Fiscal and monetary policy in a monetary union
Monetary and fiscal policy are very different, but how they interact with each other matters for the economy. While each is independent from the other, new challenges call for them to work together.
Why did we discuss the interaction between monetary and fiscal policy as part of our strategy review?
Monetary and fiscal policy support the economy in different ways
Monetary and fiscal policy are two important tools to keep the economy healthy. Both influence the economy, but in different ways.
Monetary policy is about keeping the prices of the goods and services we buy stable. It is the central bank’s job to make sure that inflation – the rate at which the overall prices for goods and services change over time – remains low, stable and predictable.
Fiscal policy refers to the economic decisions that governments take. Governments can decide to spend money to provide public services, support the economy and reduce inequalities. They can collect this money via taxes or by borrowing from financial markets.
The interaction between monetary and fiscal policy is important
Monetary and fiscal policy work in different ways. But they interact with each other too since price stability and a balanced economy are two sides of the same coin. As we saw during the pandemic, this link is particularly strong in times of crisis. The crisis hit Europe hard and hurt the economy, but monetary and fiscal policy worked side by side to make things better. This joint approach helped many people and businesses make it through the crisis. If monetary and fiscal policy had not worked together, the positive impact would have been smaller.
The way monetary and fiscal policy interact with each other matters for the health of the economy. That is why we discussed their interaction as part of our strategy review.
How do monetary and fiscal policy interact with each other in the euro area?
One monetary policy, many fiscal policies
Monetary and fiscal policy need to work hand in hand for an economy to run smoothly. That is not always easy – especially as they work independently of one another in the euro area. The ECB runs a single monetary policy for the 19 countries of the euro area. But the national government of each of those countries runs its own fiscal policy. There is a good reason for this separation. History tells us that when central banks are under the full control of the government, prices may spiral out of control.
European leaders have agreed on several key principles to prevent this from happening again. First, the ECB is independent. Governments are not allowed to tell the ECB what to do. Second, the ECB is not allowed to give money directly to governments. And third, governments must observe common rules to keep their spending in check.
New challenges call for monetary and fiscal policy to work together
These principles are still relevant today. But the last decade has also shown that new challenges need new responses from both monetary and fiscal policy.
Big changes in our society have altered the way our economy works. These include globalisation and the fact that people around the world are living longer and saving more. In addition, the global financial crisis of 2008 started a long period of economic weakness. Inflation has been too low in many economies around the world, including the euro area.
In response to these challenges, the ECB has cut interest rates. The ECB has also responded with new tools to keep prices stable during these difficult times. When interest rates are very low, or even negative, there is limited room for central banks to do more to support a weak economy.
In such a situation, government spending becomes more important and also more powerful. It can help lift the economy and bring inflation back into line with the central bank’s aim. Joint efforts by monetary and fiscal policy are especially relevant when the economy hits a rough patch.
What will the interaction between monetary and fiscal policy look like in the future?
It depends on the state of the economy
How monetary and fiscal policy interact in the future depends on the state of the economy. When the economy is not doing well, and interest rates are already very low, it makes sense that monetary and fiscal policy work together to get it back on its feet. When the economy is running smoothly, there is less of a need to work together closely. When that time comes, governments should work towards ensuring their finances are in good shape. That will help them be ready for future challenges.
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