Interaction between monetary and fiscal policies

Fiscal policy and monetary policy are The Two tools used by the State to achieve its macroeconomic 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 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) and attempts being made to form fiscal unions,there has been a significant structural change in the way in which fiscal-monetary policies interact.

There is a dilemma as to whether these two policies are complementary, or act as 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 accommodate these shocks. But in case both the authorities 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, the fiscal and monetary authorities are seen to follow conflicting policies as the fiscal authorities would follow expansionary policies to bring the output at its original state while the monetary authorities would follow contractionary policies so as to reduce the inflation created due to shortage in output caused by the supply shock.

Demand shock

During a demand shock (a sudden significant rise or fall in aggregate demand due to external factors) without a corresponding change in output that results in inflation 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 policies 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 along with 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 of government spending) close to zero. Thus, when an economy is hit by a cost push shock and given that the only policy instrument 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 repercussions 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 authority 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 lowering 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, 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 stabilise the terms of trade and maintain them at their natural 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 policies in case of deterioration in terms of trade.

Effect of price rigidities

In case of a supply shock,while the weighted average inflation is at optimum levels,the inflation levels 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 policies 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 monetary 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, potential member nations were asked to commit to the below-mentioned convergence criteria 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 maintain 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 races 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.

See also

  • Fiscal policy
  • Monetary policy
  • Expansionary monetary policy
  • Expansionary fiscal policy
  • Contractionary monetary policy
  • Contractionary fiscal policy
  • Currency union
  • Sticky prices
  • Intertemporal choice
  • Reserve requirement

Further reading

  • "The Interaction of Fiscal and Monetary Policies: Some Evidences using Structural Econometric Models" by Anton Muscatelli 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 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 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 and Stanley Fischer
  • "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.

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