Interaction Between Monetary and Fiscal Policy | CFA Level I Economics

In this lesson, we’ll summarize what we’ve learned about monetary and fiscal policy and how they interact with each other.

Monetary Policy and Fiscal Policy Explained

Monetary policy refers to the central bank’s actions that affect the money supply and interest rates in an economy. The main objective of the central bank is to maintain price stability, primarily by moderating aggregate demand. Monetary policy is said to be expansionary when the central bank increases the money supply and lowers interest rates. Conversely, when the central bank is reducing the money supply and increasing interest rates, the monetary policy is said to be contractionary.

Fiscal policy refers to a government’s use of taxation and spending to influence economic activity. The main objective of fiscal policy is to maintain economic stability, which is also moderated by adjusting government spending and tax policies to influence aggregate demand. The budget is said to be balanced when tax revenues equal government expenditures. A budget surplus occurs when government tax revenues exceed expenditures, and a budget deficit occurs when government expenditures exceed tax revenues. An increase in the budget deficit is said to be expansionary, while an increase in the budget surplus is said to be contractionary.

Four Possible Scenarios of Monetary and Fiscal Policy Interaction

Although both fiscal and monetary policy can alter aggregate demand, they are not interchangeable as they do so through differing channels with differing impact on the composition of aggregate demand. They can also be taken independent of each other, so there are four broad possible scenarios:

1. Both monetary and fiscal policies are expansionary: The combined effect will be highly expansionary, leading to a rise in aggregate demand. Interest rates are lower due to easy monetary policy. Both private and public sectors will expand.
2. Both policies are contractionary: Aggregate demand will be lower. Interest rates will be higher due to tight monetary policy, and both private and public sectors will contract.
3. Fiscal policy is expansionary while monetary policy is contractionary: The increased government spending or tax cuts will lead to higher aggregate demand. Increased government borrowing and tighter money supply will increase interest rates, causing private consumption and output to shrink. Government spending as a proportion of GDP will increase.
4. Fiscal policy is contractionary while monetary policy is expansionary: Interest rates will fall from decreased government borrowing and increased money supply. Private consumption and output will increase aggregate demand, while government spending as a proportion of GDP will decrease due to contractionary fiscal policy.