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How does fiscal policy affect monetary policy?(1)
By Sandra Mollentze

The storm that we spoke of last year has broken, and it is more severe than anyone anticipated.
(Mr Trevor Manual, Budget Speech 2009)

Introduction

olicy changes affect each and every individual in this country. Whatever decisions are made impact on every person’s economic life. Therefore, the economic performance of a country is important. Certain macroeconomic objectives may be identified: high and sustained economic growth, comparative price stability (low inflation), high and stable levels of employment (i.e., low to zero unemployment), balanced exports and imports (balance-of-payments equilibrium) and a stable external value of the country’s currency unit (exchange rate stability). These norms (or goals) are usually seen as reasons for government intervention in the economy. The problem, however, is that it is not easy to achieve these goals (objectives) simultaneously. A country usually finds it difficult to reach one or more of them at a given time. Therefore, in pursuit of economic policy, policy-makers must choose the objectives that should be prioritised . Modern central banking tends to focus on attaining price stability. Throughout the world, most central bank policy initiatives are aimed at achieving and maintaining price stability and the South African Reserve Bank is no exception.

Interaction of monetary and fiscal policy (2)

The interaction between monetary and fiscal policies relates to the fact that both types of policies have an impact on key macroeconomic variables. This, in turn, creates interdependencies in the pursuit of policy objectives. On the one hand, fiscal policy influences price developments, real interest rates and risk premia, as well as aggregate demand and potential output. On the other hand, monetary policy has an impact on short-term interest rates, inflation expectations and the risk premia incorporated in long-term yields. All these variables affect the environment in which fiscal policy operates.(3)

There are three main channels through which fiscal policy can affect the short-term environment for monetary policy. Firstly, fiscal policy can affect economic growth and prices via discretionary fiscal policy stabilisation. Secondly, the operation of automatic fiscal stabilisers(4) can contribute to reducing short-term volatility. Thirdly, governments have some instruments at their disposal that have a quick effect on price developments, such as changes in tax rates. Monetary policy on the other hand has an effect on the cost of financing government debt and the potential financial market effects of financing decisions.

In an ideal situation, fiscal policy should contribute to maintaining the environment for macroeconomic stability, while monetary policy must continuously monitor the fiscal policy stance in order to be effective. Objectives and instruments must be assigned efficiently and a clear division of responsibilities is needed. However, given the inability of both fiscal and monetary policy-makers to fine-tune economic developments, active co-ordination of fiscal and monetary policies is doomed to be ineffective. Moreover, commitments to ex ante co-ordination between monetary and fiscal policies may blur the responsibilities of monetary and fiscal authorities, and ultimately reduce the incentives to pursue their respective objectives.

In pursuit of its objectives, a central bank has to take account of fiscal policy and, in particular, the magnitude of the cyclically adjusted budget balance and the sources used to fund the deficit. With strong automatic stabilisers in place, an increase in aggregate demand would have less effect on output and inflation, and would decrease the need for the central bank to respond aggressively. Automatic fiscal stabilisers could thus play an important role in complementing countercyclical monetary policy.

The objectives of fiscal policy have changed over time. During the 1970s and early 1980s fiscal policy was centred on demand management. Fiscal policy in South Africa is now growth orientated.

The medium-term expenditure framework (NTEF) has played an important role in anchoring long-term fiscal expectations, more emphasis should be placed on automatic fiscal stabilisers to enable them to play an effective countercyclical role. Fiscal stabilisers could play an important role as a complement to countercyclical monetary policy. Prudent discretionary fiscal policy, conducted symmetrically over the economic cycle, could provide further support to monetary policy.

The most important way in which fiscal policies can improve the environment in which the central bank operates is by supporting macroeconomic stability. In the short term, automatic fiscal stabilisers rather than discretionary fiscal policy measures are likely to have a stabilising effect on the aggregate level of activity and on prices. In the longer term, both fiscal sustainability and supply-side oriented reform measures have the potential to lift the non-inflationary growth rate of the economy and improve the macroeconomic environment for monetary policy. Both fiscal and monetary policies affect aggregate demand. But because discretionary fiscal policy changes are often difficult to enact in a timely fashion, automatic stabilisers and discretionary monetary policy are viewed as the primary policy tools for macroeconomic stabilisation.

The objectives of fiscal policy have changed over time. During the 1970s and early 1980s fiscal policy was centred on demand management. Fiscal policy in South Africa is now growth orientated.

The South African government is currently pursuing a predominant Keynesian policy, based on the theory that inadequate spending is an important cause of recessions. To combat recessions caused by insufficient demand rather than slow growth of potential output, policy-makers should stimulate government spending. Therefore, policies are used to effect planned aggregate expenditure, with the objective of eliminating output gaps (i.e., stabilisation policies). Monetary policy will, therefore, have to contend with these monetary influences and create a stable financial environment to enable governments to achieve their macroeconomic objectives effectively.

“We are engaged in constructive conversations with the big four banks to see what is possible in the flow of credit to various sectors of the economy ... and to identify a number of areas we should be working on,”he told reporters.

Economic Development Minister, Mr Ebrahim Patel
Business Day, 26 August 2009


(1)The views expressed in this article are those of the author and do not necessarily reflect those of the South African Reserve Bank.

(2)Fiscal policy can be defined as: All deliberate efforts of government to use changes in government expenditure, taxation (including transfers) and government borrowing to influence aggregate expenditure in order to influence income, production, prices, unemployment and the balance of payments.

(3)The monetary transmission mechanism was discussed in a previous issue.

(4) An automatic stabiliser can be defined as any mechanism in the economy that reduces the effects of changes in autonomous demand. In terms of the Keynesian model it stabilises the economy by reducing the multiplier effects of any disturbance to aggregate demand. However, inflation and the propensity of government to spend additional tax revenue have tended to render the concept of automatic stabilisers practically irrelevant.

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