Monetary policy refers to the actions of the central bank regarding the level of money in the economy and fiscal policy is concerned with government’s taxation and spending decisions. Their mutual interaction determines the level of economic output.
If we assume that wages and prices are sticky, monetary and fiscal policy interact as follows:
- Easy fiscal policy and tight monetary policy result in higher output but also a higher interest rate which contracts private sector demand and government spending to GDP to increase.
- Tight fiscal policy and easy monetary policy cause a reduction in the interest rate and the relative proportion of private investment to government spending increases.
- If both fiscal and monetary policies are easy, it causes an increase in output, a reduction in the interest rate and growth of both private and government sectors.
- If both fiscal and monetary policies are tight, interest rates rise, aggregate demand falls and both private and government sectors shrink.
Factors affecting the mix of monetary policy and fiscal policy
In addition to stabilization of aggregate demand, one goal of governments is to grow potential output which is achieved by encouraging private investments by following easy monetary and tight fiscal policy. The government might also be required to invest in human capital or a modern infrastructure, which if not financed with taxes requires easy monetary policy, which can induce inflation. But all these considerations are influenced heavily by political context. For example, a government might continue to provide heavy subsidies to certain sectors, which must be offset with contractionary monetary policy. Other factors influencing policy choice include lack of timely and reliable data, time lags, etc.
When fiscal policy is not coupled with monetary accommodation (i.e. there is no expansionary monetary policy), government spending has a far bigger impact than transfer payments or tax cuts. However, tax cuts or transfers aimed at the poorest segments have the most impact. However, if monetary policy is accompanied by monetary accommodation, fiscal multipliers are more pronounced. However, if monetary accommodation is in the form of central bank purchases of large amounts of government debt, it might be viewed as ‘printing of money’ i.e. monetization of government deficit.
In the long-run, persistently high budget deficit may cause a high interest rate thus causing a crowding out of private investments, thereby hurting an economy’s growth potential. This and lack of fiscal discipline nullify any positive impact of expansionary fiscal policy.