The main purpose of the fiscal policy is to achieve full employment, economic stability through sustained progressive rate of growth. On the other hand, the major objective of monetary policy is to achieve price stability, which is an essential pre-condition for enhancing the economic well-being and the growth potential of an economy. Hence, fiscal policy and monetary policy are two important pillars of an economy to achieve economic stability. However, it is possible to achieve a high level of employment and economic output with a higher level of inflation, only in the short-run (Phillips curve), as there is no trade-off between employment and inflation in the long-run. As such, monetary policy plays an all-important role in the long-run. Of late, as many countries are moving towards inflation targeting, they stringently pursue the goal of price stability. By this, we gain an impression, that the role of fiscal policy becomes minimal, though, in reality, price stability needs the support from fiscal policy. However, a monetary policy more often than not operates with some lag. In a Ricardian regime, monetary policy acts as an active policy and fiscal policy act as a passive policy, because the fiscal policy quite often follows the monetary policy, as it needs to operate the fiscal tax to fulfill the condition of budget equilibrium. Macroeconomic stability is not a case of pure fiscal or a pure monetary problem. This calls for greater coordination between the framers of fiscal and monetary policies, as any disharmony between the two adversely affects the overall economic stability.
Many times, lack of coordination between the two policies, according to Blinder (1982) emanates due to three major reasons: (i) divergent objectives of monetary and fiscal authorities; (ii) difference of opinion and actions of the monetary and fiscal authorities derived from contradicting economic foundations; and (iii) different forecasts on the state of the economy formulated by the two authorities. Perfect coordination between the monetary and fiscal policies is not only necessary for a good, efficient, and stable economy, but also credible policy sustainability. However, it is not that easy to achieve the perfect coordination between the two due to several constraints. First, it is the problem of time frame, as the two policies operate with their different time lags dependent on the efficiency of transmission in the economy. Second, the monetary policy measures impact on the fiscal policy measures, and the vice versa. Third, in most of the economies, the institutions that operate these two policies are acting independently within their mandates. Across nations, the central banks that are responsible for monetary policy are independent of the governments that are in control of the fiscal policy. Fourth, conducting monetary policy when fiscal space is limited is still a challenge.
Worldwide, the conduct of monetary policy has fuelled ongoing debates and research about the need for coordinated efforts of monetary and fiscal authorities to ensure economic stability. Given this context, this paper analyses the extent of coordination of monetary and fiscal policies in India as things have greatly changed in the last decade and more particularly after the global financial crisis. In India, the Reserve Bank of India (the central bank) and the government have taken several measures to maintain price stability and economic growth, including the expansionary monetary and fiscal policy measures to stimulate aggregate demand. The extant literature does not provide a recent study that analyses the coordination of the monetary and fiscal policy outcomes more particularly in the context of an emerging economy like India.
This study investigates the extent of coordination between monetary and fiscal policies in India over the post-liberalization period (2005: Q1–2017: Q1). More often, the quantification of the extent of coordination largely depends on the appropriate policy mix that responds effectively to different shocks. More specifically, this paper estimates the macroeconomic effects of monetary and fiscal policy shocks using a Vector Auto-Regression (VAR) model as well as a vector error correction model (VECM).
The results suggest that a contractionary monetary policy: (i) has a negative effect on GDP growth; (ii) leads to a gradual decline in the inflation; (iii) tightens the liquidity conditions; and (iv) rise in the bond yields. Further, an expansionary fiscal policy: (i) has a positive effect on GDP growth; (ii) has an initial decline, but a gradual rise in the inflation levels; and (iii) leads to falling bond yields. Monetary policy is found to be more reactive to fiscal policy effects. A positive shock to the monetary policy rate is mostly accompanied by a fall in the fiscal deficit, thereby, amplifying the effects of the monetary contraction.
The remainder of the paper is organized as below. Section 2 provides a brief review of the literature on monetary and fiscal policy coordination. Section 3 outlines the data and methodology used in the estimation approach. Section 4 presents a discussion on the results. Finally, Sect. 5 presents the conclusion and policy implications.
1 From a theoretical and empirical standpoint, the fiscal policy was accorded a secondary role in favour of monetary policy due to some of the following reasons: (i) monetary policy has the potential of maintaining a stable output gap; (ii) in the emerging economies the domestic bond market is still evolving and hence limits the use of fiscal countercyclical policy; (iii) given a mix of short-recessions and lags, the possible countercyclical measures of fiscal policy could arrive too late (Blanchard, Dell’Ariccia, & Mauro, 2010).
2 The emphasis on the importance of monetary and fiscal policy coordination has historical precedence. While prescribing the way out of the Great Depression, Keynes wrote: “It seems unlikely that the influence of [monetary] policy on the rate of interest will be sufficient by itself. I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.” These views continue to be relevant in the present juncture as well.