What is monetary and fiscal policy?

In this post we look at government monetary and fiscal policy and how that are related. Very interesting stuff when you follow the actions of governments (spending/taxes), and reserve banks (interest rates).

General Monetary Policy

The process by which central banks control 1) the supply of money, 2) the cost of money or interest rates, and 3) the availability of money. See 'What is money supply?'. Monetary policy can be expansionary which increases the supply of money in the economy (used to spur economic growth); or contractionary which does the reverse.

• Expansionary policy. Total money supply can be increased by printing more money (increasing M0), lowering the cost of money (interest rates) and making easier to 'borrow' it into existence, and by lowering reserve and capital requirements on banks (allowing them to lend more). The US Federal Reserve has added an additional measure allowing banks to swap risky assets (code for assets that have lost most/all of their value, but the banks can't afford to admit it) for quality US Treasuries. This impacts their balance sheet and thus capital ratios by being able to account for the assets differently.
  
• Contractionary policy. Reducing total money supply by printing less (or taking money out of circulation), raise the cost of money (interest rates), and raising reserve requirements.

Monetary Policy Targets

Governments control or direct different policy objectives with monetary policy. These include:

1. Inflation targeting. Targeting a CPI rate of change, say 2-3% yoy, through changes to the overnight interest rate.
   
2. Price level targeting. A specific CPI number, through changes to the overnight interest rate.
   
3. Monetary aggregates. Targeting a CPI rate of change, say 2-3% yoy, by changing money supply (M0).
4. Mixed policy. Targeting low (full) unemployment and low CPI change (low inflation).
5. Gold standard. Targeting low inflation as measured by gold price by changing the fixed gold - currency rate.

Difficulties arise in monetary policy due to globalisation. With globalisation investment capital, and commodity prices are free to move across borders resulting in exchange rate fluctuations, whilst monetary policy is nation dependent. As of July 2008, we have the following quick summaries of monetary policy:

• US. Expansionary - The Fed is stuck between inflation and a failing economy, as it has dual mandates of price stability (low inflation - stability in prices) and employment (sound economy).
• China. Contractionary - Rampant inflation is being addressed with high and rising interest rates and increasing bank reserve requirements. However money supply is increasing (M0) as the Yuan is pegged to the USD, requiring China money printing and sales to artifically depress the Yuan.
• EU. Contractionary - The EU Fed mandate is price stability (low inflation) and is raising interest rates to contract the EU economy in response to high CPI. The EU economy is believed to be close to stalling point.
• Australia. The Reserve Bank is raising interest rates to slow a booming economy (based on the resources sector & government spending). Mandate is inflation targeting with yoy CPI 2-3%.

Fiscal Policy

Fiscal policy relates entirely to government spending. Like monetary policy, fiscal policy can expansionary or contractionary. Fiscal policy is expansionary when government spending exceeds income (money added to the economy), and contractionary when taxes exceed spending (money taken from the economy).

Governments spend of things like social programs, military/police, healthcare and education, as well as infrastructure like roads, airports and ports. Government spending can be funded through:

1. Taxation. Or taxes, surcharges, fees, levies, co-contributions, fines and other language that means taxes.
2. Sale of assets. Such as airports, highways, power plants, radio spectrum.
3. Draw-down of previous surpluses.
4. Borrowing money from capital markets. By selling government bonds.

Are monetary policy and fiscal policy independent?

John Hussman summarises best though this is a more advanced concept (albeit in a US environment. Swap Federal Reserve for your local central bank, and Congress for your local Government).

There is a simple way to think about the relationship between fiscal policy (government spending, taxes) and monetary policy (money supply, interest rates). It is what economists call the Government Budget Constraint

Government Spending = Tax Revenues + Change in Bonds held by Public + Change in Bonds held by Federal Reserve

What this says is that there are literally only 3 ways to finance government spending.

1. Increase tax revenues. Note that this is not necessarily accomplished best by raising tax rates. Regardless of how high the government has set top tax rates, government revenues have consistently hovered between 19% and 19.5% of GDP. The high deficits of the recent past are due to growth in the government share of GDP from about 19% in the 1960's to nearly 23% currently. This growth has been due primarily to an increase in Social Services expenditures such as Medicaid and Social Security. The share of GDP allocated to infrastructure (highways, telecommunications) as well as basic research has actually declined.

2. Sell bonds to the public. This borrowing from the public is the primary means of financing the government deficit. Other things being equal, if the government issues more bonds, the price of those bonds tends to decline, meaning that interest rates tend to rise. This does not mean that a government deficit raises interest rates (there is no statistical evidence to support this notion). The true burden of government is not how much it borrows, but how much it spends. If the government decides to raise taxes rather than borrow from the bond market, it is true that investors will need to buy fewer bonds, but only because they also will have less to invest (due to the higher taxes, which almost always fall on those individuals with the highest savings rate). Raising taxes to cut the deficit therefore does nothing to increase the supply of funds available to other borrowers, and therefore nothing to reduce the level of interest rates. A cut in government spending does increase the supply of funds available to private borrowers. This is particularly true if the tax and regulatory environment is friendly to investment, which can then offset the cut in government spending without a decline in GDP.

3. Sell bonds to the Federal Reserve. This is another way of saying print money.

In short, the Federal Reserve is not nearly as independent as it may appear. The Fed has the choice of whether government liabilities take the form of bonds held by the public, or money held by the public. The Federal Reserve can alter the mix of government liabilities (bonds held by the public vs. money held by the public), but the total amount of these liabilities is determined by fiscal policy, not monetary policy. The Fed can affect whether excessive government spending results in tight bank credit or high inflation, but it cannot prevent both unless Congress controls the growth of government spending itself.