ECON430-Topic #4: Fiscal and Monetary Policy

Fiscal and monetary policy are often uncoordinated and working at cross purposes due to the fact that monetary policy is intended to be independent of fiscal policy. However, for either to be effective, the two should be somewhat coordinated. Jared Bernstein, former Chief Economist and Economic Adviser to President Obama, recently opined about the difficulties of coordinating the two. Ben Bernanke, former chair of the Board of Governors also noted that fiscal policy can create headwinds for effective monetary policy. Paul Krugman and Mike Woodford (quoted twice (first link) within (second link) Krugman’s article) also make points that fiscal and monetary policy are more effective when controlled in tandem.

However, there are varying feelings about whether or not monetary policy even works. Scott Sumner, noted advocate of NGDP targeting, talks of how fiscal policy does not have the capacity to truly affect the economy in the necessary ways, and that the interest on reserve rate can be used in a variety of ways.

While you might consider thinking about this relationship in the U.S., China and other countries also have an interesting relationship between fiscal and monetary policy. Think about addressing whether or not fiscal and monetary policy in the U.S. can be better coordinated, or if automatic fiscal stabilizers are sufficient to address any shortfalls on its own. Monetary policy in the U.S. might have to simply operate in spite of whatever happens in Congress. Other countries like China do not have the same issues, and in fact their government is more than able to coordinate policy (to at least some degree). Are there other countries around the world that have it better (or worse) than the U.S. or China? What might be an optimal setup? If the fiscal and monetary authorities are independent, what are the implications of them operating at cross purposes? Feel free to address any of these issues as they pertain to the U.S., China, or some other country. This is a relatively free-range discussion, so please simply try to make some sort of cogent, supported point.

 

11 thoughts on “ECON430-Topic #4: Fiscal and Monetary Policy”

  1. I certainly agree with Jaren Bernstein, former chief economist to Vice President Biden, on his concern regarding monetary policy and fiscal policy coordination (1). There appears to be a disconnect between the two policies being used in tandem. When fiscal policy is in “neutral mode,” monetary policy can often be ineffective. Bernstein discusses that there is no combined effort to “lower the cost of borrowing with monetary policy and fiscal policy incentivizes people to take advantage of it” (1). Without fiscal policy working together with monetary policy, these advanced economies get “knocked out” and “the economic mind gets so battered it can no longer think straight” (1).

    Ben Bernanke, has consistently cited this problem in regards to “fiscal drag” (2). Having tight federal fiscal policy could mean that there will be a drag on economic recovery. Additionally, the strong focus on short run, federal spending cuts is taking away from the long run growth of the economy.

    Therefore, unless the two policies work in tandem, people may alter reactions based on how they perceive monetary expansion to work (3). During the 2009 crisis, people anticipated a “V-shaped recovery” and it seemed impossible to convince people of a long-run change in policy (3). In part, this had to do with a much more likely probability of Congress agreeing to a large temporary fiscal stimulus, rather than a long-term policy.
    Until Congress and the Fed can find a way to successfully synchronize fiscal and monetary policy, the US economy will continue to be “knocked out” in the ring.

    (1) http://www.washingtonpost.com/posteverything/wp/2014/11/19/a-simple-but-strangely-elusive-point-about-macro-policy-monetary-and-fiscal-policy-are-complements-not-substitutes/
    (2) http://www.cbsnews.com/news/bernanke-fiscal-policy-is-stunting-the-recovery/
    (3) http://krugman.blogs.nytimes.com/2011/06/20/woodford-on-monetary-and-fiscal-policy/?_r=0

  2. In order to reach a point of stable and continued economic growth, a country must implement a mixture of macro policies. The problem, as stated above, is an occasional coordination issue that can lead to a slow recovery or even hinder the sustainable growth in an economy. Given the fact that fiscal policies of the Federal Government take a long time (usually) to operate, and that the monetary policy of the Federal Reserve adjusts at a quicker rate, efficient coordination of the two is a must.

    Financing the budget deficit and monetary management represent the most important interaction between fiscal and monetary policies, which explains the importance of coordination. Management of debt by monetary authorities determines the cost and availability of government financing. On the other hand, government-financing methods can create a series of constraints on the functions of the central bank. If not coordinated correctly, either one of the two can lead to inefficiency or result in one policy working against the other.

    A good example of this can help explain some of America’s budget deficits. The use of a budget deficit is to “push more money into the economy than is withdrawn, and thereby raise aggregate demand” (2). Fiscal deficits help weak economies and are actually required for helping economic growth; thus are not supposed to raise the overall public debt. Better coordination of the two policies would lead to a hold in the rising budget deficit. Monetary policy (printing more money) to combat the rising deficit does no good because it needs the attention of the government to finance the deficit trough issuing bonds. Failure to coordinate between fiscal and monetary policy would lead to an attempt to monetize the debt, possibly resulting in inflation and no stop to the rising deficit. Just because the monetary policy is easier and quicker to adjust, doesn’t mean it is the sure answer. Coordination with fiscal policy is key and could have been handled better by the US to fight the rising budget deficit.

    1. https://www.imf.org/external/pubs/ft/wp/wp9825.pdf
    2. http://www.economonitor.com/blog/2012/04/a-call-for-greater-coordination-between-monetary-and-fiscal-policy/

  3. In the current state of the economy there are many suggestions being pronounced pertaining monetary and fiscal policy. Since the 2008 crisis the economy has been reverting back to pre-2008 levels. (1) The unemployment rate is at 5.5% within 1% of the natural rate, GDP has returned to a 2.4% growth last year, and PCE has also made strides to return to trend. As the economy seems to hit natural rate of unemployment and potential output, there must be an exit from current policy. (2) “Every single time the Fed has waited for full employment to be achieved before starting to withdraw accommodation, it has ended up driving the economy into recession.” Former Dallas Fed President Richard Fisher. The current reversal necessary would be to raise interest rates and promote stable inflation.
    Monetary policy is independent of fiscal policy, however they should be succinct in their approach. A suggestion for the US would be to remove IOR on excess reserves, which would lower the interest rates and create inflation. This could be dangerous but as these reserves would flood the market, the fed will use reverse repurchasing (monetary policy) to remove the excess liquidity, stabilize inflation, and increase interest rates. This could be successful, but does run risk. Instead if monetary policy worked with fiscal policy, the government could increase their spending as necessary with the reverse repurchasing. This increase in spending would further raise interest rates and add another dimension of control over the economy. (3) However fiscal policy must also be under surveillance in order to control the deficit that has been growing as taxes are cut and spending has increased. As you can see both fiscal policy and monetary policy alone are fragile and possibly volatile, but together they provide a less risky policy that may be the answer to our near zero lower bounds and low inflation.

    1) https://research.stlouisfed.org/fred2/
    2) http://www.dallasfed.org/news/speeches/fisher/2015/fs150210.cfm
    3) http://www.frbsf.org/education/publications/doctor-econ/2002/march/fiscal-monetary-policy

  4. The European Union provides an interesting case study to analyze the interaction between fiscal and monetary policy. The EU is unique in that while it has a central bank and single currency, and thus a monetary union, most fiscal decisions remain at the national level, and therefore has no fiscal union. While fiscal standards exist and sanctions can be placed on member countries, taxing and spending decisions are still left largely up to individual governments. Even with a centralized and coordinated monetary authority, member nations vary greatly in economic health. In February 2015, ten year interest rates ranged from 0.2% in Denmark to 9.72% in Greece (1). In 2013, unemployment ranged from 4.9% in Austria to 27.3% in Greece (2). You’d be thick-headed to argue that monetary policy was a cure-all solution; if it was then we wouldn’t see these large disparities.

    With ECB quantitative easing already underway, there is clearly a strong push from the monetary side to provide economic tailwinds. However, over the past couple years, fiscal policy has been largely contractionary. Since austerity measures began in 2009, matters have only gotten worse for the EU (3). Many are arguing that monetary policy isn’t enough and that Europe needs fiscal stimulus to lift itself out of deflation. Bruegel Research Institute, a Brussels-based think tank, for example, has been making this argument for some time (4). The link between monetary and fiscal policy, like almost everything else in economics, is still largely unknown. But as the ECB turns to more and more desperate measures, why not try providing a push from the fiscal side?
    1) http://www.ecb.europa.eu/stats/money/long/html/index.en.html
    2) http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Unemployment_rate,_2002-2013_%28%25%29.png
    3) http://www.bbc.com/news/business-13856580
    4) http://www.bloomberg.com/news/articles/2014-09-03/eu-needs-fiscal-policy-in-bid-to-raise-inflation-bruegel

  5. Can fiscal and monetary policy be better coordinated in the United States? The Fed spent a total of $3 trillion for quantitative easing during the financial crisis (1). While the Federal Government cut spending during the sequester by $85 billion in 2013 (2). It’s pretty apparent the two aren’t very well coordinated currently, and it would be mutually beneficial if they matched their policy decisions better.

    It can be hard to coordinate these policies, because the Fed controls monetary policy and Congress controls fiscal policies. These two tools being controlled by different groups acts like a “separation of powers,” so one group doesn’t have too much power. However, it can hurt the Economy when they aren’t working in tandem. The Fed can much more easily introduce their policies because they don’t have to get their policies to pass through the House, Senate, and the President like fiscal policies.

    Policies taking so long to go through Congress leads to even more lags than the Fed has, so it wouldn’t be beneficial if Congress had more power over the Fed’s policies. Ultimately that lag in passing policies, and lack of knowledge by Congress, is what gives the Fed the advantage and the reason the Fed should have more of a say in fiscal policies. It could help if the Fed got some type of vote on Fiscal policies when they are being voted on in Congress. Not necessarily the power to totally veto fiscal policies, but maybe they should get some type of a vote nonetheless. This way they can still be over ruled by a majority, but still get to influence fiscal policies that can work in tandem with their monetary policies.

    (1) http://www.washingtonpost.com/blogs/wonkblog/wp/2014/10/28/the-federal-reserves-experiment-in-quantitative-easing-is-coming-to-an-end/
    (2) http://www.usatoday.com/story/news/politics/2013/02/28/hidden-costs-of-sequestration/1951759/

  6. Japan has been in monetary expansion for some time now with a weak fiscal policy. Prime Minister, Shinzo Abe, and his “Abenomics” drove Japan economy into recession(1). Their monetary expansion plan worked fine, correcting the yen’s strength and driving up stocks, but the fiscal policy was a disaster. The increase in sales tax from 5 to 8 percent slaughtered consumer spending and Abe was forced to stop his plan before the 3rd stage begun(2). This is a prime example of Jared Bernstein argument that monetary policy is not a substitute, but a compliment of fiscal policy(2). Abe’s plan was fighting itself from the inside. As of March, their primary budget deficit, excluding interest payments on debt, is 6.6% of GDP(3). Japan has been trying to clean up their act with one policy without even addressing the other. The U.S. Treasury voiced its opinion towards Japan and how they can speed up economic recovery. Japanese Finance Minister, Taro Aso, responded with, “Japan will continue to steadily implement policies of simultaneously promoting growth and rebuilding the government’s finances,” in response to the Treasury’s voiced opinion(4). Their plan is to balance out their monetary and fiscal policies. In order for Japan to power through this and experience high levels of economic growth they must keep both monetary and fiscal policy in expansionary levels.
    (1) http://www.ft.com/intl/cms/s/2/7502b594-cbcd-11e4-beca-00144feab7de.html#axzz3WwPVmyRA
    (2) http://www.washingtonpost.com/posteverything/wp/2014/11/19/a-simple-but-strangely-elusive-point-about-macro-policy-monetary-and-fiscal-policy-are-complements-not-substitutes/
    (3) http://www.economist.com/news/asia/21648020-government-shinzo-abe-increasingly-odds-central-bank-end-affair
    (4) http://www.economist.com/news/asia/21648020-government-shinzo-abe-increasingly-odds-central-bank-end-affair

  7. The Greek debt crisis presents a unique situation regarding fiscal and monetary policy. Greece, as a member of the Eurozone, has its monetary policy controlled by the European Central Bank (ECB), which is strongly influenced by larger economies in the Eurozone. When Greece entered the EU, low nominal interest rates expanded credit in the market. However, “in the case of Greece, the combination of low nominal interest rates with an inflation rate that during the period 2002-2007 was, on average, 1.2 percentage points higher than the euro zone mean of 2.2%, meant that real interest rates were kept very low or, in some cases, even negative. This inevitably discouraged saving while encouraging credit expansion, thereby playing a crucial role in the persistence of imbalances and the increase of Greece’s foreign indebtedness” [1]. Furthermore, as a member of the Eurozone, Greece could not devalue its foreign debt because of the adoption of the Euro, which implied an exchange rate predicated on the economic conditions of other euro zone members.

    Greece’s fiscal policy was subject to pressure from international creditors due to the need for bailout money to avoid a disorderly default. While Greece was in a recession, instead of pursuing an expansionary fiscal policy the Greek government was forced by creditors to enact austerity measures such as reduced government spending and increased tax rates and tax collection.

    A monetary policy focused on growing the economy combined with a contractionary fiscal policy has left Greece in a precarious situation. Renewed focus by the Syriza government on fiscal stimulus and cutting back on contractionary policies may aid economic growth, although such policies are being opposed by creditors [2].

    [1] “Fiscal Policy and the Recession: The Case of Greece”. Intereconomics.eu
    [2]. http://www.npr.org/2015/03/23/394789463/eurozone-threatened-by-divide-between-greece-and-germany

  8. It would make intuitive sense for the use of fiscal policy to support the direction of monetary policy, but this is not the case for most countries. An example of a country that has relatively healthy relationships between monetary and fiscal policy is Switzerland and the SNB. The SNB’s mandate is focused on maintaining price stability, therefore all monetary policy is geared towards this goal since 2000[2]. The monetary policy conducted lately by the SNB is still limited somewhat by binding rules in that their currency was pegged against the euro for 3 years [3]. However, the banks abandonment of this policy contributed to huge currency volatility and distrust in the bank’s ability to maintain stable prices and avoid deflation [3]. On the other hand, fiscal policy in Switzerland is restricted by rules and does not allow for discretionary policy [1]. Fiscal policy has been conducted heavily since a “debt brake” implemented in 2003 that requires government expenditures to be less than what is brought in financially for an entire economic cycle [1]. This has resulted in shrinking public debt in Switzerland. During the financial crisis of 2008, the Swiss relied heavily on monetary policy, by cutting interest rates to increase liquidity, to maintain stability [1]. What is not as obvious is that the federal government had already been preparing the economy for a crisis through their use of preventative fiscal policy in the cutting of expenditures and shrinking of debt [1]. This is evidence in support of monetary and fiscal policy working in tandem to ease issues created in a recession.

    [1]http://www.snb.ch/en/mmr/speeches/id/ref_20121121_zur%20/source/ref_20121121_zur.en.pdf
    [2] http://www.snb.ch/en/iabout/monpol/id/monpol_strat
    [3] http://www.cnbc.com/id/102340182#.

  9. Due to the economic climate of the past five years, policymakers on Capitol Hill are calling for an audit of the Fed (1). Immediately, this should imply two things: First, those responsible for fiscal policy believe that the Fed has been acting irresponsibly, and second, those who conduct fiscal policy and monetary policy are in disagreement about what actions should be taken. Those in favor of a Fed audit claim that “the audit’s goal is more fundamental: to assure that the checks and balances in a democratic government also apply to central bankers. It means figuring out how our elected representatives can effectively oversee unelected monetary ‘experts.’” (1). The goal of this claim was to provide a routine check on the power of the Fed through some other branch of government, but the author destroys the sentiment by sarcastically implying that the elected officials in Congress are somehow more “experts” on monetary policy than those who sit on the Board of Governors. The author goes on to suggest that the reason the Fed should be audited is to engage in the necessary level of checks and balances that all other branches of government are subjected to. Yet, those at the Fed fear that such an audit would add political agendas to monetary policy, subjecting monetary policy to the same type of political manipulation that fiscal policy also endures (2). Janet Yellen has made multiple attempts to make monetary policy more transparent then ever before, but still there are calls for an audit (3). More likely, the calls to audit the Fed are founded in the same type of political manipulation the Fed is sheltered from through legislative protections: it’s presidential season. Most calls to audit the Fed occur during and before presidential candidates run for election. Thus, calls for an audit of the Fed might reflect a desire for political relevance, rather than a real mishandling of monetary policy that warrants an audit of the Fed.

    (1) http://www.wsj.com/articles/alex-j-pollock-its-high-time-to-audit-the-federal-reserve-1427064432
    (2) http://nypost.com/2015/02/26/why-does-the-federal-reserve-fear-a-real-audit/
    (3) http://www.washingtonpost.com/opinions/catherine-rampell-audit-the-fed-not-so-fast/2015/01/29/bbf06ae6-a7f6-11e4-a06b-9df2002b86a0_story.html

  10. Bernstein makes the case that Japan is currently in the 7 box indicating that the Bank of Japan is implementing expansionary measures while the Japanese government is using contractionary measures in response to the economy (1). Japan has very recently stated that it is now aiming for a balance between monetary and fiscal policy in the face of US criticisms of their overdependence on monetary policy (2). While this statement two days ago appears like a step in the right direction, Shinzo Abe, the prime minister, is acting contrarily by undermining monetary policy. Haruhiko Kuroda, the Bank of Japan’s central governor, believed the plan of the Japanese government of imposing an increase in consumption taxes a second time but the second tax increase has yet to be seen (3). Kuroda took actions into his own hands by implementing another round of quantitative easing in an attempt to force Abe to install the second increase in consumption tax but it has worked in the opposite as Abe postponed the increase in taxes until 2017 (3). Fiscal policy in Japan has essentially stalled so the Bank of Japan has been increasing their quantitative easing, much to the chagrin of the Japanese government, and the United States has been taking notice. The balance between fiscal and monetary policy in Japan is lop-sided in favor of monetary policy and this is contributing to the depreciation of the yen. While that is increasing net exports, many of the Japanese citizens are not feeling the benefits of the increase in exports (3). The Bank of Japan has been striving for an inflation rate of 2% but through quantitative easing the inflation rate remains at 0% (3). The differences in how the US is now treating the balance of monetary and fiscal policy is significantly better than the current state of the Japanese’s balance of the two.

    1) http://www.washingtonpost.com/posteverything/wp/2014/11/19/a-simple-but-strangely-elusive-point-about-macro-policy-monetary-and-fiscal-policy-are-complements-not-substitutes/
    2) http://www.nasdaq.com/article/japan-pursues-balanced-fiscal-monetary-policies-20150409-01256
    3) http://www.economist.com/news/asia/21648020-government-shinzo-abe-increasingly-odds-central-bank-end-affair

  11. Paul Krugman has an interesting approach when comparing monetary policy and fiscal policy. His argument is derived from establishing credibility when implementing policy. Krugman suggests that fiscal policy doesn’t need convincing to be credible in order to create expectations, while the Fed needs to be. However, Paul explains that fiscal stimulus is “a hard sell” to politicians, especially to republicans. Furthermore, he states that a “…fiscal stimulus in a liquidity trap doesn’t require that you convince the market that you’re going to behave differently once the crisis is past…the government just goes out and creates jobs.” He also argues that a combination of “campaign on both fronts, trying to convince influential players both that austerity is wrong and that the Fed needs to start signaling its willingness to see more inflation before it raises rates” would be beneficial to combating the recession, hence the tandem between monetary and fiscal policy. His opinions were formed after he read Mike Woodford’s latest paper: Methods of Policy Accommodation at the Interest-Rate Lower Bound. (1)

    Trying to combat austerity makes sense. Since austerity results in lower government spending or higher taxes, expansion made on the fiscal front could not be achieved using this strategy. Especially if one believes that a stimulus package would help spur the economy forward.

    (1) http://krugman.blogs.nytimes.com/2012/09/01/monetary-versus-fiscal-policy-revisited/?_r=0

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