3. MONETARY AND FISCAL POLICY - AN OVERVIEW
4. FUNDAMENTALS OF MONETARY AND FISCAL POLICY COORDINATION:
5. LITERATURE REVIEW
6. THEORETICAL FRAMEWORK AND THE METHODOLOGY
a. MONETARY AND FISCAL POLICY GAME DIAGRAM (Nordhaus)
b. HYPOTHESIS BASED ON THE POLICY GAME
7. FURTHER ANALYSIS, RESULTS AND RECOMMENDATIONS
A GENERIC STUDY ON MONETARY POLICY AND FISCAL POLICY COORDINATION
This paper attempts to study the importance of both Monetary Policy and Fiscal Policy in the international context. And also to understand the chemistry between Monetary and Fiscal policy and extent to which the coordination can be achieved. In any open economy, Monetary policy is designed, formulated and being conducted by the central Bank, wherein the National Planning or Ministry of Finance of the respective country is responsible for designing, formulating and conducting the Fiscal policy for the nation. This research paper finds that there is a close linkage between Monetary and Fiscal policy and hence the proper coordination leads to addressing today's biggest talk of nation’s deficit.
Currently there is an abundance of literature available on both Monetary and Fiscal policy. There is also good number of books available containing plethora of information on the subject. This research paper addresses the importance, impact, and issues of Monetary and Fiscal policy in open economy.
There is a lot of debate going on over the role of Central bank and the government in the recent economic crisis of the world. This has really placed both these entities in a spotlight. Questions like the coordination between Monetary and Fiscal policy of the nation are hovering around to tackle the future financial crisis. These questions include:
- Is it better for the economy to have fiscal and monetary authority to decide about its own policies independently without consulting each other?
- s it better to have the coordination between both the entities while formulating and or deciding about the policies?
- Is it really having considerable amount of impact on the value of inflation and unemployment rates, interest rates, and output of the economy when there is a cooperation and consultation between both the entities?
Sargent (1999: 1463) is of the opinion that ‘Monetary policy can be constrained by fiscal policy if fiscal deficits grow large enough to require monetization of government debt. This fact implies that the administrative independence of central banks does not by itself imply that monetary policy is independent of the fiscal decisions of governments’. This clearly states that both Monetary and Fiscal authorities count on each other directly or indirectly. This also signifies the impact of every single policy drafted by one authority, on another authority’s policies. Having said this, if we take an example of Greek crisis which revealed the cracks in the Euro zone, in Euro zone there is no unified authority exists in case of fiscal policy. However, the unified authority exists only in case of monetary policy field. European Central Bank (ECB) is acting as the unified authority in Euro zone, wherein each member country has its own fiscal policy and supervision.
As the saying goes 'the role of monetary policy is to convert bad loans into good ones'. This does not entirely mean that the central bank of the nation can take care of the financial position of the banks during the distress call. Sometimes, it may not be possible to the central bank to maintain both - the price stability in the economy by managing its own portfolio and, insuring the deposits of the banks by acting as the lender of last resort. But certainly it is of a great deal to the central bank if there is a proper coordination with fiscal authority. As, if central bank of the nation intends to bailout distress bank, without the coordination of fiscal authority, will have to sacrifice the price stability factor in order to prevent the failure of the distressed commercial bank.
3. MONETARY AND FISCAL POLICY - AN OVERVIEW:
Now I would like to throw light on the aspect of functioning of the Monetary and Fiscal policy in an open economy. Have we ever heard about nation’s central bank worrying about the expenditures from Government? The straight answer might be no, but ideally it should be yes, for proper coordination and tackling the issues which are on the brink during the current financial crisis. The main objective of the monetary authority is to stabilize the nation’s economy and strive hard to increase the rate of economic growth. For this, the monetary authority usually makes use of different tools including the widely used ones - Interest rate, exchange rate, and or money supply. Generally the monetary authority lowers the interest rate during the recession and whenever there is an anticipation or experience of inflationary pressure, the interest rates will be raised. However, the monetary authority prefers to have the lower inflation rate instead of lower rate of unemployment in the nation. This is due to the fact that the lower interest rate raises the aggregate demand in the economy which in turn leads to higher rate of depreciation of nation’s currency. In contrary to this, the higher rate of interest lowers the aggregate demand in the economy and leads to higher rate of appreciation of nation’s currency and also higher level of prices.
In the other hand, the main objective of the fiscal authority is to stabilize the nation’s economy and strive hard to increase the rate of economic growth. For this, the fiscal authority usually makes use of the tool wherein it concentrates more on counter-cyclical tax rate policy of the economic growth. In other words, the fiscal policy relates to taxation and spending related decision carried out by the respective government. The main aspect here is that the fiscal policy makers usually focus on is government’s deficits and debt including the tax and its level of expenditure.
4. FUNDAMENTALS OF MONETARY AND FISCAL POLICY COORDINATION:
Conversely, the issue of monetary policy maker’s independence has been brought into the limelight repeatedly in the recent years. Result of which, as a proactive measure to economic crisis and downturn, many of the countries now have granted independence to their monetary policy making authority (Central Bank) in their policy formulations. (Nordhaus: 1994). Nevertheless the extent to which independence is granted varies from country to country. For example Germany, the monetary authority is totally independent and, in case of Japan, where the monetary authority is the responsible entity to its finance ministry. It has been argued by many scholars including Bartolomeo and Gioacchino (2008) that if country does not have coordinated policies between monetary and fiscal authorities, there is a high level of possibility of suffering from high inflation pressure and deficit in the economy. Further it was stated that countries current fiscal authorities would be more likely to decrease the government spending. This will lead to high budget deficit and inflationary pressures. Countries monetary authorities on the other side will have a thoughtless standpoint on the inflation and deficit. Predominantly monetary authorities would be willing to give importance to deficit as it feels low inflation is preferred vehicle over the high inflation to achieve its main object of stabilizing the price. Many scholars believe that the coordinated effort between monetary and fiscal policy authorities will have relative effectiveness in stabilizing the demand pressure.