The consensus view on interest rates and fiscal policy: reality or innocent fraud?

Abstract

Current economic policy upgrades monetary policy and downgrades fiscal policy. Monetary policy involves the manipulation of the central bank interest rate, with the specific objective of achieving the main goal of monetary policy, which is, in most cases, the inflation rate. Fiscal policy should not be used as an instrument of stabilization policy. This raises two issues. The first is the theoretical underpinnings of this mode of economic policy. The second is the extent the quantitative impact of monetary and fiscal policy in the real world adhere to the principles set out by theory. Both aspects are investigated in this paper. We summarize results drawn from the euro area, the United States, and the United Kingdom. Two important conclusions emerge: the empirical results point to a relatively weak effect of interest rate changes on inflation. Also, monetary policy can have long-run effects on real magnitudes. Fiscal policy does have strong effects after all.