We empirically show that a central bank’s ability to affect global energy prices crucially alters monetary policy transmission. We first provide novel evidence that euro area monetary policy significantly affects energy prices. Employing a Lucas critique-robust counterfactual framework, we find that this ability strengthens and accelerates transmission to inflation and substantially alleviates the inflation-output trade-off. We further show that this ability materially shapes the mandate-optimal policy response to an energy supply shock: the optimal response implies a smaller interest rate increase and a more favorable inflation-output allocation than in a scenario where energy prices are unaffected by monetary policy.

In business-cycle models the effects of monetary policy depend on the fiscal reaction to interest rate changes. This paper investigates the fiscal reaction by presenting new evidence on the effects of U.S. monetary policy on fiscal policy instruments. Subsequently, it estimates a Heterogeneous Agent New Keynesian model with flexible fiscal feedback rules to match and interpret the empirical results. I find that U.S. fiscal policy responds to monetary-induced output contractions with debt-financed, countercyclical tax and transfer policies, amid a gradual decline in spending to accommodate the debt increase. The model implies that monetary policy unopposed by a business-cycle stabilization motive of fiscal policy would be roughly one-third more contractionary. As a result, the fiscal channel renders the effects of monetary policy state-dependent on the fiscal capacity for stabilization policy.