demand. The budgetary
improvement is somewhat stronger than in the preceding cases. This is because of lower unemployment. In
conjunction with the effect of lower interest rates on the budget, also the debt/GDP ratio declines
somewhat.
A stronger role for monetary policy
44. The simulations show the positive medium-term effects of the reforms on the government budget,
with the gains being larger in the simulations that show a stronger improvement in the primary budget
balance. However, the effects on indebtedness are minor, because of the deceleration in inflation induced
by the reforms. A more accommodating monetary policy would contribute to improve the budgetary results
further. The central role of monetary policy in accompanying the reforms is shown by simulations that
again reduce the structural unemployment rate, but now under alternative monetary policy assumptions.
The first assumes that real interest rates decline as well as the exchange rate, while the other assumes that
nominal interest rates and exchange rates stay at the baseline level.
45. The simulation shown in Figure 7 suggests that an easier monetary policy would stimulate
demand considerably. It is assumed that real interest rates are about 100 basis points below the baseline
level on average over the simulation period, while the euro is assumed to decline by 5% in real effective
terms.6 The effects on external and internal demand would push the output gap above the baseline level,
which would limit the deceleration of inflation. The budgetary improvement would be considerably
stronger, in terms of deficits and of debt developments. Concerning the latter, the impact of the
improvement in the primary deficit of lower interest rates is not offset by the disinflationary effect and the
debt/GDP ratio would decline by 10 percentage points with respect to the deadline at the end of the
simulation period.
46. If, on the other hand, nominal interest rates and exchange rates are kept at their baseline values,
the higher real interest rates dampen demand considerably and the output gap remains larger than in the
baseline scenario throughout the simulation period (Figure 7). With activity weaker and unemployment
higher, the improvement in the primary deficit is much slower to come and offset by higher interest
payments, while nominal GDP rises by less because of lower inflation. The debt/GDP ratio deteriorates
considerably as the snow-ball effect is reinforced by lower inflation.
6. In this simulation the exchange rate adjustments are assumed to respond to both inflation and interest rates developments. On the one hand,
exchange rate purchasing power parity rule is supposed to apply in the long term, implying stable real effective exchanges rates. On the other
hand, the lower real interest rates in the euro area induce a weakening a real depreciation of the euro exchange rate at least in a transitory period.
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