Monetary Policy Should not Care About Fiscal Policy

For some reason a fairly extensive part of the literature on monetary economics is dedicated on the “interaction between monetary and fiscal policy”. I am not sure what this means, nor why it matters at all. As a core idea, and again resorting to Friedman’s notion that Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, the level of inflation is 100% under the control of and thus determined by the central bank. The only additional assumptions required to make this hold is central bank independence, the importance of which has been long established, and at least some degree of central bank competence, without which we can essentially stop talking about monetary policy in general.

Let’s start from a point where a central bank is achieving its target, however defined. Now let’s bring in fiscal policy, and let’s say it tries to increase spending. Clearly this increase in spending would, momentarily, move the economy away from what the central bank is targeting, which would require central bank intervention to bring it back on track. In the end, for the macroeconomic indicators that are generally included in the objective function of central banks, the fiscal policy does not do much after the initial short-lived shock. The whole concept is essentially summarized by the concept of “monetary offset”, basically explained in this paper by Scott Sumner (.pdf).  This inability of fiscal policy to do much on a macroeconomic level in a world where the central bank actually does its job is a feature, not a bug. Fiscal policy should concentrate on achieving democratically determined goals, and as such it can legitimate alter e.g. the income and wealth distribution in an economy in order to bring them in line with this consensus view on what it should be, as well as give the central bank a different target if it so desires. The optimal target a central bank should be given very much depends on what is possible on a fiscal level, particularly in terms of the ability of governments to tax different things. Yet once that is determined, the central banks job is to make sure that whatever the fiscal authorities do does not move the economy away from the target it’s job it is to achieve. Apart from the target setting itself this is essentially a strictly objective task.

In other words the central bank will always dominate the fiscal authorities given the two basic assumptions I made. It should not be the job of fiscal policy to achieve these targets in the first place. If a situation arises where someone has to give in, it is always the fiscal authority that will unless at least one of the two assumption is violated. In terms of final macroeconomic variables targeted by the central bank (once its target is set) like the level of inflation or the level of NGDP, what fiscal policy does, or even its very existence, is irrelevant.

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4 thoughts on “Monetary Policy Should not Care About Fiscal Policy

  1. So what you’re saying is we don’t need fiscal policy if monetary policy would do its job. I don’t think anyone would disagree with this. Surely, though, fiscal policy should take into account what monetary policy does?* If monepol doesn’t do the job because, say, it is up against the ZLB, or it is governed by a bunch of Austrians (not our compatriots, the von Mises-Hayek apostles) fiscal policy should take over.

    *) Surely no sentence beginning with “surely” can validly contain a question mark at the end? (Paul Samuelson)

    • Surely fiscal policy should take into account what monetary policy does – in a sense that monetary policy somewhat limits the set of actions at the disposition of fiscal policy. As a straight-forward example, a government running massive deficits (in non ZLB-times) will most likely run into trouble at some point if central banks refuse to finance these deficits by printing new money, which it should if these deficits would drive up inflation beyond its target. Monetary policy should keep the big macro variables (such as the overall price level) at its target, while fiscal policy can tinker with the relative prices (with all the unintended consequences involved). In a way, monetary policy sets the frame, fiscal policy paints the picture. What the picture looks like is not really the central banks business, yet once you start painting on the wall it’s the central bank who is doing it wrong.

      In financial markets this line gets a bit blurry, as e.g. macroprudential regulation is generally counted as being in the realm of monetary policy, yet it very legitimately can and probably should affect some relative prices.
      I would also agree with your practical assessment, yet more often than not the ZLB seems to be used as an excuse to let monetary policy off the hook.

      • Oh, I think it’s not true that monetary policy doesn’t affect relative prices. It certainly affects the interest rate which is just the relative price of a euro today in terms of euros tomorrow. It may also affect the relative prices of goods because not all sectors of the economy can respond equally quickly to inflation (different degrees of price-stickiness). So that distinction is going nowhere.

        Also, from a public finance point of view, monetary policy is one source of government revenue -seignorage. And you want the central bank to generate just the amount of seignorage such that the marginal excess burden from the Inflation tax is the same as the marginal excess burden from all other taxes. So in that sense, monetary policy should not be Independent from fiscal policy. But of course, that has nothing to do with your original post which was about stabilization policy.

  2. Well, you are right about the interest rate argument – I did miss that. Also, I have no doubt monetary policy affects other, non interest rate relative prices. I was just questioning whether it’s monetary policies job to care all that much, since particularly interest rates are just too blunt an instrument to try and use in this regard. When it comes to other relative prices, monetary policy in terms of interest rate setting seems to be at best a second- if not third-best option. Both fiscal and macroprudential policies are superior in that regard. I currently don’t really have a strong opinion on whether interest rates should, for instance, be used to fight “bubbles”, whatever that might mean, and I wouldn’t say it’s due to lack of information but at the moment rather due to information overload. My master’s thesis touches on the topic, for instance.

    On the public finance standpoint – that’s exactly what I meant in the post with “the optimal target a central bank should be given very much depends on what is possible on a fiscal level”. But for practical purposes it would seem that the target of a central bank is generally best viewed as exogenously given.

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