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"Monetary and Fiscal Policy: Privileged powers, entwined responsibilities"

The Covid-19 crisis has brought to the fore the nexus between monetary and fiscal policies. Faced with an unprecedented economic collapse, monetary and fiscal authorities acted in unison to stabilise markets and shore up activity. The two policies have worked smoothly together so far. But there are questions about whether they will continue to do so as the crisis fades and about the implications of any tensions that may arise.This note examines these issues by standing back and exploring the deeper nexus between the two policies. This perspective emphasises that monetary and fiscal policies are intrinsically entwined as carried out by organs of the state -the government and the central bank -with privileged access to resources. Privileged powers come with commensurate responsibilities. The powers have limits that, if breached, can seriously damage the economy. And breaching them in one policy domain would jeopardise sustainability in the other.

Monetary and fiscal policy: privileged powers, entwined responsibilities www.suerf.org/policynotesSUERF Policy Note No 2382This note examines these issues by standing back and exploring the deeper nexus between the two policies. This perspective emphasises that monetary and fiscal policies are intrinsically entwined as carried out by organs of the state -the government and the central bank -with privileged access to resources.2Privileged powers come with commensurate responsibilities. The powers have limits that, if breached, can seriously damage the economy. And breaching them in one policy domain would jeopardise sustainability in the other. Thus, achieving overall economic stability requires that policymakers wield the powers responsibly. Both policies need to work consistently with a common focus on long-term sustainability. In turn, this calls for institutional arrangements that encourage a balanced reliance on each and an appropriate degree of coordination, which varies with the economic context. Those arrangements have worked very well during the pandemic, when monetary and fiscal policies worked in close concert to limit the pandemic's fall out. But more challenging tests lie ahead, as tensions between the two policies are likely to re-emerge.

Privileged powers

Fiscal and monetary policies are intimately linked and share common roots (Figure 1). Both are key policy functions of two organs of the state: the government and the central bank. And both are tools through which the state gains privileged access to resources, through, respectively, the power to tax and the power to issue "money" -irredeemable debt that acts as means of payment. Money, in turn, is the cornerstone of the central bank's ability to set interest rates, through which it exerts a pervasive influence on the economy.

Entwined responsibilities

Despite the common root of their powers, monetary and fiscal policies exert their impact on the economy through very different channels. Fiscal policy impinges directly on economic activity through the compulsory transfer of resources via taxes, which in turn provides the basis for government expenditures and transfers -another major influence on activity. Indeed, the government wears a double hat: it spends on private-sector goods and services and it produces non-marketable services -it is a major employer in the economy.Importantly, fiscal policy also affects the incentives that drive decisions about resource allocation. It can thus work to shape economic growth, encouraging certain types of activity or sectors over others.