Fiscal policy and monetary policy are the two tools used by the state to achieve its macroeconomic objectives. While for many countries 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 IS/LM model is one of the models used to depict the effect of policy interactions on aggregate output and interest rates. The fiscal policies have a direct impact on the goods market and the monetary policies have a direct impact on the asset markets; since the two markets are connected to each other via the two macrovariables output and interest rates, the policies interact while influencing output and interest rates. Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses were made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals, lest the two policy tools be aimed at mutually inconsistent targets. But more recently, 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 and 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 as interacting 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 the other. The issue of interaction and the policies being complements or substitutes for each other arises only when the authorities are independent of each other. But when the goals of one authority are made subservient to those of the other, then one authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy are not influenced by the other, there is no direct interaction between them.
Professor Eric Leeper has defined terminology as follows:
In case of an active fiscal policy and a passive monetary policy, when the economy faces an expansionary fiscal shock that raises the price level, money growth passively increases as well because the 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 are contained to some extent by the monetary policies.
During a negative supply shock, the fiscal and monetary authorities may follow conflicting policies if they do not coordinate, as the fiscal authorities would follow expansionary policies to bring the output back to its original state while the monetary authorities would follow contractionary policies so as to reduce the inflation created due to the cutback in output caused by the supply shock.
During a demand shock (a sudden significant rise or fall in aggregate demand due to external factors) without a corresponding change in output, inflation or deflation may result. Here monetary and fiscal policies may 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.
In case of a positive fiscal shock (increase in fiscal deficits), aggregate output may rise beyond potential (sustainable) output due to the fiscally induced rise in aggregate demand. Subsequently, this leads to dissavings and lowering of investments which would depress output in the long run. Monetary authorities react in a countercyclical way to this, tightening monetary policy in the short run but perhaps in the long run adopting quantitative easing to counter the longer-term fall in output.
In case of policy shocks consisting of a sudden positive (negative) change in banking policy rates such as the statutory liquidity ratio, cash reserve ratio or the repo rates, the fiscal authority initially reacts by following expansionary (contractionary) policy but subsequently reverses.
When an economy is a part of a monetary union, its monetary authority is no longer able to conduct its monetary policies independently in response to the needs of the economy. Under such a situation the interaction between fiscal and monetary policies undergoes 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 policies 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.
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 may be far from optimum. In such a scenario, given that the degrees of price rigidity in all the nations are equal, 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; otherwise either of the objectives is achieved at the cost of other as monetary policies fail to influence the terms of trade.
But in case of varying degrees of price rigidities amongst the nations, the terms of trade are 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, the greater would be the relative role of fiscal policies in economic stabilisation.
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 conditions for an optimum currency area, potential member nations were asked to commit to the following convergence criteria as spelled out in the Maastricht Treaty:
In addition to the above requirements, members were to maintain exchange rates within a 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 on inflation rates to bring them down to the levels spelled out in the Treaty. This led to changes in the structure of monetary-fiscal interactions in the member nations.