3. Interaction Between Monetary and Fiscal Policy: Active and Passive Monetary Regimes

This chapter analyses the interaction between monetary and fiscal policy in detail. We want to understand why there is no clear relation between debt and inflation. The current price level and inflation is not determined just by current monetary policy. Expectations about how monetary policy evolves in the near and distant future play a crucial role. Since monetary policy actions frequently have some fiscal impact, the effectiveness of monetary policy also depends on the response of fiscal policy. With government debt usually being denominated in nominal terms, movements in the price level may have substantial impact on the real value of debt. The real value erodes in periods of hyperinflation; it increases in periods of deflationary spirals. We distinguish between different regimes, depending on who is the active player. In one regime, fiscal policy automatically adjusts such that monetary policy is allowed to control inflation. Here monetary policy is active, free to pursue its objectives, with fiscal policy assumed to be passive, being constrained by central bank actions. However, there can also be an alternative regime, with active fiscal and passive monetary policy.