The Never Ending 'Game': Interaction between Fiscal and Monetary Measures

The interaction between monetary and fiscal policies can't be clearly delineated into neatly divided quadrants but one can broadly capture the policies and their impact on the economy as shown in the chart below.

 Impact of Fiscal and Monetary measures:

The impact of fiscal spending/contraction has a time lag when compared to monetary policy. The impact of fiscal measures is more targeted, long lasting and the multiplier effect is much bigger when compared to monetary measures. Monetary authorities are much more nimble footed when compared to their fiscal counterparts but their impact is only short term in nature.

 State of the Economy: 

Both fiscal and monetary authorities respond depending on the current state of the economy - expansion, recession or stagflation etc.

The following paragraphs describe each of the scenarios outlined in the quadrants above. 

Q1 - Both fiscal and monetary policies are expansionary:

When the economy is going through a protracted downturn due to internal mishaps or external shocks, both fiscal and monetary authorities respond with favorable measures to encourage both private consumption and investment. Fiscal authorities resort to deficit spending on infrastructure, welfare schemes, job creation, production incentives etc. Monetary authorities help by maintaining a low interest rate environment and adequate liquidity in the economy. Both these measures help in increasing the aggregate demand and aggregate supply, thereby boosting the economic activity. 

However, the economy needs to guard against the risks of overheating and inflation. Particularly, the fiscal purse (whiplash of the government!) is like the 'thunder' from the heavens above whose impact can be felt wide,long and far after. Prolonged inflationary situation in any economy disturbs the faith of its people in 'money and its purchasing power' - vitamin M is the most important nutrient for the health of any economy.

When the governments are in expansionary mode, monetary authorities maintain adequate liquidity to keep the borrowing costs low and ensure that private investment is not crowded out due to higher borrowing costs. But sometimes, monetary authorities fall short on curbing the inflation in a timely manner. Once the inflation 'genie is out of the bottle' - it is difficult to control without 'hard-landing'. This is the current situation of the US economy. Think of the impact of a 'hard-landing' on those people at the bottom of the pyramid! 

There is only so much stimulus that an economy can hold in an year - there are constraints arising out of price pressures, supply side limitations, lack of adequate infrastructure, technological limitations etc.Therefore, co-ordination between fiscal and monetary authorities is critical in prevention of overheating in the economy. Although, not with great precision, the multiplier effect of any fiscal stimulus can be estimated before execution - price-levels (not just populism!) have to be factored and calibrated.

Q2 - Fiscal consolidation and monetary expansion:

Before discussing anything about fiscal contraction, one needs to note that fiscal consolidation is not the same as fiscal 'austerity'. Fiscal austerity has proven to be a failed experiment particularly in countries such as Greece after the sovereign debt default. In a recessionary environment, austerity is probably the worst and 'most cruel' policy in the last couple of decades, with the benefit of hindsight and Economics 101.

If the economy is in a steady and sweet spot, then private expenditure and consumption should take control and the fiscal authorities can limit themselves to limited regulation, welfare and infrastructure expenditure. Depending on price levels in the economy the monetary authorities can switch from 'dovish' to 'hawkish' stance or vice versa.

'Liquidity trap' is a situation where monetary authorities maintain sufficient liquidity and a favorable interest rate environment but private consumption and/or investment don't respond,much to the aberration of the former. In such situations we need to fall back on the good old fiscal purse.

For emerging markets, fiscal consolidation is limited by the need for infrastructure development and large scale poverty.

Q3 - Steady fiscal expansion and monetary contraction:

This situation is similar to the one described in Q2. When the economy is in a state of steady expansion , both fiscal and monetary authorities balance each other in the best interest of the economy.

Alan Greenspan's era at the helm of the Federal Reserve is considered to be the best phase in their economic history, before the onset of the Great Recession of 2008.

Q4 - Both fiscal and monetary measures are in contraction mode: 

When the global economies are in overheating mode, then fiscal spending has to steadily fall and monetary authorities can go all out to establish macro-economic stability. At the same time, we need to think about those people at the bottom of the pyramid as stated above.

The US economy is probably now in Q3/Q4 situation stated in the matrix above.

There's no Nash's Equilibrium or a sweet spot:

Like in 'game theory', there's no equilibrium or one particular approach, as global economies are in a constant state of flux. It is probably safe to be in a Q2/Q3 kind of a situation, where fiscal and monetary polices are balancing each other and bulk of the burden of growth falls on the private participants.

A steady growth rate,macro economic stability, low unemployment, minimum standards of living for the poor should be the central objectives of fiscal and monetary policies.

 to be continued.....