Interaction of Monetary and Fiscal Policies

August 31, 2005

This paper by Paul Hilbers, Advisor, IMF European Department, was presented at an IMF Seminar on Current Developments in Monetary and Financial Law, Washington, D.C., May 24-June 4, 2004.



8Interaction of Monetary and Fiscal

Policies: Why Central Bankers Worry

about Government Budgets


T his 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.


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


Paul Hilbers 3 each will do to help smooth economic cycles and achieve macroeco-nomic stability and growth. That is why it is crucial to pursue a con-sistent monetary-fiscal policy mix and coordinate these (and other) policies as much as possible to avoid tensions or inconsistencies. This policy mix is a key component of the IMF’s macroeconomic policy advice and of IMF-supported economic adjustment programs, to-gether with external, structural, and financial sector policies. In prac-tice, imbalances in the budgetary position have in many cases proven to be a key element in both macroeconomic problems and their solu-tion. For this reason, the IMF was sometimes jokingly said to stand for “It’s Mostly Fiscal,” although in reality the macroeconomic prob-lems countries are faced with generally consist of a broader mix of imbalances and require a broader set of policy responses.


How does fiscal policy affect monetary policy and thus the cen-tral banks? There are both direct and indirect channels. Starting with the first category, there are a number of ways in which fiscal policy may impinge on monetary policy. First and foremost, an expansionary fiscal policy may result in excessive fiscal deficits, which may create a strong temptation for governments to resort to the printing press (i.e., monetary financing by the central bank) to finance the deficits. An expansionary fiscal policy, then, leads to an expansionary mone-tary policy, fueling inflationary pressures, causing a possible real ap-preciation of the currency and hence balance of payments difficulties, potentially even resulting in a currency (and/or banking) crisis.

But even if governments finance their deficits in a non-monetary way, that is, through the markets, there may be cause for concern, specifically about crowding out: if governments take up (too) much funding in the markets, the result may be too little or too expensive credit for the private sector. This may harm economic development and growth, which would certainly be a concern of central bankers. On the external side, there is the risk that too much dependence on foreign funding of domestic debt results in exchange rate and/or balance-of-payments risks, which again would be worrying to central banks.

There is another, more direct channel of fiscal policy affecting central bankers and that is the impact of indirect taxes on the price

4 y Interaction of Monetary and Fiscal Policies.

level and thus on inflation. If governments feel forced to resort to substantial increases in indirect taxes—sales taxes, value added taxes—rather than taxes on various forms of income, this will have a direct impact on prices. The key concern here is that a one-off in-crease leads to a wage-price spiral and therefore permanent (higher) inflation and inflationary expectations.

In addition to these direct relationships between fiscal and mone-tary policy, there is the more indirect channel through expectations. Perceptions and expectations of large and on-going budget deficits and resulting large borrowing requirements may trigger a lack of con-fidence in the economic prospects. This may become a risk to the sta-bility in financial markets. Such a lack of confidence in the sustain-ability of the financial position of the government may become a po-tential destabilizing factor on bond and foreign exchange markets, eventually even leading to the collapse of the monetary regime.

Impact of Fiscal Expansion

Conceivably, expansionary fiscal policy may at some stage be-come ineffective as a means to stimulate demand and, similarly, fiscal contractions may turn out to be expansionary.1 When economic agents realize that the government is borrowing too much for its own good, they will conclude that this can only lead to higher taxation levels in the future, and they may decide to compensate for that al-ready now by saving more and consuming less. This so-called “Ri-cardian equivalence” means that the financial behavior of economic agents—on which central banks base their monetary policy deci-sions—depends on their perception of fiscal sustainability. It is there-fore another example of how fiscal policy can (indirectly) affect the effectiveness of monetary policy.

It should be noted that the impact of fiscal policy on central bank objectives is not automatically avoided when the central bank is inde-pendent. Even when the central bank has independence, and hence is not submitted to the fiscal needs of the government, the need to offset the impact of expansionary fiscal policy on aggregate demand and inflation in the economy could prompt the central bank to tighten monetary policy, by raising interest rates or reducing credit in the fi-nancial system. The resulting high interest rates could depress eco-nomic activity, attract short-term and easily reversible capital in-

Paul Hilbers 5 flows—thereby adding to inflation and appreciation pressures on the currency, and eventually damaging macroeconomic and financial sta-bility.

Severe budgetary problems may even lead to crises. There have been a number of examples of such severe tensions in the past, in which large and growing fiscal deficits—in the absence of needed public sector reforms—led to high real interest rates. This intensified the government’s debt-servicing costs, causing a buildup of short-term and foreign currency-linked public debt, thus increasing the sen-sitivity to interest rate, exchange rate, and rollover risks, which mate-rialized as foreign capital inflows that had helped to finance the debt were suddenly reversed. Examples of this set of circumstances were apparent in the run up to the crises in Turkey (1994, 2001), Mexico (1994), Russia (1998), Brazil (1999), and Argentina (2001).

Even in countries where such extreme conditions did not materi-alize, the sustainability of the monetary regimes can be challenged by fiscal policies that are too accommodating. This has happened in the past in, for example, Israel and Poland where expansionary fiscal pol-icy caused an overheating of the economy, reviving inflationary pres-sures and worsening the current account. High interest rates—required to contain inflation—attracted capital inflows that compli-cated the implementation of monetary policy. Sterilization of capital inflows to keep inflation under check became increasingly difficult and costly for the central bank.

Financial Markets

Another area where monetary and fiscal policy come together is the development of financial markets. Both finance ministries and central banks have a strong interest in financial market development because (1) it is indispensable for economic development and growth;

(2) it facilitates funding of deficits and debt; and (3) it enables mar-ket-based operations by central banks. As part of financial market development, it is important for the authorities to engage in a discus-sion with (potential) market participants about market practices, con-ditions, and possible impediments.

The relationship between monetary and fiscal policy depends strongly on the development of financial markets. The transition from

6 y Interaction of Monetary and Fiscal Policies.

a rudimentary financial system to a fully developed system can be divided into four stages.2 In the undeveloped stage, there is no gov-ernment debt outside the central bank, and fiscal deficits are essen-tially accommodated by money creation. In the next stage, marketable securities are introduced, but there is no secondary market and inter-est rates are inflexible. In the transitional stage, a secondary market for government debt instruments exists, interest rates have become more flexible, and central banks conduct more active and independent liquidity management. In the final developed stage, medium-term debt instruments are offered through auctions, interest rates are fully flexible, and central banks control liquidity in the markets through indirect and market-based instruments (e.g., repos). In particular, in the latter two stages, good coordination between the government’s financial management (issuance of treasury bills, etc.) and the central bank’s monetary policy operations is required.

The Role of Central Bankers

What can central banks do about fiscal policy? First of all, coor-dination is very important. Even if central banks act on the short end and governments on the long end of the market, their financial activi-ties should be coordinated. Second, communication is key as well. Central bankers expressing views on budgetary policies have become regular features in the international financial press, often in the con-text of presentations in Parliament and at presentation of reports on the economy. Of course, timing and frequency are important ele-ments, and governors are not expected to issue statements each day. The effectiveness of the message will be affected by the stature and image of the governor and his or her institution.

In their messages, central bankers tend to focus on the medium-term sustainability of fiscal policy more than the short-term policies. This includes a focus on a solid and realistic budgetary process that (1) does not require frequent adjustments during the year (which tend to make markets nervous); (2) is based on “conservative” macroeco-nomic assumptions, in particular with regard to economic growth (a key variable in any budget), but also with respect to interest rates, exchange rates, and exogenous variables such as energy prices; (3) does not include too many one-off measures and open-ended com-mitments; and (4) does not imply too many and too frequent funda-mental changes in the tax regime (which might create uncertainty and

Paul Hilbers 7 inefficiencies). At the same time, they will focus on the bottom-line (i.e., deficits and debt) rather than on the specific line-items, to avoid being dragged into a very specific political debate. Last but not least, there appears to be a certain tendency among central bankers to “lean against the wind,” that is, to not to be too optimistic when things go well, and not too pessimistic when thing take a turn for the worse, but rather to be realistic.

Medium-term Fiscal Frameworks

In recent years, an increasing number of countries have adopted formal fiscal rules. Central bankers are generally among the propo-nents of such rules, which can help fiscal authorities better withstand pressures for higher spending and slower fiscal consolidation. The rules, which are often focused on targets for deficits and debt, or on a multiyear spending timeline, are to be embedded in a medium-term fiscal framework based on balanced assumptions for macroeconomic developments.3

Fiscal rules can be particularly helpful in cases in which there is no unique counterpart for the central bank, as is the case, for example, in the euro-zone, which is also faced with the issue of a new currency that has a limited track record. In order to enforce fiscal discipline and to ensure that national fiscal policies support the stability-oriented monetary policies by the European Central Bank (ECB), member countries adopted the Stability and Growth Pact (SGP) as a tool for fiscal policy coordination. The rules of the SGP aim at fiscal sustain-ability by strengthening fiscal discipline through requirements for budget deficits and debts and medium-term fiscal policy objectives.4


Finally, incorporating transparency into monetary and fiscal pol-icy is key to their effectiveness. In this context, the IMF has devel-oped two important international standards: the Code of Good Prac-tices on Transparency in Monetary and Financial Policies5 for central banks and supervisors, and the Code of Good Practices on Fiscal Transparency6 for governments. These codes are important instru-

8 y Interaction of Monetary and Fiscal Policies.

ments to support clarity in discussions on the necessary coordination between monetary and fiscal policy.


1See Rodrigo de Rato, Benefits of Fiscal Consolidation, Presentation to the Real Academia de Doctores (Barcelona, 2004).

2See Sundararajan, V., Peter Dattels and Hans Blommestein, eds., Coordi-nating Public Debt Management, International Monetary Fund, Washington, 1997.

Paul Hilbers 9 3 See Teresa Daban, Enrica Detragiache, Gabriel di Bella, Gian Maria Milesi-Ferretti, and Steven Symansky, Rules-based Fiscal Policy in France, Germany, Italy and Spain, IMF Occasional Paper 225, 2003.

4 See Anthony Annett, Jorg Decressin, and Michael Deppler, Reforming the Stability and Growth Pact, IMF Policy Discussion Paper, PDP/05/02.

5 IMF, 2000,

6 IMF, 2001,