Interaction of Monetary and Fiscal Policy

Monetary and fiscal policies can both be 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  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

We will assume wages and prices are fixed in the following discussions.

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 taking a larger percentage of the ovcerall national income.

Tight fiscal policy/easy monetary policy

A tight fiscal policy paired with an easy monetary policy with low interest rates will grow the private sector (and increase its contribution to GDP) and shrink the public sector.

Easy monetary policy/easy fiscal policy

When both fiscal and monetary policies are easy, the economy will expand, leading to increased aggregate demand, reduced interest rates subject to the monetaryimpact being larger, and the expansion of both the private and public sectors.

Tight monetary policy/tight fiscal policy

Interest rates increase (if the impact from monetary policy on interest rates is larger), suppressing private demand. Simultaneously, increased 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, (tight monetary policy) to pay for the increased government spending, it can lead to an expansionary fiscal stance. If the increased government spending is 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 monetary and fiscal policies are hampered by imprecise current economic data due to revision and time lags. However, fiscal policy, compared to monetary policy, has additional challenges. . Fiscal policy is slower to implement, and it is politically easier to loosen than to tighten fiscal policy. On the other hand, since central banks are independent, they can more easily increase interest rates when needed.
• Monetary and Fiscal Policy Interplay: The relationship between these policies influences decisions. For instance, if tax cuts don’t impact private spending because of anticipated future higher taxes, policymakers might lean towards monetary policy tools.
• Empirical Considerations: The IMF did a study that highlighted the interaction between monetary and fiscal policies. They explored global fiscal loosening scenarios and how monetary policy responded. Key findings include:
  • 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. Labor tax cuts have a much bigger impact than social transfers.
  • 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 a greater 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.