. Explains Interdependence of monetary and fiscal policies

 Fiscal policy and  monetary policy are the two tools used by the State to achieve

its  macroeconomic objectives. While 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 celebrated  IS/LM model is one of the models used to depict the effect of interaction on aggregate output and interest rates. The fiscal policies have an impact on the goods market and the monetary policies have an impact on the asset markets and since the two markets are connected to each other via the two macrovariables — output and interest rates, the policies interact while influencing the output or the interest rates.

 Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals as the two were perceived to aim at mutually inconsistent targets. But in recent years, 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-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 to interact 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 other.