How fiscal and monetary policy affect the economy

It’s been said in the past that economics is an ivory tower type of profession with economists removed from the daily concerns of average people, and instead, engrossed in theoretical models and equations. Yet, if you were to ask economists about this – not only would they dispute this claim – you’d find that many of the core topics economists are exploring the same questions that citizens, policy makers, and tax payers alike are also asking themselves. Can fiscal policy increase economic growth? How much impact do central banks and monetary policy really have on society? What is fiscal policy’s effect on businesses?

Nobel Laureate Finn Kydland was awarded the prize in 2004 for his contributions to dynamic macroeconomics and has done extensive research on the driving forces behind business cycles and the time consistency component to economic policy. He has published more than 50 papers, many of which have been focused on monetary policy.

“Monetary policy mainly consists of controlling the speed with which new money is created and, in the long run at least, the rate of inflation is determined by how quickly the money stock is increased,” says Kydland. “Fiscal policy has to do directly with the government budget. The government needs to spend a certain amount for goods and services. They also have to pay interest on their outstanding debt. And they need to get the money from somewhere, just like you and me, they need to balance the budget. We cannot spend more than we take in in wages. The main way they get revenue is through various forms of taxes. They can make up for potential shortfall by borrowing.”

“The conduct of all of that, that’s what we call fiscal policy,” he continues. “Now, both types of policy are such that decision makers’ view about what the policy is going to be in the future affects what they do today. So, for example, in the monetary arena, if you think that the central bank is going to speed up the extent to which they create money, today prices would start going up. Prices wouldn’t wait until the actual speedup takes place as long as that’s what people believe.”

If a country increases the speed in which they print money, they run the risk of hyperinflation. Hyperinflation is when the prices of goods and services rise drastically while the actual value of a currency decreases. This happened in Germany in the 1920s and in several Latin Americans countries in the 1980s. Hyperinflation is also behind the currency instability of Venezuela that began in 2016. According to Bloomberg, Venezuela’s now four year bout of hyperinflation is one of the longest in the world.

“In the case of fiscal policy, tax policy in particular, the forward-looking, growth-promoting decisions about innovative activity and creating new capital, new factories, new machines, office buildings and so on – they’re very expensive activities as they take place,” says Kydland. “The returns come over after they’re finished, and here’s where fiscal policy can be quite important because these returns, two, three, five, ten years into the future, it’s after tax returns that matter. So in some sense, I would argue that by and large, unless there is an emergency or something, it’s fiscal policy that’s really important for real economic sustainable growth.”

Fellow Nobel Laureates Thomas Sargent and Christopher Sims, who were co-awarded the prize in 2011, agree about the practical importance of fiscal policy and discuss how fiscal policy can increase economic growth, and its limitations.

“Fiscal policy of certain kinds can have a more immediate impact,” says Sim. “If there’s lots of unused resources in the economy, the government can hire people and start building things quite promptly. There the delay is not so much in the effect of the action on the economy as it is in the political process for actually getting any fiscal policy changes implemented.”

“Fiscal policy has a huge ability to affect an economy because of its taxes and expenditures,” echoes Sargent. “The central bank’s a sideshow. This isn’t what you hear in the news, but to a first approximation, it’s a place to start. If you look at big events where governments have had huge effects on people, it’s through fiscal policy, it’s taxes. I probably shouldn’t say that, but it’s true.”

This somewhat controversial aspect of that comment is rooted in the fact that this was not always the stance taken by economists. One of the most important economic papers in the 20th century was The Role of Monetary Policy by Milton Friedman in 1968. In it, Friedman argued that central banks couldn’t affect unemployment or interest rates long term. What monetary policy could do, he wrote, was prevent money itself from being a major source of economic disturbance and provide a stable background for the economy.

“Policy reacts to the state of the economy, so the interest rate moves because other things in the economy have changed,” says Sims. “But then when policy takes action, there’s a response in the economy. And in that sense, these relationships are reciprocal.”

Sims has built models using regulated methods that suggest that a tightening of monetary policy in ordinary times takes approximately one year to have its full effect on the level of business activity, and slightly longer than that to have its full effect on inflation. These types of methods and estimates are important when modeling for uncertain times, events like recessions or pandemics.

“One of our problems is when an economy goes into recession, we usually don’t know that this has happened until around six months at least after it’s actually happened because there’s a lack of data,” says Sims. “And so even fiscal policy, even if it’s applied quickly, tends to be a little late. That’s why we have recessions because if we knew when they were coming, we could take action to avoid them.”

“This is one reason why central banks think they need to anticipate changes in interest rates, changes in inflation, because they know that any action they take is going to have effects only slowly on the economy,” he continues. “If they wait until inflation is actually way below or way above their target, it’s going to take a long time to get back to target.”

While the effect fiscal and monetary policy have on businesses and the overall health of the economy is clear, a newer area being explored is the link between monetary policy and equality. Nobel Laureate Joseph Stiglitz doesn’t think there’s a silver bullet that can undo the inequalities that have been created and sustained for the last few decades, but he does see an opportunity for multiple policies, working cohesively, that could make a big difference. Progressive income taxes, expenditure programs, secure retirement and access to healthcare are a few of the areas where he believes we need better policies.

“Equality is really something that touches every aspect of policy. As inequality has become one of the dominant problems in our society, we have to use that lens of how policy affects inequality,” says Stiglitz. “For instance, monetary policy, it used to be nobody in a central bank talked about inequality. But today we realize that monetary policy has played a very big role in increasing inequality and wealth. And so central banks simply cannot ignore the impact that their policies have on inequality.”

Kydland also sees the need for new commitments and policy implications to ensure that fiscal and monetary policy are used for long-term stability.

“There’s a need for a commitment mechanism, a way to commit the government to good policy over a reasonably long run,” says Kydland. “The best example we have of such a commitment mechanism is the idea of making a central bank independent of political pressure. It turns out, if you rank nations in terms of the independence of the central banks, monetary policy tends to be more benign under independent central banks.”

“In the arena of fiscal policy, it’s much harder. There’s nothing analogous to a central bank conducting fiscal policy,” he says. “It’s governed by voting. How you commit to good future fiscal policy is something I regard as especially serious these days.”