Changes in fiscal and monetary policies

In case of policy shocks consisting of a sudden positive negative change in banking policy rates such as the statutory liquidity ratiocash reserve ratio or the repo ratesthe fiscal authority initially reacts by following expansionary contractionary policy but subsequently reverses.

Fiscal monetary interaction in the European Monetary Union[ edit ] The European Central Bank was created in December and from onwards the euro became the official currency of the member nations of the European Monetary Unionand a single monetary policy was adopted under the European Central Bank.

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.

To ensure that the member nations meet the conditions for an optimum currency areapotential member nations were asked to commit to the following convergence criteria as spelled out in the Maastricht Treaty: Demand shock[ edit ] During a demand shock a sudden significant rise or fall in aggregate demand due to external factors without a corresponding change in output, inflation or deflation may result.

Also, fiscal policies are used to stabilise the terms of trade and maintain them at their natural levels.

Here monetary and fiscal policies may work in harmony. Passive monetary policy is one that sets interest rates to accommodate fiscal policies.

But in case of varying degrees of price rigidities amongst the nations, the terms of trade are no longer insulated from monetary policies. But in case both the authorities are active, then the expansionary pressures created by the fiscal authority are contained to some extent by the monetary policies.

Meeting these criteria forced the member nations to restrict the adoption of stabilising fiscal policies and concentrate on inflation rates to bring them down to the levels spelled out in the Treaty. This led to changes in the structure of monetary-fiscal interactions in the member nations.

Given the common monetary policies and the price levels for all the nations under the union, the fiscal authority of the home country is led to follow contractionary policies in case of deterioration in terms of trade.

This is so because, the monetary policies would be directed towards keeping the inflation of the nations with higher degree of price rigidities at optimum levels so as to reduce their terms of trade losses and the fiscal policies of the rest of the countries would assume a relatively effective role in stabilising the national inflation as the price levels would respond to the change in public spendings.

Fiscal policies are then used to minimise the country specific welfare losses arising out of such policies. Monetary authorities react in a countercyclical way to this, tightening monetary policy in the short run but perhaps in the long run adopting quantitative easing to counter the longer-term fall in output.

Active and passive monetary and fiscal policies[ edit ] Professor Eric Leeper has defined terminology as follows: Supply shock[ edit ] During a negative supply shockthe fiscal and monetary authorities may follow conflicting policies if they do not coordinate, as the fiscal authorities would follow expansionary policies to bring the output back to its original state while the monetary authorities would follow contractionary policies so as to reduce the inflation created due to the cutback in output caused by the supply shock.

In case of an active fiscal policy and a passive monetary policy, when the economy faces an expansionary fiscal shock that raises the price level, money growth passively increases as well because the monetary authority is forced to accommodate these shocks.

Active monetary policy is one that pursues its inflation target independent of fiscal policies. Active fiscal policy is one in which the tax and spending levels are determined independent of intertemporal budget consideration.

In short, lower the degree of price rigidities in an economy belonging to a monetary union, the greater would be the relative role of fiscal policies in economic stabilisation.

Interaction between monetary and fiscal policies

Fiscal shock and policy rate shock[ edit ] In case of a positive fiscal shock increase in fiscal deficitsaggregate output may rise beyond potential sustainable output due to the fiscally induced rise in aggregate demand.

Central Bank independence A stability-oriented monetary policy with the primary objective of maintaining price stability Obligations of the member states to treat the economic policies, in particular, fiscal policies as a matter of common concern. Presence of monetary union[ edit ] When an economy is a part of a monetary unionits monetary authority is no longer able to conduct its monetary policies independently in response to the needs of the economy.

Under such a situation the interaction between fiscal and monetary policies undergoes certain changes. Subsequently, this leads to dissavings and lowering of investments which would depress output in the long run.

Effect of price rigidities[ edit ] In case of a supply shockwhile the weighted average inflation is at optimum levels, the inflation levels of the nations hit by such a shock may be far from optimum.

Generally, the monetary union follows policies to keep the overall inflation at such levels so as to keep the overall gap between the actual aggregate consumption and desired consumption close to zero.IMF Home page with links to News, About the IMF, Fund Rates, IMF Publications, What's New, Standards and Codes, Country Information and featured topics.

Fiscal policy and monetary policy are the two tools used by the state to achieve its macroeconomic objectives.

While for many countries the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to .

Changes in fiscal and monetary policies
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