Essay on interaction between monetary and fiscal policy
Answers
Explanation:
Introduction:
The objective of macroeconomic policies is to obtain noninflationary, stable economic growth. Fiscal and Monetary policies are major components of macroeconomic policy. In many countries central banks choose monetary policy with a certain degree of independence with literally no direct control from government. On the other hand fiscal policy is chosen by governments using the tax levels and government spending. While fiscal and monetary policies are chosen by two different bodies independently but theoretically these policies are not independent. Due to conflicting objectives tension can arise between government and central bank on what each will do to stabilize economy during downturn and achieve economic stability and growth.
Literature Review
During 20th century, targeting inflation has become a popular tool for achieving price stability. In introduction we emphasized that monetary policy is committed to stable lower level of inflation, this raises the question why monetary policy maker should coordinate with fiscal policy makers who aim to have higher growth and lower unemployment levels? We can find numerous researches in area of inflation targeting to stabilize prices but in all these analysis the behavior of fiscal policy is ignored; the debate on fiscal and monetary policy coordination is not new it started ate same time when monetarist recommended the independence of monetary policy in 1960. The analysis of coordination between monetary and fiscal policies was initiated by Brainard (1967) and Poole (1970) both studied the behavior of policy makers with uncertainties and economic constraints, but in their work the goals of fiscal policy makers were not explicitly discussed. Based on Poole’s work Pindyck (1976) and Rible (1980) studied the possibility of conflict between monetary and fiscal policy makers and analyzed the inefficiency of uncoordinated policies. Kydland and Prescott (1977) revolutionized the research in this area using game theory. They focused on a game between monetary policy makers and government. They incorporated rational expectations and dynamic consistency, but The major breakthrough to this literature comes from Sargent and Wallace (1981), who emphasized that the monetary policy and inflation level are not exogenous to fiscal deficits and to an extent the path to government’s fiscal deficits is unsustainable and predetermined;