Interaction of Monetary and Fiscal Policy

Monetary and fiscal policies are tools used to influence the broader economy. However, the effectiveness of monetary policy on aggregate demand can vary based on the fiscal policy in place and vice versa.

Even though both policies can influence aggregate demand, they work differently and affect its composition in varying ways. They cannot simply replace one another.

Recall that the central bank applies monetary policy to change the cost, demand, and availability of credit. It controls credit through open market operations, bank rates, selective methods of credit control, and variable cash reserve ratio.

On the other hand, Fiscal policy focuses on the government in relation to taxation, borrowing, and expenditure. These three elements mostly influence aggregate spending.

The Relationship Between Monetary and Fiscal Policy

Consider the following assumptions, assuming wages and prices remain fixed:

Easy fiscal policy/tight monetary policy

With reduced taxes or increased government spending, aggregate output will rise. However, with reduced money supply counteracting the fiscal boost, interest rates increase, diminishing private sector demand. As a result, there’s a rise in output and interest rates, with government spending becoming a more significant part of the national income.

Tight fiscal policy/easy monetary policy

With fiscal reductions paired with an accommodating monetary stance leading to decreased interest rates, the private sector gets a boost and grows a share of GDP, while the public sector diminishes.

Easy monetary policy/easy fiscal policy

When both fiscal and monetary stances are accommodating, the combined effect is highly stimulative. This results in a spike in aggregate demand, potentially reduced interest rates, and expansion of both private and public sectors.

Tight monetary policy/tight fiscal policy

Interest rates potentially increase, suppressing private demand. Simultaneously, elevated taxes and reduced government expenditure result in decreased aggregate demand from both the public and private sectors.

Factors Influencing the Interaction of Monetary and Fiscal Policies

• Promotion of Potential Output Growth: Governments aim to stabilize aggregate demand near full employment and grow potential output. Encouraging private investment can be achieved via accommodative monetary policy (low interest rates) and tight fiscal policy to ensure resources for a growing private sector.
• Infrastructure and Workforce Quality: Sometimes, the absence of quality infrastructure or a trained workforce can hinder growth. The government may prioritize spending in these sectors. If not balanced by increased taxes, this can lead to an expansionary fiscal stance. Paired with a loose monetary policy, it may induce inflation.
• Political Context: Policy decisions are influenced by politics. A weak government might increase spending to appease specific vested interests. To counteract potential inflation, restrictive monetary policy (higher interest rates, limited credit) might be employed.
• Data Limitations: Both policies are hampered by imprecise current economic data due to revisions and time lags. However, fiscal policy, compared to monetary policy, has additional challenges. It’s slower to implement and politically easier to expand than a contract.
• Monetary and Fiscal Policy Interplay: The relationship between these policies influences decisions. For instance, if tax cuts don’t impact spending because of anticipated future taxes, policymakers might lean towards monetary tools.
• Empirical Considerations: The IMF’s study highlighted the interaction between monetary and fiscal policies. They explored global fiscal loosening scenarios and how monetary policy responded. Key findings include:
  1. Without monetary accommodation: Government spending has a significantly larger effect on GDP than social transfers. Targeted transfers to the poorest have a greater effect than non-targeted ones.
  2. With monetary accommodation: Fiscal multipliers are generally larger. The impact of government expenditure and social transfers on GDP grows substantially, except for labor tax cuts.

Question

Which one of the following will most likely have important effect on aggregate demand?

1. Government expenditures.
2. Increased transfer benefits.
3. A reduction of personal income tax at all income levels.

Solution

The correct answer is A.

Direct spending by the government has a greater impact on GDP than taxes and transfer benefits.