Fiscal and monetary policies are frequently used together to restore an economy to full employment output. For example, suppose an economy is experiencing a severe recession. One possible solution would be to engage in expansionary fiscal policy to increase aggregate demand.
Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy. By contrast, fiscal policy refers to the government's decisions about taxation and spending. Both monetary and fiscal policies are used to regulate economic activity over time.
Explanation:
Fiscal policy and monetary policy are the two tools used by the state to achieve its macroeconomic objectives. While for many countries the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. The IS/LM model is one of the models used to depict the effect of policy interactions on aggregate output and interest rates. The fiscal policies have a direct impact on the goods market and the monetary policies have a direct impact on the asset markets; since the two markets are connected to each other via the two macrovariables output and interest rates, the policies interact while influencing output and interest rates.
Traditionally, both the policy instruments were under the control of the national governments. Thus traditional analyses were made with respect to the two policy instruments to obtain the optimum policy mix of the two to achieve macroeconomic goals, lest the two policy tools be aimed at mutually inconsistent targets. But more recently, owing to the transfer of control with respect to monetary policy formulation to central banks, formation of monetary unions (like European Monetary Union formed via the Stability and Growth Pact), and attempts being made to form fiscal unions, there has been a significant structural change in the way in which fiscal and monetary policies interact.
There is a dilemma as to whether these two policies are complementary, or act as substitutes to each other for achieving macroeconomic goals. Policy makers are viewed as interacting as strategic substitutes when one policy maker's expansionary (contractionary) policies are countered by another policy maker's contractionary (expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic complements, then an expansionary (contractionary) policy of one authority is met by expansionary (contractionary) policies of the other.
The issue of interaction and the policies being complements or substitutes for each other arises only when the authorities are independent of each other. But when the goals of one authority are made subservient to those of the other, then one authority solely dominates the policy making and no interaction worthy of analysis would arise. Also, fiscal and monetary policies interact only to the extent of influencing the final objective. So long as the objectives of one policy are not influenced by the other, there is no direct interaction between them.
