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Interaction between monetary and fiscal policies - Wikipedia, the free encyclopedia

Interaction between monetary and fiscal policies

From Wikipedia, the free encyclopedia

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.

Contents
1 Active and passive monetary and fiscal policies
2 Supply shock
3 Demand shock
4 Cost push shocks
5 Fiscal shock and policy rate shock
6 Presence of monetary union
6.1 Effect of price rigidities
7 Fiscal monetary Interaction in European Monetary Union
8 See also
9 Footnotes
10 Further reading
11 External links

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11 External links

Active and passive monetary and fiscal policies

Professor Eric Leeper has defined:[1]
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.[2] 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.

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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.

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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.[3]
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

Footnotes
1. ^ Leeper, Eric M. 1991. "Equilibria under active and passive monetary and scal policies". Journal of Monetary
Economics, 27, 12947
2. ^ "How does the exchange rate react to a costpush shock?" (http://www.norgesbank.no/upload/import/publikasjoner/skriftserie/skriftserie-32/roisland.pdf) istein Risland and Tommy Sveen,
Norges Bank
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3. ^ "Monetary and fiscal policy interactions during the financial crisis"

(http://www.ecb.int/press/key/date/2010/html/sp100226.en.html) Speech by Jos Manuel Gonzlez-Pramo,
Member of the Executive Board of the ECB. Madrid, 26 February 2010

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"
(http://www.rbi.org.in/scripts/PublicationsView.aspx?id=13841) 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
"Coordination without explicit cooperation: monetary-fiscal interactions in an era of demographic change"
(http://ec.europa.eu/economy_finance/publications/publication12107_en.pdf) Andrew Hughes Hallett,
European Commission
"Fiscal and Monetary Interaction"
(http://www.unc.edu/depts/europe/euroeconomics/Fiscal%20Monetary%20Interaction.php) Euro
Economics, Center for European Studies at the University of North Carolina.
"Analyzing the Interaction of Monetary and Fiscal Policy: Does Fiscal Policy Play a Valuable Role in
Stabilisation?" (http://dipeco.economia.unimib.it/persone/tirelli/MuscatelliTirelli.pdf) V. Anton Muscatelli and
Patrizio Tirelli
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