Interrelation and Coordination of Monetary and Fiscal Policies | Economics

Monetary and fiscal policies are complementary, and not contradictory to each other. They are interrelated and have to be judiciously combined to promote and stabilise the economic activity.

The interrelation of monetary and fiscal policies is clear from the following points:

(i) Monetary policy provides financial infrastructure and regulates money supply. Fiscal policy through its instruments of taxation, borrowing and deficit spending has considerable impact on the money supply and liquidity in the economy.

(ii) Monetary policy influences the aggregate demand, and, in turn, output, income and employment, indirectly by regulating the flow of credit and money supply. Fiscal policy has direct, through lagged, impact on aggregate demand.

(iii) Monetary policy provides stability in the economy in the long run, while built-in stability of fiscal policy iron out short run fluctuations.

(iv) Monetary policy is more flexible and can be easily adjusted to the changing needs. Fiscal policy, on the other hand cannot be easily and quickly changed,

(v) Monetary policy has fiscal implications and fiscal policy has monetary implications,

(vi) Monetary and fiscal policies are interdependent and mutually reinforce each other.

(vii) Monetary and fiscal policies are complementary to each other; when one fails, the other succeeds. Monetary policy is more effective during inflation, while fiscal policy is more effective during deflation.

(viii) A judicious combination of monetary and fiscal policies is required to meet economic exigencies.

Monetary Implications of Fiscal Policies:

Since fiscal policy is concerned with the money flows into and out of the Treasury, the budgetary operations of the government have a monetary aspect. Fiscal policy creates two types of monetary problems- How to finance a budgetary deficit and what to do with the funds resulting from a budgetary surplus.

The existence of a large public debt itself gives rise to monetary issues:

1. Financing a Deficit Budget:

A budget deficit has expansionary monetary impact which depends upon how the deficit is financed. The budget deficit can be financed- (a) through printing currency notes; and (b) through the sale of securities, i.e.., increasing interest-bearing public debt.

Further, the securities can be sold to (or funds can be borrowed from)- (i) the non-banking public, such as individuals, corporations, institutional investors like insurance companies, etc.; or (ii) the commercial banks; or (iii) the central bank.

The expansionary effect of these methods is discussed below:

(i) Printing of currency notes to finance the excess of government expenditure over tax receipts increases money supply and, if not matched by increased productivity, raises the price level.

(ii) Regarding the sale of securities, the expansionary effect of the deficit budget is maximum when the securities are sold to the central bank and the least when they are sold to the non-banking public.

(iii) Sale of securities to the central bank creates deposits in favour of the government which, when spent, puts the funds into the hands of the public. These funds are deposited in the commercial banks. The result is that the public’s demand deposits and the banks’ reserves increase.

With this increase in deposits, the banks, on the basis of the system of fractional reserves, create additional deposits through the process of credit multiplier. Thus, this method of financing budget deficit injects money into the economy with cumulative force.

(iv) The sale of securities to commercial banks increases government’s demand deposits with the banks. These deposits, when spent, put money into the hands of the public. Since there is no change in the bank reserves, banks cannot create more demand deposits. Thus, the expansionary effect in this case is less than in the case of borrowing from the central bank,

(v) The sale of securities of non-banking public simply transfers demand deposits from the public to the government. When the government spends money, these deposits again come into the hands of the public. There is change in the excess reserves and thus no net addition to money supply. This method is least inflationary.

(vi) Deficit financing through the sale of securities to the banks or the non-banking public also poses the problem of debt management which creates a monetary problem for the future.

2. Surplus Budgeting:

A surplus budget has deflationary impact on the economy which depends upon what the government does with the excess receipts. Budget surplus can be used to redeem securities held by the central bank or the commercial banks or the non-banking public. Maximum deflationary effect will be produced if the government redeems securities held by the central bank or accumulates the idle deposits at the commercial banks.

The deflationary effect will be somewhat less powerful, if the government retires securities held by the commercial banks. The deflationary effect will be minimum if the surplus receipts are used to retire bonds held by the non-banking public.

Integration of Monetary and Fiscal Policies:

Monetary policy and fiscal policy arc complementary, and not contradictory, to each other. When monetary policy fails, the fiscal policy can succeed, and when fiscal policy is ineffective, monetary policy can do the job.

To be specific, monetary policy is more effective weapon to fight inflation, while fiscal policy is more effective to deal with deflation. During inflation, a tight money policy with high interest rates is required to control credit expansion and money supply and restrict speculative investment.

But, monetary policy is weak against deflation because the marginal efficiency of capital (or the profit expectations) falls so low that a cheap money policy with low interest rate fails to stimulate investment. During deflation, fiscal measures, such as, public works programmes, can help to increase employment, output and income in the economy.

Fiscal policy, which was advocated by Keynes to deal with the unprecedented situations like the Great Depression, remained popular till the end of 1960s. Since 1970s, the worldwide inflationary tendency has led to the revival of monetary policy?

Thus, both monetary policy and fiscal policy have their points of relative strength and relative weakness. What is needed is not accepting one and rejecting the other absolutely, but to deal effectively with a particular economic situation.