Interaction between Monetary and Fiscal Policy

1981 words (8 pages) essay in Economics

24/04/17 Economics Reference this

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The objective of macroeconomic policies is to obtain noninflationary, stable economic growth. Fiscal and Monetary policies are major components of macroeconomic policy. In many countries central banks choose monetary policy with a certain degree of independence with literally no direct control from government. On the other hand fiscal policy is chosen by governments using the tax levels and government spending. While fiscal and monetary policies are chosen by two different bodies independently but theoretically these policies are not independent. Due to conflicting objectives tension can arise between government and central bank on what each will do to stabilize economy during downturn and achieve economic stability and growth.

The experience of recent great recession fortifies the need for coordination between both policy making institutions to effectively tackle the economic shocks. An agreement between government and central bank about the target inflation, output, deficits and unemployment will result in coordinated fiscal monetary policies. Which can response at rapid pace to tackle the economic shocks and can lead economy closer to the targeted level of output in much faster manner compared to the non-cooperative fiscal-monetary policies outcome. Dahan (1998) also mentioned the need of the coordination between monetary and fiscal policy in his study of monetary implications of government’s reaction and budgetary implications of central banks actions.

As both authorities work to achieve similar objectives using different policy tolls it should be advisable for both authorities to achieve some form of coordination between them. Countries whose policies are not coordinated suffer from inflationary pressure, high unemployment, and unstable financial markets due to high deficit. Monetary authorities are normally harsh or inflation and deficit as they prefer low inflation over high inflation to achieve price stability on the other hand fiscal authorities have main objective is get reelected and therefore will be reluctant to choose policies which can increase prices and unemployment.

Each authority has two instruments to use for achieve its objective. Fiscal authority may use tax rate or increased government spending as policy instruments. Money stock or interest rate can be used by monetary authority as policy instrument. The interaction between fiscal and monetary authorities relates to the financing of the budget deficit and its consequences for the monetary management. An expansionary fiscal policy will increase aggregate demand and hence have consequences for rate of inflation. The monetary policy stance affects the capacity of government to finance the budget deficit by affecting cost of the debt service and by limiting or expanding the available source of financing.

The debate on policy coordination is not new to academics, the early debate reached to a point where large pole of economist ask for coordination between fiscal and monetary policies to tackle with huge deficits and high inflation, the supported by arguing that fiscal and monetary policies are not independent of each other.

There are different ways in which both policy makers can interact with each other, we can gain an intuitive understanding by considering following example , in a typical government budget session for year 00, where stance of fiscal policy is being discussed. Assume a negative demand shock if foreseen for that year, while inflation is expected to stay at the targeted level of 2%. Hence policymakers are faced with the choice between following options (a) do nothing, let the automatic stabilizers work, with the perspective that monetary policy would be set on moderately expansive path. In this case, we will then observe a moderate fiscal deficit and low interest rate, (b) neutralize the fiscal stabilizers, hence hold the deficit close to balance, and expect a more expensive monetary policy by lowering interest rates; (c) decide upon a more aggressive fiscal stance, resulting in deficit with expectation that monetary policy would then be set on mildly restrictive tone, with high nominal interest rates. If we assume the all of above choices will result in same output and inflation outcome, but these outcome will not in general be equivalent.

In this paper I will look at the coordination between monetary and fiscal policies in India and Pakistan while trying to achieve their objectives. I have chosen these countries due to several factors, recently India has achieved remarkable growth, and Pakistan had a consistent economic growth as well, same time both countries have introduce several structural reforms and liberalization of financial sector. India is still growing at an average rate of 8% compared to Pakistan whose growth is declined to 2% over the last three years. There can be several factors behind this one of the most important is political stability in India since last decade compared to Pakistan which has five different government in the same period. Indian political stability and continuation of incumbent policies by new office holders helped Indian economy to grow. In case of Pakistan we have seen a reverse scenario a sharp decline in economic growth, increased budgetary deficit, and higher level unemployment. Since coordination between both policies can be critical for economy which is growing and facing problem of price stability, analyzing India and Pakistan will provide some fruitful results how a country was able to maintain economic growth with stable price level on the other hand its neighbor was not able to sustain its economic growth and now facing high inflation.

The rest of the paper is organized as following, the next section presents literature review, section 3 discuss the theoretical model, section 4 discusses data and methodology which is followed by section 5 which highlights the results and last section concludes the papers.

Literature Review

During 20th century, targeting inflation has become a popular tool for achieving price stability. In introduction we emphasized that monetary policy is committed to stable lower level of inflation, this raises the question why monetary policy maker should coordinate with fiscal policy makers who aim to have higher growth and lower unemployment levels? We can find numerous researches in area of inflation targeting to stabilize prices but in all these analysis the behavior of fiscal policy is ignored; the debate on fiscal and monetary policy coordination is not new it started ate same time when monetarist recommended the independence of monetary policy in 1960. The analysis of coordination between monetary and fiscal policies was initiated by Brainard (1967) and Poole (1970) both studied the behavior of policy makers with uncertainties and economic constraints, but in their work the goals of fiscal policy makers were not explicitly discussed. Based on Poole’s work Pindyck (1976) and Rible (1980) studied the possibility of conflict between monetary and fiscal policy makers and analyzed the inefficiency of uncoordinated policies. Kydland and Prescott (1977) revolutionized the research in this area using game theory. They focused on a game between monetary policy makers and government. They incorporated rational expectations and dynamic consistency, but The major breakthrough to this literature comes from Sargent and Wallace (1981), who emphasized that the monetary policy and inflation level are not exogenous to fiscal deficits and to an extent the path to government’s fiscal deficits is unsustainable and predetermined; this result is similar to the fiscal theory of price level by Leeper (1991) and Woodford (1995). Schmitt and Uribe (1997) and Cochrane (1998) extended the fiscal theory for conditions under which either monetary or fiscal policy alone determined the price level, they showed that if government expenditure and taxes are exogenous, Ricardian Equivalence holds, then monetary policy can alone determine the price level. These conditions are normally violated in real economies as if these conditions hold then real interest rate will be determine by real resources and will be unaffected by monetary policy but we know that government spending and taxes affect the economic output and prices, and higher prices can lead to higher expectation about real interest rate. For US economy Nordhaus (1994) demonstrated that which independent monetary and fiscal policies, the resulting equilibrium will have higher real interest rates and budget deficits then expectations of monetary and fiscal policy makers. Similarly, Ahmed (1993) argued that the there is positive correlation between budget deficits and inflation, through the expectation on price level. In monetary policy regime the interest rate will rise if the expectations about future prices are higher than targeted inflation level, under this policy regime fiscal policy is not stable. Dixit (2000) and Lambertini (2001) analyzed the independence between central bank and government in a model where central bank had limited control over inflation, and inflation was directly affected by fiscal stances. They demonstrated that fiscal and monetary policy rules are complement for desired level of equilibrium output, inflation, and unemployment. Lewis and Leith (2002) demonstrated that for stability of real interest rates should be reduced if there is excess inflation due to government spending. Rovelli et al (2003) analyzed the coordination between monetary and fiscal policies using Stackelberg equilibrium and concluded that in preferable outcome fiscal authority appear as the leader in policy game. In case of emerging countries Shabbir (1996), Zoli (2005) and Khan (2006) found that there is fiscal dominance in India, Pakistan, China, Brazil a and Argentina, as fiscal policy actions affected the movements in exchange rated with a higher degree compared to monetary policy maneuvers, this helped them to conclude that fiscal policy does effect monetary variables. Wyplosz (1999), Meltiz (2000) analyzed the behavior of both policies over the cycle and demonstrated that in recessionary periods both policies are subtitles and in expansionary economic conditions both policies are complement to each other. Wyplosz and Meltiz concluded that a looser fiscal or monetary stance can be match by monetary or fiscal contractions.

Early empirical work in this area was mainly based on ordinary cross sectional, panel data or game theory techniques. Game theory techniques were used to observe the behavior of both policy makers and who they can achieve the best possible equilibrium results. On the other hand to examine the relationship between monetary and fiscal policy over the cycle cross sectional and panel data techniques were used. Recent empirical studied on monetary and fiscal policy interaction have used single technique known as Vector Auto regression (VAR), VAR analysis provides flexibility to analyze the different shocks to economy under individual policy regimes or coordinated policies using Impulse response function. Muscatelli (2005) analyzed the all G-7 countries for fiscal and monetary policy coordination using the VAR and Bayesian VAR models and demonstrated using impulse response function that fiscal shocks hit economy with higher magnitude compared to monetary shocks to economy, and the degree of dependence between both monetary and fiscal policies have increase after 1970’s due to the increase trade, investment, and coordination among world economies. Muscatelli showed that the degree of dependence in fiscal and monetary policy vary among countries and depended of several factors for example imports and export level, budget deficits, capital market structure, consumer debt level, how long current government is in office, and unemployment level.

In terms of emerging markets especially India and Pakistan, expect a study by Nasir et al (2009) and Khan (2004) we are unable to find any other empirical work. Khan demonstrated that over the period of 1975-2003 Indian policy makers have increased the level of coordination and it helped them to keep economy on growing track in 2001 recession, on the other hand Nasir et al found that the coordination between Pakistani Policy makers have decline over the same period and due to this declining coordination Pakistani economy was not able to bear the different economic shocks and due to higher political instability it was unable to maintain its economic growth level of 1999-2004 in 2005 and onwards.

All the studies that addressed the coordination between monetary and fiscal policies emphasized on the coordination among policy makers, because without coordination individual policy will be not full effective and stability in economy can’t be achieved. Therefore there should be a mechanism or mechanisms for coordination between policy makers, as without coordination high inflation and high budget deficit are expected to exist in economy.

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