Examining fiscal and monetary policy implications

In the discussions about policy institutions many analysts emphasize the importance of Central Bank’s independence so that the responsibilities for fiscal policy (the Ministry of Finance) and monetary policy (the independent central bank) are clearly delineated.

In the discussions about policy institutions many analysts emphasize the importance of Central Bank’s independence so that the responsibilities for fiscal policy (the Ministry of Finance) and monetary policy (the independent central bank) are clearly delineated.

It is argued that an independent central bank can take decisions necessary for financial stability without being hindered by political intervention. Studies have tried to show that countries with independent central banks have lower rates of inflation.

Studies carried out by Richard Froyen(1974) and Grant Reuber(1964) assert that central bank objectives have typically been taken to include a balance –of –payments target, an inflation target and possibly some response to exogenous shocks such as oil price inflation.

Here, an attempt is also made to determine the extent to which the central bank accommodates the credit requirements of the government sector without squeezing private sector credit availability and reacts to foreign debt accumulation.

However, in reality, fiscal policy has constantly monetary implications. Firstly, stabilization policy to flourish in Rwanda we need co-ordination between the finance ministry and central bank.

Even where the central bank is independent, however, there has to be an agreement on the objectives of economic policy and there has to be co-ordination in policy design and implementation.

Nevertheless, fiscal policy can influence monetary policy through different channels. Sergeant and Wallace (1981) show that in a so-called “fiscal dominant” regime, where the fiscal authority sets its budget independently of public sector liabilities, a fiscal expansion may eventually require monetization, and hence resulting in higher inflation. Fiscal policy has an impact on inflation also through its effects on the aggregate demand.

In early stages of economic development, when financial markets are still rudimentary, fiscal and monetary policy are the same.

An expansion of the fiscal deficit can only be financed by the central bank as there is no market for government bonds.

Later on, when financial markets develop, the government can sell bonds to commercial banks and other financial institutions and, later on, also to the general public.

At this stage, there will also emerge a secondary market where outstanding bonds can be traded and which the central bank can use for its open market operations.

Under these conditions fiscal and monetary policy can become more independent: the Ministry of Finance can sell bonds to finance its deficit and the central bank can intervene on the secondary market to regulate liquidity and control inflation.

But even under these conditions close co-ordination is desirable in our country’s economy for the number of reasons: Monetary policy affects fiscal balances. For instance a loose monetary policy will reduce rates and thus reduce the debt –servicing cost of government debt.

On the other hand, if the loose monetary policy leads to higher inflation, the interest rates and interest expenses will rise or, if the low cost of borrowing would induce the government to increase the deficit, the increased supply of bonds will lead to increase in the interest rates: in this case, there is a clear conflict between monetary and fiscal policy.

Further, a tight monetary policy will increase the interest rate and the cost of deficit financing. In my view, and the view of most development economists, if such tight monetary policy is accompanied by a bulky fiscal deficit, there will be a policy conflict.

The huge deficit financing and the high interest cost together will lead to a rapid increase in debt service cost and thus to a further expansion of the deficit.

In this case, however, monetary policy would not be credible as the market would anticipate that the large fiscal deficit will ultimately show the way to inflation.

To the other side, fiscal policy has monetary consequences. An increase in the fiscal deficit is financed by borrowing from the central bank (i.e. the money supply increases), by issuing bonds (which may lead to an increase in market interest rates) or by borrowing abroad (which may increase reserves and the money supply).

However, the most cardinal issue is that coordination is a paramount issue because monetary and fiscal policies operate in different time frames: fiscal variables take some time to adjust while monetary policy instruments can be adjusted on a daily basis. 

Hence, fiscal policy follows further the longer term trends where monetary policy can be used for the fine-turning. Still, the relative roles of fiscal and monetary policy depend on the exchange rate regime and the degree of capital mobility.

With fixed exchange rates and perfect capital mobility fiscal policy can be more useful and monetary policy ineffective. Under flexible rates with perfect capital mobility the outcome have a tendency to reverse.

But the extremes conditions do not occur: fixed exchange rates can be adjusted and flexible rates are managed and capital mobility is on no account fully perfect. Under these conditions a policy mix becomes realistic and necessary.

To avoid conflicts between fiscal and monetary policy therefore, some countries have introduced rules. Most of countries have statutory limits to the lending by the central bank to the government: in some countries it is fully prohibited. This limits the fiscal deficit to the amount that the government can finance on the market.

On the other hand, other countries have introduced rules of fiscal policy e.g. the law on the budget balance in the United States. Nevertheless fiscal discipline is essential in countries like Rwanda since the government can only finance the deficit that the market would accept and a high deficit will erode the credibility of the currency board like in the case of Argentina.

Ideally, monetary policy ought to be fully integrated with fiscal policy and other elements of macroeconomic strategy. Fiscal and monetary authorities need to share information with each other and as well be in the regular contact on the formulation and implementation of the policies.

The author works with the ministry of Finance and Economic Planning in Rwanda and can be reached at: sfeston2000@yahoo.co.uk

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