The Coordination of Monetary and Fiscal Policy

In considering the components of effective monetary policies to control inflation, the previous chapters have highlighted the decisive role played by credibility and shown how credibility can be established and enhanced through rules-based policy frameworks and independent agencies to implement such regimes. This chapter examines how the same test of credibility, hence supportive public expectations, must also be passed by fiscal policy. For if this fiscal test is failed, even the best designed monetary policy efforts will be unavailing. It also shows how transparent rule-based inflation targets can facilitate resolution of the most intractable fiscal problems. At the time of writing, such problems were most apparent in several of the countries that use the euro. Attempts to address concerns about their solvency by fiscal tightening were having the counterproductive effect of damaging growth, hence further increasing their debt-to-GDP ratios, and all the while raising the likelihood of a social and political backlash against higher taxes and spending cuts.