What does the government do to help the economy function smoothly?

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.

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.

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.

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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The two major examples of expansionary fiscal policy are tax cuts and increased government spending. Both of these policies are intended to increase aggregate demand while contributing to deficits or drawing down budget surpluses. Normally, they're employed during recessions to spur a recovery or amid fears of one to head it off.

Classical macroeconomics considers fiscal policy to be an effective strategy for use by the government to counterbalance the natural depression in spending and economic activity that takes place during a recession. As business conditions deteriorate, consumers and businesses cut back on spending and investments. This cutback causes business to deteriorate further and sets off a cycle from which it can be difficult to escape.

• Two examples of expansionary fiscal policy are tax cuts and increased government spending.
• Expansionary fiscal policy is used to prevent or end recessions, or to prevent high unemployment.
• The Economic Stimulus Act of 2008 allowed the government to put money directly into consumers' pockets in the hope of stimulating spending.
• A downside of expansionary fiscal policy tax cuts is that they must be reversed later.
• John Maynard Keynes identified fiscal policy as key to alleviating the negative economic consequences of slowing spending and economic activity.

During recessions, the purchasing behavior of individuals changes. They must make new decisions about the types of products to buy. Overall, their spending decreases. This reduction in spending and economic activity leads to less revenue for businesses. That, in turn, leads to greater unemployment and an even greater diminishment of spending and economic activity.

During the Great Depression, John Maynard Keynes was the first to identify this self-reinforcing negative cycle in his book, "General Theory of Employment, Interest, and Money." He identified fiscal policy as a way to smooth out and prevent these tendencies of the business cycle.

Faced with an economic slowdown, the government may attempt to bridge the reduction in demand by giving a windfall to citizens via a tax cut or an increase in government spending. This can create jobs and alleviate unemployment.

An example of tax cuts as expansionary fiscal policy is the Economic Stimulus Act of 2008, in which the government attempted to boost the economy by sending taxpayers $600 or $1,200 depending on their marital status and number of dependents. The total cost was $152 billion.

Tax cuts are favored by conservatives for effective expansionary fiscal policy because they have less faith in the government and more faith in markets.

Liberals tend to be more confident in the ability of the government to spend judiciously and are more inclined towards government spending, rather than tax cuts, as a means of expansionary fiscal policy.

An example of government spending as expansionary fiscal policy is the American Recovery and Reinvestment Act of 2009. This effort was made in the midst of the Great Recession and totaled $831 billion. Most of this spending targeted infrastructure, education, and extension of unemployment benefits.

A government can stimulate spending by creating jobs and lowering unemployment. Tax cuts can boost spending by quickly putting money into consumers' hands. All in all, expansionary fiscal policy can restore confidence in the government. It can help people and businesses feel that economic activity will pick up and alleviate their financial discomfort.

All the new spending spurred by expansionary fiscal policy can cause inflation to rise. Also, the tax cuts made to support spending must be reversed at a later time. Moreover, politicians can use expansionary fiscal policy for their political purposes, rather than for the good of the country.

The three types of fiscal policy are neutral, expansionary, and contractionary. A neutral policy is one where the government takes no steps to provide economic support because it feels the economy is healthy and stable. An expansionary fiscal policy involves increasing spending or cutting taxes to prevent or end a recession or depression. A contractionary fiscal policy involves cutting spending or raising taxes to slow down unsustainable economic growth.