Extreme crises like the Covid-19 pandemic bring policy decisions into the spotlight.
In the short term emergency transfers and spending (fiscal policy) and interest rate and money supply adjustments (monetary policy) can take place, with the longer run implications being of concern only later. In non-cirisis or normal times economic reasoning requires policies to be consistent. At a deep level, monetary & fiscal policies can never be independent.
This presentation by Eric M, Leeper (University of Virginia) shows how both monetary policy and fiscal policy must work together, and that monetary policy draws its power from fiscal backing. He discusses how monetary and fiscal policy have two tasks: firstly, to control inflation, and secondly, to stabilise debt. To establish what ‘consistent’ policies are, he models how two regimes – a monetarist/New Keynesian view whereby Monetary Policy targets inflation and Fiscal Policy targets real debt (called active MP/passive FP), and a ‘fiscal theory’ view in which Monetary Policy maintains value of debt and Fiscal Policy controls inflation (called passive MP/active FP) – impact the economy.
Inconsistent policies emerge when fiscal and monetary policy imply different levels of inflation. Through a combination of economic models and case studies, the presentation shows the consequences of having monetary and fiscal policies thatat are either fully backed (fiscal and monetary wealth effects exactly offset each other), partial backing (smaller fiscal wealth effect offset: negative monetary wealth effects remain) or have no backing (only negative monetary wealth effects present).
Some of the key take aways from this presentation are that conventional perceptions of inflation miss a channel for fiscal inflation; perception that Monetary Policy can always stop an inflation that breaks out assumes the necessary fiscal backing will always be forthcoming; and if inflation has fiscal roots, Monetary Policy cannot offset it. Two policy options are therefore 1) to impose enforceable rules on fiscal behaviour and 2) to give different mandates to central banks.