Set the transmission channels of fiscal policy against those of monetary policy for output and asset markets, and specify what the region of stability is in terms of both stances taken together.
The idea
Monetary and fiscal policy both steer demand but through different doors. Monetary policy works indirectly. The policy rate moves market interest rates, credit conditions, asset prices and wealth, the exchange rate and expectations, and these change spending with a lag. Fiscal policy acts directly on demand through government spending, taxes and transfers, with the size of the effect set by multipliers. It reaches asset markets through the volume of government bond issuance, the outlook for growth and inflation, and perceived sovereign risk. The region of stability is the set of fiscal and monetary stances that, taken together, keep inflation anchored and public debt sustainable. In practice the central bank must raise real rates when inflation rises, which is the Taylor principle: the policy rate rises by more than one for one with inflation. The government must adjust its primary balance to stabilise debt. The usual mistake is judging each policy alone. Stability is a joint condition, and a looser fiscal stance requires more monetary tightening only up to a limit.
A practice question
Which statement best distinguishes how fiscal policy and monetary policy reach output?
- Both work only through interest rates, and they differ only in which authority sets those rates.Why not: Treats fiscal policy as another interest-rate lever and ignores its direct spending and tax effects on demand.
- Fiscal policy acts directly on demand through spending, taxes and transfers; monetary policy acts indirectly through rates, credit, asset prices and the exchange rate. - correct
- Monetary policy changes demand directly by buying goods and services and setting tax rates, while fiscal policy works only through the exchange rate and bank credit supply.Why not: Reverses the two: it is fiscal policy that spends directly, and monetary policy that works through the exchange rate among other channels.
- Fiscal policy affects asset prices alone and has no effect on output, while monetary policy controls output entirely.Why not: Denies that fiscal policy moves output at all, though spending and tax changes are direct demand effects.
Fiscal policy moves demand directly through spending, taxes and transfers (the multiplier), whereas monetary policy transmits indirectly via market rates, credit, asset prices, the exchange rate and expectations. Treating them as the same lever is the key error.
A harder one
A government announces a large debt-financed spending increase. The central bank holds its policy rate unchanged and keeps its inflation target. Which immediate market reaction best fits how fiscal policy reaches asset markets?
- More bond supply and a stronger demand and inflation outlook push government yields up, and real yields rise unless offset. - correct
- Yields fall because the extra spending raises tax receipts by more than the spending itself.Why not: Assumes the spending pays for itself in full, which ignores the extra issuance and the stronger inflation outlook.
- Yields are unaffected, because only a central bank rate decision can ever move government bond yields at any maturity.Why not: Ignores that long-term yields respond to bond supply, growth and inflation expectations, not only to the policy rate.
- The currency must fall in proportion to the deficit, because deficit spending lowers the central bank policy rate.Why not: Wrongly links deficit spending to a lower policy rate, when the central bank holds the rate unchanged in the stem.
Debt-financed spending adds to bond supply and lifts expected growth and inflation, so government yields tend to rise, and real yields rise if the policy rate is not changed in response. Fiscal policy reaches asset markets through this financing and outlook channel.
The hardest tier
A central bank follows the rule: policy rate = 1.0% + 0.8 x inflation. Inflation rises from 3% to 5%. What happens to the real policy rate (policy rate minus inflation), and what does this imply?
- It rises by 0.8 percentage points, which is enough to anchor inflation.Why not: Uses the rule's coefficient as the change in the real rate, when the real rate changes by (0.8 - 1) x 2 = -0.4 points.
- It falls by 0.4 points, from 0.4% to 0.0%, so the rule is not stabilising and lies outside the region. - correct
- It rises by 1.6 percentage points, equal to the rise in the nominal policy rate, so policy is clearly tightening against inflation.Why not: Compares the 1.6 point rise in the nominal rate with the 2 point rise in inflation, instead of in the real rate which fell.
- It stays at 1.0%, because the intercept of the rule sets the real rate.Why not: Treats the intercept as the real rate, ignoring that a coefficient below 1 lets the real rate drift as inflation changes.
Policy rate: 1.0 + 0.8 x 3 = 3.4% and 1.0 + 0.8 x 5 = 5.0%, so the nominal rate rises 1.6 points while inflation rises 2 points. The real rate falls from 0.4% to 0.0%. A coefficient below 1 breaks the Taylor principle, so monetary policy is not stabilising.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Monetary and fiscal policy: safeguarding stability and trust
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