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 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.
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. The issue of interaction and the policies being complement or substitute
to each other arises only when the authorities are independent of each other.
But when, the goals of one authority is made subservient to that of others,
then the dominant authority solely dominates the policy making and no
interaction worthy of analysis would arise.Also, it is worthy to note that fiscal
and monetary policies interact only to the extent of influencing the final
objective. So long as the objectives of one policy is not influenced by the
other, there is no direct interaction between them.
Active and passive monetary and
fiscal policies
1) Passive
fiscal policy is one in which the authority raises or reduces taxes to balance
the budget intertemporally. 2) Active fiscal policy is one in which the tax and
spending levels are determined independent of intertemporal budget
consideration. 3) Active monetary policy is one that pursues its inflation
target independent of fiscal policies. 4) 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, the economy faces an expansionary fiscal shock that
raises the price levels and money growth as 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 is contained to some
extent by the monetary policies.
Supply
shock
During a negative supply shock, the fiscal and monetary authorities are seen to follow conflicting
policies as the fiscal authorities would follow expansionary policies to bring
the output at its original state while the monetary authorities would follow
contractionary policies so as to reduce the inflation created due to shortage
in output caused by the supply shock.
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 that
results in inflation or deflation which can also be termed as inflation or a deflation shock, it is
observed that the two policies 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.
Cost
push shocks
A cost-push shock is defined as a change in
inflation that is not a result of pressures in the economy. The macroeconomic
goal under such a situation is to optimise between reducing inflation and
reducing the gap between the actual output and the desired level of output. A
contractionary monetary policy under such a scenario raises the real interest
rates which in turn not only reduces consumption thereby dampening aggregate
demand and inflation but also raises the labour supply as workers are willing
to sacrifice current leisure along with current consumption. This further
dampens the inflation rates.