Are Fiscal and Monetary Policies Interdependent?

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Each issue of The Regional Economist, published by the Federal Reserve Bank of St. Louis, features the section “Ask an Economist,” in which one of the Bank’s economists answers a question. The answer below was provided by Senior Economist Fernando Martin.

Are fiscal and monetary policies interdependent?

Yes, indeed they are. Some of the key insights in our understanding of the link between fiscal and monetary policies were articulated in an influential 1981 paper by Thomas Sargent, an economist at NYU and 2011 Nobel laureate, and by Neil Wallace, an economist at Penn State.¹

Arguably, one of the main roles of any central bank (e.g., the Federal Reserve) is to manage the inflation rate. Inflation erodes the real value of nominal assets and is, therefore, costly to society. However, when a government issues bonds in its own currency, inflation alleviates the financial burden of inherited debt. Thus, central banks have a natural incentive to finance past deficits by using inflation to reduce the real value of government debt.

When a fiscal authority (e.g., the Treasury Department) evaluates how to finance its obligations with taxes and debt, it takes into account its expectations about future monetary policy. In particular, issuing more debt today may induce the central bank to increase inflation tomorrow, which would make the new debt less financially burdensome. This bias toward deficit financing is mitigated (and even overcome) by the fact that higher expected inflation translates into lower demand for bonds and, thus, higher interest rates.

There are episodes that highlight this interaction. During World War II, the U.S. federal debt climbed to about 100 percent of output. What followed was a period (1946-1948) of significant inflation. Lee Ohanian, an economist at UCLA, estimates that the reduction of the real value of debt due to the increase in prices was equivalent to a repudiation of debt worth 40 percent of GNP.²

Various institutions have been developed in order to mitigate the incentives to use inflation as a means to finance current and/or past deficits. More and more central banks are endowed with explicit low-inflation objectives and are sheltered from political influence. In addition, central banks are usually prohibited from directly financing deficits—a lesson learned from numerous hyperinflation episodes. Fiscal authorities can also help in disciplining monetary policy. For example, starting in 1997, the U.S. Treasury has been issuing Treasury Inflation-Protected Securities (TIPS). As of October 2011, these inflation-indexed bonds accounted for about 7 percent of the total federal debt held by the public.

Notes and References

¹ Sargent, Thomas J.; and Wallace, Neil. "Some Unpleasant Monetarist Arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, Fall 1981.

² Ohanian, Lee. The Macroeconomic Effects of War Finance in the United States: Taxes, Inflation, and Deficit Finance. New York, Garland Press, 1998.

Additional Resources

• Regional Economist: Ask an Economist
• On the Economy: Why Did Markets Drop after the FOMC Meeting?
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