1. Active and Passive Monetary and Fiscal Policies

Professor Eric Leeper has defined terminology as follows:^[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, 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.

2. Supply Shock

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.

3. 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, 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.

4. Fiscal Shock and Policy Rate Shock

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.

5. 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 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.

5.1. 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 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.

6. Fiscal Monetary Interaction in the 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 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:

• 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.^[2]

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.