Fiscal and monetary policies are the two important instruments in the hands of the modern public authority. During and after the Second World War period these have gained ever-increasing importance in macroeconomic analysis and policy. It was Keynes who first recognized the need of regulating private enterprise economy. In his General Theory (1936) he asserted that large-scale public expenditure is to be made from time to time to avoid cyclical fluctuations in economic activities and to maintain high levels of employment and income. Since then fiscal policy has come into prominence. Almost all modern governments today collect resources to the extent of 30 percent or more of the national income and spend this on a variety of economic activities. 

Classical economists before Keynes were opposed to large-scale fiscal policy and government expenditure. They held a simple belief: "That government is best which taxes the least or which spends the least." This is because they were of the view that government spending causes unnecessary intervention in private economic activities. They believed that the free enterprise system is a self-equilibrating one and public intervention will only cause disturbances in its smooth working. But Keynes opposed such a view. He pointed out that throughout the 19th century, western free enterprise economies have suffered frequent problems of cyclical fluctuation. The recent experience during the Great Depression (1929-33) is a flagrant example of it. During the Depression, output and employment levels fell by 40 percent for a prolonged time.
The modern public authority has a responsibility of promoting public welfare. It cannot play a passive role during such major economic crises. Again the classical school generally suggested that if there is any problem of inflation or deflation then public authority instead of directly intervening in the form of fiscal policy can use monetary policy. This basically concerns the regulation of money supply. It may be said that the economy can be kept in order with the help of the monetary policy which operates indirectly. Keynes, however, opposes this argument. It can neither be effective nor adequate during the periods of widespread unemployment and such other major crises.


The great depression of the 1930s has had a profound influence on both economic and political thinking. The consequences of this event turned out to be of such a dimension that broad consensus emerged on governments doing their best to prevent such disasters from happening again. But even beyond this extreme case, there is general agreement that a stable and predictable economic environment contributes substantially to social and economic welfare. In the short-run, households prefer to have economic stability with continuous employment and stable incomes, allowing them to maintain stable consumption over time. In the long-run, unnecessary economic fluctuations can reduce growth, for example by increasing the riskiness of investments. A highly volatile economic environment might also have a negative impact on the choice of education profiles and career paths. In short, by maintaining a stable macroeconomic environment, economic policy can thus contribute to economic growth and welfare.

 A need for stabilization?
But what needs to be stabilized and how? Moreover, to what extent are cyclical fluctuations “acceptable”? What is a “feasible” degree of stabilization? And what are “effective” stabilization tools?
These questions have long been debated by economists and – without surprise – the answers provided have changed considerably over time. Back in the 1960’s, the heydays of Keynesian economics, economists spoke optimistically of an end to the business cycle. A book written in 1969 and titled ‘Is the Business Cycle Obsolete?’ quotes Hyman P. Minsky, at the time a leading authority on monetary theory and financial institutions, saying:
‘It was felt that if the policy prescription of the New Economics were applied, business cycles as they had been known would be a thing of the past’ (p. vi)
In the late 1960’s the Keynesian view became increasingly challenged by Monetarism. The debate between Keynesians and monetarists often focused on the effectiveness of policy instruments, with monetarists arguing for the ineffectiveness of fiscal tools and Keynesians believing in the superiority of fiscal stabilisation policy. In the context of this discussion, Milton Friedman addressed the question of whether and how much to stabilise at his 1967 Presidential Address to the American Economic Association. Concerned about the possibility that monetary policy actions may themselves be a source of economic instability, Friedman argued that macroeconomic stability is best achieved using an “unconditional” policy rule: his famous “k-percent” money growth rule.
While nowadays nobody seems to support the use of such rigid rules, Friedman’s basic underlying idea remains relevant. His view on stabilisation policy was grounded in the firm belief that the economic system is eventually self-stabilizing whereas available knowledge about the economic system is too limited for effectively addressing short-run fluctuations.
Even if one would subscribe to Friedman’s view of an eventually self-stabilizing economy, the question of whether reliance on self-stabilizing forces alone generates economic fluctuations of politically and economically acceptable magnitudes remains open. From a purely economic viewpoint, the optimal degree of stabilization depends on whether observed macroeconomic fluctuations constitute efficient responses of the economy to shocks or whether these fluctuations are partly due to economic frictions, to be addressed with the tools of stabilization policy. However, from a political economy viewpoint, self-stabilization may lead to short-term fluctuations of an intolerable size and even seriously undermine agents’ trust in a market-based economic system, as several historical episodes have shown.
In an article published only two years ago, Robert E. Lucas confirmed his long-held view that the welfare gains from stabilization policy must be fairly modest. According to his findings, the potential welfare gains from improved stabilization policy going beyond stability of monetary aggregates and nominal spending is likely to be small. While this result rests on important simplifying assumptions, it seems to have proven to be a fairly robust finding.
In recent times the overall stabilization problem has become much less severe. In particular, economic volatility – measured by the standard deviation of quarterly output growth – seems to have fallen considerably in many industrialized countries when comparing the recent two decades to the preceding post World War II experience. Some economists, including David and Christina Romer, suggested this to be due to a fundamental change in the understanding among policymakers about what aggregate demand policy can accomplish. This possibly validates the view that, in the past, severe recessions have been partly caused by over-ambitious macroeconomic policies. Whether this optimistic view about the source of business cycles is the final word on the issue remains to be seen. Clearly other views have been expressed, including the one that the recent experience is simply due to a fortunate sequence of extraordinarily small economic shocks. Whatever viewpoint will ultimately turn out to be correct, they both request discussing the role of monetary and fiscal stabilisation policies, be it to educate our minds and to avoid the mistakes of the past, or be it for effectively counteracting larger disturbances should these reappear.

Fiscal Policy at work
i) During Unemployment: Fiscal policy has been strongly recommended by Keynes and his followers under the conditions of depression. Though the fiscal policy can take both expansionary and contractionary forms, it is the expansionary fiscal policy and deficit financing that has dominated the post Second World War period. It intends to maintain a high and growing size of the effective demand. Keynesians are of the view that only such policies can cure unemployment, stabilize the economy and help in maintaining high levels of output and employment. The classical opponents of Keynes however uphold the price and wage-cut policy that leaves out public intervention in economic activities. Those who follow the classical view also fear that government expenditure and its attempts to increase effective demand may cause inflation. Keynesians counter argue that if a choice is to be made between inflation and unemployment then the former should be preferred. Inflation is a lesser evil than unemployment. The classicists further state that without any government spending, natural full employment equilibrium can be established with the help of a price-wage cut in the long run after a lapse of time. But Keynes himself had made the witty statement: "In the long run all of us are dead." This suggests that even if long run equilibrium is possible with a cut in the wage-rate, it is not advisable to follow. Labor is an extremely perishable commodity. Every day in the workman’s life matters. It is improper to ask thousands or millions of workers to wait for few months or years before the economic situation can be improved and jobs can be made available. The controversy between the two view points can conveniently be explained with the help of a figure.

Figure 24
Level of Real Income / Employment
In figure 24 we find that levels of real income and employment have been shown on the horizontal axis and various price levels appear on the vertical axis. AD1 and AD2 are aggregate or effective demand curves and SAS1 and SAS2 are short run aggregate supply curves. The vertical line Y2e3 e2Ls is the long run supply curve. It stands for natural or full employment level of resources and output. Let’s begin with initial demand and supply conditions along AD1 and SAS1. The two curves have intersected at point e1 which is an equilibrium position. At point e1 level of output (or real income) and employment is Y1and level of price is P1.
This is however not a full employment equilibrium. Since Y2 is a long run full employment and output level, there is still some labor unemployed at Y1. Now one is faced with the problem of how to overcome this amount of unemployment. The classical writers assert that if price level is lowered and if wage rates are cut the cost of production will reduce. Employers will be induced to invest more and employ the workers who are unemployed. This will bring about a downward shift in the aggregate supply curve which will now be SAS2. The new supply curve intersects AD1 at point e3. This equilibrium point is on the long run supply curve and therefore ensures full employment. In this equilibrium position output level is Y2 and price level is P3. It has become possible to attain the condition of full employment without any government spending, simply by cutting wage rate. This is the classical solution.
Keynes rejects this proposition. For him such an equilibrium is unattainable. Laborers, with the backing of their trade unions, will not accept a cut in wages. The wage rates are downward sticky or rigid. Therefore the supply curve cannot shift downwards. Yet unemployment can be cured. The only requirement here is to make adjustments on the demand side. If the government undertakes fiscal policy and increases public spending, effective demand will increase. This will cause aggregate demand curve to shift upwards as AD2. The new demand curve intersects both the old supply curve SAS1 as well as the long run supply curve at point e2. Therefore this is the full employment equilibrium. At this point output and employment levels are Y2 and price level is P2. Therefore though the price level P2 is somewhat higher, the problem of unemployment has been solved immediately.
ii.    During Inflation: Keynesian expansionary policy helps to overcome the problem of unemployment with an upward shift in the effective demand level. Similarly, his contractionary policy can be used to mitigate an inflationary rise in the price level. In this case what is needed is a downward shift in the effective demand and a reduction in public spending. This has been shown in figure 25.

Figure 25
Level of Real Income and Employment
The levels of income are shown on the horizontal and that of price are shown on the vertical axis. AD1 and AD2 are the two demand curves while SAS1 and SAS2 are two supply curves. The only change this time is an upward shift of the supply curve in the form of SAS2. The initial full employment equilibrium occurs at point e1 with Y1 as the level of income and P1 as the price level. The point e1 is the point of intersection between AD1 and SAS1. If now aggregate demand increases and shifts upward as AD2 then a new equilibrium position is established at e2. This is the point of intersection between AD2 and SAS1. At this point, the level of income is Y2 and the price level is P2. Both income and prices appear to have risen because of the shift in the demand curve. However, increase of income (Y1 to Y2) is purely nominal or monetary in form. Since level Y1 represents the full employment output level, there are no further resources to be employed. Hence there cannot be any real additions to the output (or real income) and income. Again e2 point of equilibrium is not stable. Due to the rising price level, workers and other resource owners will demand a rise in wages and remuneration. With this kind of an increase in the cost of production, the supply curve will shift upwards as SAS2. The new supply curve SAS2 intersects the new demand curve AD2 at point e3, establishing a fresh equilibrium position. At e3 the income level has fallen back to full employment level Y1. But the price level has sharply risen to P3. The point e3 is a stable equilibrium point since it is on the long run full employment supply curve LS Y1. But at e3 the net inflationary rise in the price level is P1 to P3. If the inflation is to be removed and price level is to be restored as P1 then the effective demand will have to be contracted. With a fall in public expenditure, the aggregate demand curve will shift down from AD2 to AD1. The economy will then revert to the old equilibrium point e1. Thus the contractionary policy of reducing public expenditure is helpful during periods of inflation.
It may be noted that either under expansionary or contractionary policies the level of income increases or decreases from Y1 to Y2 respectively. This becomes possible with fiscal policy of increasing or decreasing public expenditure. But such adjustments in public expenditure need not be of the same size as of the desired changes in the income level. Public expenditure needs to be smaller in size yet because of the presence of the multiplier effect a much larger final change in the income becomes possible.
iii.    Crowding-out effect: Keynes' fiscal policies of expansion and contraction have been popular with modern public authorities. These policies have been used effectively over the past years in many economies the world over. However, modern followers of the classical school, also known as monetarists, point out the faults of such fiscal measures. It is pointed out that extra government expenditure is financed through public borrowings. As a result of this, the money available for loans is reduced and there is a greater demand for loanable funds in the money and capital markets. With a sudden rise in the demand the price of loanable funds or the rate of interest starts rising. Again extra public expenditure, which gives rise to an upward movement of the price level, also has a similar effect on the rate of interest. Rising level of the interest rate has a discouraging effect on private investment activity. Thus increased public investment expenditure causes a fall in the private investment activity. This is called the 'crowding-out' effect. It is claimed therefore that fiscal policy is likely to develop a self-defeating tendency. On the other hand, during the phase of inflation, contraction in public expenditure can be equally self-defeating. In this case with a fall in the effective demand, the rate of interest will tend to fall and will encourage private investment activity. This is exactly the opposite case and therefore can be called the 'crowding-in' effect.

Monetary policy - the example of the ECB
In general, stabilization policies can be implemented with the aid of either monetary or fiscal policy. As to the role of monetary stabilization policy, let me take the example of the euro area.
In the euro area the Maastricht Treaty assigns to monetary policy the responsibility for maintaining price stability. The clear assignment of price stability as the overriding objective of the European Central Bank – specified by a quantitative definition – provides guidance to economic agents as to what can be expected from monetary policy. Without doubt this enhances the credibility of monetary policy, contributing to the anchoring of medium and long-term inflation expectations in the euro area.
Stable inflation expectations eliminate an important source of macroeconomic instability, namely the possibility that economic shocks affecting inflation in the short-term become amplified via a corresponding adjustment in inflation expectations. In turn, the stability of these expectations contributes to economic welfare via a reduction of inflation risk premier contained, for example in nominal bond yields. By insuring price stability, monetary policy can thus make an important contribution to macroeconomic stability.
In its monetary policy strategy the Euro system has adopted a medium-term orientation. The forward-looking nature of this strategy insures that timely action is taken to address any potential threats to price stability. Yet, the medium-term orientation also reflects the existence of economic shocks, the consequences of which monetary policy cannot control without inducing excessively high variability in real activity and interest rates. A medium-term orientation should effectively guarantee that monetary policy itself does not become a source of economic fluctuations: it avoids misguided reactions to short-term developments, providing a safety net against overly ambitious economic fine-tuning. As is well-known, monetary history is full of examples where monetary policy activism – concerned too much with the short run – led to a sequence of decisions which had to be reversed within short periods of time. Such a policy is a source of instability and generates results opposite to the ones initially envisaged.
Overall, the medium-term orientation of monetary policy – guided by the objective of price stability – helps policy concentrating on the relevant economic shocks, that is on shocks and economic developments that monetary policy can effectively address. The focus on the medium-term may in a certain sense be interpreted as a practicable and economically reasonable compromise between Friedman’s idea on economic self-stabilization, which focuses entirely on the long-run, and the Keynesian view on economic fine-tuning, focused on shorter-term developments.

The role of fiscal policy
Fiscal policy can promote macroeconomic stability by sustaining aggregate demand and private sector incomes during an economic downturn and by moderating economic activity during periods of strong growth.
An important stabilizing function of fiscal policy operates through the so-called “automatic fiscal stabilizers”. These work through the impact of economic fluctuations on the government budget and do not require any short-term decisions by policy makers. The size of tax collections and transfer payments, for example, are directly linked to the cyclical position of the economy and adjust in a way that helps stabilizing aggregate demand and private sector incomes. Automatic stabilizers have a number of desirable features. First, they respond in a timely and foreseeable manner. This helps economic agents to form correct expectations and enhances their confidence. Second, they react with an intensity that is adapted to the size of the deviation of economic conditions from what was expected when budget plans were approved. Third, automatic stabilizers operate symmetrically over the economic cycle, moderating overheating in periods of booms and supporting economic activity during economic downturns without affecting the underlying soundness of budgetary positions, as long as fluctuations remain balanced.
In principle, stabilization can also result from discretionary fiscal policy-making, whereby governments actively decide to adjust spending or taxes in response to changes in economic activity. I shall argue, however, that discretionary fiscal policies are not normally suitable for demand management, as past attempts to manage aggregate demand through discretionary fiscal measures have often demonstrated. First, discretionary policies can undermine the healthiness of budgetary positions, as governments find it easier to decrease taxes and to increase spending in times of low growth than doing the opposite during economic upturns. This induces a tendency for continuous increases in public debt and the tax burden. In turn, this may have adverse effects on the economy’s long-run growth prospects as high taxes reduce the incentives to work, invest and innovate. Second, many of the desirable features of automatic stabilizers are almost impossible to replicate by discretionary reactions of policy makers. For instance, tax changes must usually be adopted by Parliament and their implementation typically follows the timing of budget-setting processes with a lag. Not surprisingly, therefore, discretionary fiscal policies aiming at aggregate demand management have tended to be pro-cyclical in the past, often becoming effective after cyclical conditions have already reversed, thereby exacerbating macroeconomic fluctuations.
Clearly, the short-term stabilizing function of fiscal policy can become especially important for countries that are part of a monetary union, as nominal interest rates and exchange rates do not adapt to the situation of an individual country but rather to that of the union as a whole. Fiscal policy can then become a crucial instrument for stabilizing domestic demand and output, which remains in the domain of individual governments. At the same time, however, the limitations of active fiscal policy may be greater when there is increased uncertainty about future income developments. This is the case today in many European countries where there is a growing concern about the difficulties faced by public pension and health care systems in view of demographic trends. Under such circumstances, cyclically-oriented tax cuts and expenditure increases today may simply translate into higher taxes or lower expenditure tomorrow. Aware of this, the public may increasingly react to fiscal expansions by raising precautionary savings rather than consumption.
In the light of the previous discussion, what is the scope for discretionary fiscal policies? Discretionary policies are needed to implement long-term structural changes in public finances and to deal with exceptional situations, particularly when the economy experiences extraordinary shocks. Discretionary policies in fact reflect the changing tastes about the desirable size of the public sector, about the priorities of public spending, and about the level and characteristics of taxation. These policies determine the structure of public finances and substantially affect the functioning of the economy but also the features of a country's automatic stabilizers. Discretionary fiscal policy decisions are also needed to preserve the sustainability of public finances in the medium-term. This is the precondition for automatic stabilizers to operate freely, as fiscal policy can only act as an effective stabilizing tool when there is the necessary room for man oeuvre.
The experience of the industrialized countries in recent decades clearly shows that persistent fiscal imbalances limit the room for fiscal policy to stabilize the economy. Imbalances often necessitate tight fiscal policies during downturns to prevent unsustainable deficits and debt developments. Hence, when sustainability is in doubt, expansionary measures and even automatic stabilizers may not have the desirable effect on output as people adjust their behavior. Consolidation measures may then re-establish confidence and improve expectations about the long-term outlook of public finances. These so-called ‘non-Keynesian’ effects may have the result that fiscal consolidation even has an expansionary impact on the economy. Active fiscal consolidation with discretionary policies is therefore appropriate when budgetary positions are perceived as not being safe or when there are risks to fiscal sustainability due to high debt and future fiscal obligations. Finally, although automatic fiscal stabilizers are effective in dampening normal cyclical fluctuations, there may be situations where active policy decisions might be needed. For example, automatic stabilizers alone may not be sufficient to stabilize the economy when economic imbalances do not stem from normal cyclical conditions or are considered as irreversible. However, the benefits from expansionary policies in a recession must still be assessed against the risks to long-term sustainability or the persistent adverse effects on the structure of public finances, such as a permanently higher tax level, as well as the economic costs of an eventual policy reversal.

The relation between monetary and fiscal policy – the case of EMU
How should fiscal and monetary authorities co-ordinate their policies to stabilise the economy? To avoid being vague and too general, let me take again the case of EMU as an example. With an independent central bank and its stability-oriented strategy, the euro area has a highly predictable monetary policy. There is no ambiguity as to how monetary policy will respond to economic, including fiscal developments: it will respond to the extent that they pose risks to price stability. The principle of central bank independence and the overriding focus of the single monetary policy on the objective of price stability are two cornerstones of the economic policy constitution enshrined in the Maastricht Treaty. They reflect the underlying economic logic that a clear division of responsibilities between the ECB and other economic policy actors is the institutional arrangement most conducive to the attainment of the wider objectives of the European Union. Naturally, fiscal policies and structural reforms have monetary policy implications if such reforms affect price developments. Therefore, a stability oriented monetary policy will take fiscal policy measures into account in its analysis. Yet, there cannot be a commitment to an automatic or even ex-ante monetary policy reaction in response to fiscal consolidation policies or structural reforms. Given the absence of credible enforcement mechanisms, ex-ante coordination between monetary and fiscal policies are unlikely to be successful, as I have argued elsewhere in detail. In addition, ex-ante coordination tends to blur the fundamental responsibilities for the respective economic actors and may even increase uncertainty about the general policy framework.
A clear division of responsibilities between monetary and fiscal actors is consistent with implicit policy co-ordination between authorities. A single monetary policy that is committed to maintaining price stability in the euro area will by itself facilitate “appropriate” economic outcomes in the Member States. If national fiscal authorities correctly perceive the behaviour of the single monetary policy they will take actions that would likely lead to implicitly “co-ordinated” policy outcomes ex post. Of course, an open exchange of views and information between individual policy actors – without any commitment or mandate to take and implement joint decisions – will assist the overall outcome, if it manages to improve the understanding of the objectives and responsibilities of the respective policy areas and does not dilute accountability.
7. Conclusions
Let me conclude. In my remarks I have argued that monetary policy contributes best to macroeconomic stability by anchoring inflation expectations at a level consistent with price stability. A forward-looking, medium-term oriented monetary policy provides the best framework to this purpose. Fiscal policies too should have a medium to long-term orientation and largely rely on automatic stabilisers in the short-term. In specific circumstances, however, discretionary measures may be appropriate when countries are hit by severe recessions or when structural changes in public finances are warranted. But these measures should be well targeted and effective in addressing the underlying causes. Moreover, I have argued that a clear assignment of policy responsibilities, as in the Maastricht Treaty, is truly compatible with the emergence of implicitly coordinated policy outcomes ex-post. In particular, with different policy authorities being responsible and accountable for easily identifiable policy areas, such an assignment is the best possible contribution to Community objectives.
Let me emphasise that fiscal stabilisation and sustainability are in fact fully compatible objectives. They are complementary aspects of a fiscal policy strategy aimed at maintaining medium-term budgetary positions close to balance or in surplus. Yet, with demographic and other structural changes negatively affecting the structural budget position of countries, discretionary fiscal measures that restore the longer term budgetary outlook are called for.

[1] I wish to thank Klaus Adam and Marco Catenaro for their valuable contribution.
[2] Martin Bronfenbrenner, ed. (1969), New York: Wiley
[3] See Edward M. Gramlich (1971) ‘The Usefulness of Monetary and Fiscal Policy as Discretionary Stabilization Tools’, Journal of Money Credit and Banking, Vol. 3(2), 506-532 for a review of this literature.
[4] Robert E. Lucas (2003), ’Macroeconomic Priorities’, American Economic Review Vol. 93(1), 1-14.
[5] Christina Romer and David Romer (2002), ‘The Evolution of Economic Understanding and Postwar Stabilization Policy’, in Rethinking Stabilization Policy, Federal Reserve Bank of Kansas City, 11-87
[6] Blanchard, O. and J. Simon (2001), ‘The Long and Large Decline in US Output Volatility’, Brookings Papers on Economic Activity 1, 135–174.
[7] Marco Pagano and Francesco Giavazzi (1990), ‘Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries’, NBER Macroeconomics Annual, Cambridge, Mass. and London: MIT Press, 75-111
[8] See also R. Barro (1974) ‘Are governments bonds net wealth?’, Journal of Political Economy vol. 82(6), pp. 1095-1117. More recently, A. Rzonca and P. Cizkowicz (2005) ‘Non-Keynesian effects of fiscal contraction in new Member States’, ECB Working Paper no. 519 and F. Giavazzi et al. (2005) ‘Searching for non-monotonic effects of fiscal policy: new evidence’, NBER Working Paper 11593.
[9] See Antonio Fatas, J├╝rgen von Hagen, Andrew Hughes Hallett, Rolf Strauch and Anne Sibert (2003) ‘Stability and Growth in Europe: Towards a Better Pact’. London: CEPR/ZEI,
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