<blockquote>
<p>How do we know that which of the effects will dominate?</p>
</blockquote>
<p>You would have to do empirical/statistical analysis to see which effect dominates.</p>
<blockquote>
<p>Are the monetary and fiscal policy working opposite to each other?</p>
</blockquote>
<p>Using your own assumptions (which are not consistent with standard macroeconomic models such as IS-LM AD-AS model) both policies work together, since they are both expansionary.</p>
<p>However, you are assuming your own special policy function for central bank, normally independent central bank following Taylor rule, would lean against expansionary fiscal policy because it is inflationary.</p>

CC BY-SA 4.0
2024-02-26T13:13:14.513Z
Sorry I meant working opposite to each other in terms of the interest rate. Don't central backs lower interest rates in a setting where recession hits hard and prices fall? For example, if recession causes inflation to fall below the target of let's say 2%.
user52932
CC BY-SA 4.0
2024-02-26T16:35:50.297Z
@user52932 Recessions are by themselves inflationary, if you observe recession and deflation at the same time it usually due to some combination of other factors. The fact that during most recent great recession there was deflation is more of an exception to the rule since for example Romer (Advanced Macroeconomics ch 5) shows evidence most recessions (even unconditionally) are inflationary, and conditionally fall in output should virtually always be recessionary. This is why I said that what you propose would be typically inconsistent with CB behavior, if government increases spending that
1muflon1
CC BY-SA 4.0
2024-02-26T16:38:02.580Z
will be inflationary, and central bank should lean against that.
1muflon1
CC BY-SA 4.0
2024-02-26T21:39:59.520Z
Sorry, I am perhaps confused. Are you suggesting that in a recession the central bank will raise interest rates, to counteract the inflation that comes with the recession? This seems slightly crazy if true - won't the raise in interest rate deepen the crisis? I think this may be true for a cost push inflation and an aggregate supply shock. What if the shock is a climate disaster, which leaves firms unharmed but greatly impacts household income?
user52932
CC BY-SA 4.0
2024-02-27T09:28:11.210Z
@user52932 1. it will do that in response to expansionary fiscal policy that decreases unemployment but increases inflation. Central bank’s policy function under Taylor rule is given by the level of unemployment and inflation, if unemployment is low and inflation is high it will tighten. As mentioned in my answer you also assume away basic economic relations such as effect of fiscal policy on AD, due to shifts in IS curve, once you account for the relationship this becomes optimal CB response. 2. Also it won’t deepen the crisis, just cancels some of the effect of fiscal policy.
1muflon1
CC BY-SA 4.0
2024-02-27T09:29:51.197Z
3. No the increase in interest rate will just counteract the inflationary effect of the fiscal policy. The fiscal multiplier will be lower as a result, but it shouldn’t deepen the crisis if it’s executed according to let’s say Taylor rule. It just leads to waste of public funds. 4. No it has nothing to do with whether inflation is cost push or demand pull.
1muflon1
CC BY-SA 4.0
2024-02-27T16:13:25.650Z
Thank you. Accepted as answer for details provided in the comments to the answer.
user52932
CC BY-SA 4.0
2024-02-26T13:04:27.617Z
2024-02-26T13:04:27.617Z
1muflon1
<p>Suppose there is a recession, and the government aims to provide a fiscal stimulus. Assuming an independent CB, the government will issue treasury bills to borrow and finance the stimulus. Consider the simple case where all treasury bills have zero coupon, and have a face value of 100 to be received in a year. The market for such a bond would have a price. For example, the bond can be purchased for 95, and will give 100 in a year making the interest rate 5.2%. If these bonds flood the market, this price will go down. Consequently, the interest rate will increase.</p>
<p>At the same time, the CB which is independent, wants to boost the economy through a monetary stimulus. This is because this recession is one with very low rates of inflation. It does this by lowering the rates of borrowing so that people can borrow and purchase more.</p>
<p>How do we know that which of the effects will dominate? Are the monetary and fiscal policy working opposite to each other? What am I getting wrong?</p>

<interest-rate><monetary-policy><fiscal-policy>
How do Fiscal and Monetary policy interact intuitively?
user52932
# How do Fiscal and Monetary policy interact intuitively?

(Asked by: username_0 on 2024-02-26)

Suppose there is a recession, and the government aims to provide a fiscal stimulus. Assuming an independent CB, the government will issue treasury bills to borrow and finance the stimulus. Consider the simple case where all treasury bills have zero coupon, and have a face value of 100 to be received in a year. The market for such a bond would have a price. For example, the bond can be purchased for 95, and will give 100 in a year making the interest rate 5.2%. If these bonds flood the market, this price will go down. Consequently, the interest rate will increase.

At the same time, the CB which is independent, wants to boost the economy through a monetary stimulus. This is because this recession is one with very low rates of inflation. It does this by lowering the rates of borrowing so that people can borrow and purchase more.

How do we know that which of the effects will dominate? Are the monetary and fiscal policy working opposite to each other? What am I getting wrong?

**Tags:** interest-rate, monetary-policy, fiscal-policy


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## 1 answers

### Answer by username_1 on 2024-02-26. Score: 1 | Accepted answer

> How do we know that which of the effects will dominate?

You would have to do empirical/statistical analysis to see which effect dominates.

> Are the monetary and fiscal policy working opposite to each other?

Using your own assumptions (which are not consistent with standard macroeconomic models such as IS-LM AD-AS model) both policies work together, since they are both expansionary.

However, you are assuming your own special policy function for central bank, normally independent central bank following Taylor rule, would lean against expansionary fiscal policy because it is inflationary.

> **Comments:**
> **username_0**: Sorry I meant working opposite to each other in terms of the interest rate. Don't central backs lower interest rates in a setting where recession hits hard and prices fall? For example, if recession causes inflation to fall below the target of let's say 2%.  
> **username_1**: @username_0 Recessions are by themselves inflationary, if you observe recession and deflation at the same time it usually due to some combination of other factors. The fact that during most recent great recession there was deflation is more of an exception to the rule since for example Romer (Advanced Macroeconomics ch 5) shows evidence most recessions (even unconditionally) are inflationary, and conditionally fall in output should virtually always be recessionary. This is why I said that what you propose would be typically inconsistent with CB behavior, if government increases spending that  
> **username_1**: will be inflationary, and central bank should lean against that.  
> **username_0**: Sorry, I am perhaps confused. Are you suggesting that in a recession the central bank will raise interest rates, to counteract the inflation that comes with the recession? This seems slightly crazy if true - won't the raise in interest rate deepen the crisis? I think this may be true for a cost push inflation and an aggregate supply shock. What if the shock is a climate disaster, which leaves firms unharmed but greatly impacts household income?  
> **username_1**: @username_0 1. it will do that in response to expansionary fiscal policy that decreases unemployment but increases inflation. Central bank’s policy function under Taylor rule is given by the level of unemployment and inflation, if unemployment is low and inflation is high it will tighten. As mentioned in my answer you also assume away basic economic relations such as effect of fiscal policy on AD, due to shifts in IS curve, once you account for the relationship this becomes optimal CB response. 2. Also it won’t deepen the crisis, just cancels some of the effect of fiscal policy.  
> **username_1**: 3. No the increase in interest rate will just counteract the inflationary effect of the fiscal policy. The fiscal multiplier will be lower as a result, but it shouldn’t deepen the crisis if it’s executed according to let’s say Taylor rule. It just leads to waste of public funds. 4. No it has nothing to do with whether inflation is cost push or demand pull.  
> **username_0**: Thank you. Accepted as answer for details provided in the comments to the answer.  

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