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IFT Notes for Level I CFA® Program

LM05 Monetary and Fiscal Policy

Part 4


14. The Relationship between Monetary Policy and Fiscal Policy

Both monetary and fiscal policies are used to stabilize an economy. But the impact of one varies based on the other’s stance, and their interaction, as illustrated in the table below:

Note: convention in the table below

First line denotes the effect of fiscal policy

Second line denotes the effect of monetary policy

Third line denotes the overall effect on the economy

Easy/Expansionary Fiscal Policy Tight Fiscal Policy
Easy/Expansionary Monetary Policy AD up.

Low rates → private sector demand up.Growing private and public sector.

AD down.

Low rates → private sector stimulated.

The public sector will become a smaller percentage of the economy.

Tight Monetary Policy AD up.

High interest rates → private sector down.

Public spending will become a higher percentage of GDP.

AD down.

High interest rates → private sector demand down.

Shrinking private and public sectors.

Section 14.1 in the curriculum talks about the factors influencing which quadrant to choose from the table above, i.e. what is the right mix of monetary and fiscal policy. Key points are listed below:

  • To increase overall output, private investment spending is important. For this, monetary policy with low interest rates and tight fiscal policy works best.
  • If infrastructure is poor and there is a lack of skilled labor, then an expansionary fiscal policy and loose monetary policy works best, but at the risk of inflation.
  • Fiscal loosening methods that can be reversed after a specific time period include:
    • Social transfers to households.
    • Decrease in income tax.
    • Increase in government spending.
    • Increase in transfers to poor people.
  • Monetary policies that will go with the above fiscal policies for the same duration include:
    • No monetary accommodation: any increase in AD will lead to increase in interest rates.
    • Interest rates stay unchanged for the duration when the fiscal policy is implemented and reversed.

Section 14.2 talks about quantitative easing – an unconventional approach adopted by the U.S. and U.K. governments during the recent recession of 2008-09 to print money. As interest rates were already near zero level, there was no option of reducing it further to stimulate growth. The central bank (prints money) bought trillions of dollars’ worth of government bonds to increase money supply in the system, increase expenditure and avoid deflation.

Section 14.3 talks about the risk of large fiscal deficits that grow year on year. This increases the real interest rate, inflation expectations, and crowds out private investment.

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