Interaction Of Monetary And Fiscal Policies: Why Central Bankers Worry About Government Budgets

This is a topic on which there is an abundance of literature. Books are filled with information on the topic of the interaction be- tween monetary and fiscal policies, which is one of the key, but also one of the more complex, relationships in economic theory. With the role of the central bank lawyer in mind, the discussion below will ad- dress the issue from one specific angle, namely the relevance of fiscal policy for central bankers. Background Fiscal policy generally refers to the government's choice regard- ing the use of taxation and government spending to regulate the ag- gregate level of economic activity. In the same vein, the use of fiscal policy entails changes in the level or composition of government spending or taxation, and hence in the government's financial posi- tion. Key variables that policy makers focus on include government deficits and debt, as well as tax and expenditure levels. Monetary policy refers to the central bank's control of the avail- ability of credit in the economy to achieve the broad objectives of economic policy. Control can be exerted through the monetary system by operating on such aggregates as the money supply, the level and structure of interest rates, and other conditions affecting credit in the economy. The most important objective of central bankers is price stability, but there can be others such as promoting economic devel- opment and growth, exchange rate stability and safeguarding the bal- ance of external payments, and maintaining financial stability. Key variables in this policy area include interest rates, money and credit supply, and the exchange rate. While monetary and fiscal policy are implemented by two different bodies, these policies are far from independent. A change in one will influence the effectiveness of the other and thereby the over- all impact of any policy change. Tensions can arise between what