Interaction between monetary and fiscal policies
Encyclopedia
Fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

 and monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 are the two tools used by the State to achieve its macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 objectives. While the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. The celebrated IS/LM model
IS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...

 is one of the models used to depict the effect of interaction on aggregate output and interest rates. The fiscal policies have an impact on the goods market and the monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates, the policies interact while influencing the output or the interest rates.

Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals as the two were perceived to aim at mutually inconsistent targets. But in recent years, owing to the transfer of control with respect to monetary policy formulation to Central Banks, formation of monetary unions (like European Monetary Union formed via the Stability and Growth Pact
Stability and Growth Pact
The Stability and Growth Pact is an agreement among the 27 Member states of the European Union that take part in the Eurozone, to facilitate and maintain the stability of the Economic and Monetary Union...

) and attempts being made to form fiscal unions,there has been a significant structural change in the way in which fiscal-monetary policies interact. Also there is a dilemma whether these two policies are complementary or substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one policy maker's expansionary (contractionary) policies are countered by another policy maker's contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements,then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of other.

The issue of interaction and the policies being complement or substitute to each other arises only when the authorities are independent of each other. But when, the goals of one authority is made subservient to that of others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis would arise.Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy is not influenced by the other, there is no direct interaction between them.

Active and passive monetary and fiscal policies

Professor Eric Leeper has defined :
  • Passive fiscal policy is one in which the authority raises or reduces taxes to balance the budget intertemporally.
  • Active fiscal policy is one in which the tax and spending levels are determined independent of intertemporal budget consideration.
  • Active monetary policy is one that pursues its inflation target independent of fiscal policies.
  • Passive monetary policy is one that sets interest rates to accommodate fiscal policies.

In case of an active fiscal policy and a passive monetary policy, the economy faces an expansionary fiscal shock that raises the price levels and money growth as monetary authority is forced to accomodate these shocks.
But in case both the authorites are active, then the expansionary pressures created by the fiscal authority is contained to some extent by the monetary policies.

Supply shock

During a negative supply shock
Supply shock
A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price....

, the fiscal and monetary authorities are seen to follow conflicting policies as the fiscal authoriies would follow expansionary policies to bring the output at its original state while the monetary authorities would follow conractionary policies so as to reduce the inflation created due to shortage in output caused by the supply shock
Supply shock
A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price....

.

Demand shock

During a demand shock
Demand shock
In economics, a demand shock is a sudden event that increases or decreases demand for goods or services temporarily. A positive demand shock increases demand and a negative demand shock decreases demand. Prices of goods and services are affected in both cases. When demand for a good or service...

 (a sudden significant rise or fall in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 due to external factors) without a corresponding change in output that results in inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 or deflation which can also be termed as inflation or a deflation shock, it is observed that the two policies work in harmony. Both the authorities would follow expansionary polcies in case of a negative demand shock in order to bring back the demand at its original state while they would follow contractionary policies during a positive demand shock in order to reduce the excess aggregate demand and bring inflation under control.

Cost push shocks

A cost-push shock is defined as a change in inflation that is not a result of pressures in the economy.. The macroeconomic goal under such a situation is to optimise between reducing inflation and reducing the gap between the actual output and the desired level of output. A contractionary monetary policy under such a scenario raises the real interest rates which in turn not only reduces consumption thereby dampening aggregate demand and inflation but also raises the labour supply as workers are willing to sacrifice current leisure alongwith current consumption. This further dampens the inflation rates. On the other hand, changes in government spending is able to influence aggregate demand alone and hence is less effective in comparison to monetary policy.Moreover a deviation from the given level of government spending has an impact on optimal provision of public goods which then has direct welfare costs.Hence the optimal fiscal policy is to keep the government spending gap (i.e the gap between the actual and the socially desired levels ofgovernment spending) close to zero. Thus,when an economy is hit by a cost push shock and given that the only policy instument in the hand of fiscal authority is public spending (ignoring the impacts of taxes and debt), the monetary policy dominates fiscal policies in reviving the economy.But this holds true only when the economy has zero government debt.

Once government debt becomes positive, then a non zero government spending gap becomes essential to absorb any reprucussions of cost push shocks or monetary policy responses.This is because the rise in real interest rates raises the cost of debt which then requires the fiscal auhority to deviate from its natural rate of public spending so as to nullify the impact of increasing interest rates.

Fiscal shock and policy rate shock

In case of a positive fiscal shock i.e increase in fiscal deficits, the aggregate output rises beyond the potential output thus raising the aggregate demand. Subsequently, this leads to dissavings and loweing of investments which further depresses output in the long run. Monetary authorities react in a countercyclical way to this and in the long run adopts quantitative easing to counter the fall in output caused due to fiscal expansion.
In case of policy shocks, caused by a sudden positive (negative) changes in policy rates such as statutory liquidity ratio
Statutory Liquidity Ratio
Statutory liquidity ratio is the amount of liquid assets, such as cash, precious metals or other approved securities, that a financial institution must maintain as reserves other than the cash with the Central Bank...

, cash reserve ratio or the repo rates, the fiscal authority initially reacts by following expansionary (contractionary) policy subsequently narrows down (expands up)

Presence of monetary union

When an economy is a part of a monetary union, its monetary authority is no longer able to conduct its monetary policies independently as per the requirements of the economy. Under such situation the interaction between fiscal and monetary policies undergo certain changes.
Generally, the monetary union follows policies to keep the overall inflation at such levels so as to keep the overall gap between the actual aggregate consumption and desired consumption close to zero. Fiscal polices are then used to minimise the country specific welfare losses arising out of such policies. Also, fiscal policies are used to stablilise the terms of trade
Terms of trade
In international economics and international trade, terms of trade or TOT is /. In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports...

 and maintain them at their natual levels.
Given the common monetary policies and the price levels for all the nations under the union, the fiscal authority of the home country is led to follow contractionary polcies in case of deterioration in terms of trade
Terms of trade
In international economics and international trade, terms of trade or TOT is /. In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports...

.

Effect of price rigidities

In case of a supply shock
Supply shock
A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price....

,while the weighted average inflation is at optimum levels,the inflation levles of the nations hit by such a shock is far from optimum. In such a scenario, given that the degree of price rigidities in all the nations are equal, then the fiscal polcies would achieve the dual goal of attaining optimum public spending and maintaining the natural levels of terms of trade only when the shocks hitting the nations under the union are perfectly correlated else either of the objective is achieved at the cost of other as moneatary policies fail to influence the terms of trade owing to equality of the degree of price rigidities amongst the nations.

But in case of varying degrees of price rigidities amongst the nations, terms of trade is no longer insulated from monetary policies. This is so because, the monetary policies would be directed towards keeping the inflation of the nations with higher degree of price rigidities at optimum levels so as to reduce their terms of trade losses and the fiscal policies of the rest of the countries would assume a relatively effective role in stabilising the national inflation as the price levels would respond to the change in public spendings. In short, lower the degree of price rigidities in an economy belonging to a monetary union, greater would be the relative role of fiscal policies in economic stabilisation and vice versa.

Fiscal monetary Interaction in European Monetary Union

The European Central Bank was created in December 1998 and from 1999 onwards the euro became the official currency of the member nations of the European Monetary Union and a single monetary policy was adopted under the European Central Bank. To ensure that the member nations meet the optimum currency area
Optimum currency area
In economics, an optimum currency area , also known as an optimal currency region , is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. It describes the optimal characteristics for the merger of currencies or the creation of a...

, potential member nations were asked to commit to the below-mentioned convergence criteria
Convergence criteria
The euro convergence criteria are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union and adopt the euro as their currency...

 as spelled out in the Maastricht Treaty:
  • Central Bank independence
  • A stability-oriented monetary policy with the primary objective of maintaining price stability
  • Obligations of the member states to treat the economic policies, in particular, fiscal policies as a matter of common concern.

In addition to the above requirements, members were to maitain exchange rates within specific band and bring inflation, long term interest rates and budget deficits to levels specified in the Treaty. Meeting these criteria forced the member nations to restrict the adoption of stabilising fiscal policies and concentrate of inflation raes to bring them down to the levels spelled out in the Treaty. This led to change in the structure of monetary fiscal interaction in the member nations.

Further reading

  • "The Interaction of Fiscal and Monetary Policies: Some Evidences using Structural Econometric Models" by Anton Muscatelli
    Anton Muscatelli
    Professor Vito Antonio "Anton" Muscatelli FRSA FRSE AcSS is the Principal of the University of Glasgow and one of the United Kingdom's leading economists.-Early life:...

     et al
  • "Stabilising Output and Inflation in EMU: Policy Conflicts and Cooperation under the Stability Pact" by Buti Marco and Roeger W.
  • Macroeconomics by N. Gregory Mankiw
    N. Gregory Mankiw
    Nicholas Gregory "Greg" Mankiw is an American macroeconomist and Professor of Economics at Harvard University. Mankiw is known in academia for his work on New Keynesian economics....

     7th Edition, Worth Publishers, Harvard University
  • "Monetary and Fiscal Policy Interactions in a Microfounded Model of a Monetary Union" by Roel M.W.J.Beetsma and Henrik Jensen (2002): European Central Bank
    European Central Bank
    The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

     Working Paper No. 166
  • "Monetary and Fiscal Policy Interaction : The Current Consensus Assignment in the light of Recent Developments" by Tatiana Kirsanova et al.
  • Macroeconomics by Rudi Dornbusch
    Rudi Dornbusch
    Rüdiger "Rudi" Dornbusch was a German economist who worked for most of his career in the United States.-Biography:...

     and Clarence Stanley Fisher
    Clarence Stanley Fisher
    Clarence Stanley Fisher was an American archaeologist.Born in Philadelphia, Pennsylvania, C. S. Fisher was a graduate of the school of architecture, University of Pennsylvania, but devoted his subsequent career to Near Eastern archaeology...

  • "An Empirical Analysis of Monetary and Fiscal Policy Interaction in India" Janak Raj, J. K. Khundrakpam & Dipika Das, Reserve Bank of India
  • "Monetary and Fiscal Policy Interaction : The Consequences of Joining a Monetary Union" by Jason Jones.

External links


See also

  • Fiscal policy
    Fiscal policy
    In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

  • Monetary policy
    Monetary policy
    Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

  • Expansionary monetary policy
    Expansionary monetary policy
    In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth. In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply...

  • Expansionary fiscal policy
  • Contractionary monetary policy
    Contractionary monetary policy
    Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry....

  • Contractionary fiscal policy
  • Currency union
    Currency union
    A currency union is where two or more states share the same currency, though without there necessarily having any further integration such as an Economic and Monetary Union, which has in addition a customs union and a single market.There are three types of currency unions:#Informal - unilateral...

  • Sticky prices
  • Intertemporal choice
    Intertemporal choice
    Intertemporal choice is the study of the relative value people assign to two or more payoffs at different points in time. Most choices require decision-makers to trade-off costs and benefits at different points in time. These decisions maybe about savings, work effort, education, nutrition,...

  • Reserve requirement
    Reserve requirement
    The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

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