There is much discussion about how governments and central banks reacted during the coronavirus crisis. Some voices argue that the authorities did not do enough. Some other ones, on the contrary – they did too much, and the long-term consequences are detrimental.
However, most of the discussion comes from the misunderstanding of basic principles beyond monetary and fiscal policies. This is what this article tries to fix.
How to Fight Economic Recessions
Monetary policy refers to the actions of a central bank directed to influence the quantity of money and credit in an economy. For example, a household may be influenced to spend or save more using monetary policy. Central banks use interest rates and, most recently, unconventional monetary policy tools like quantitative easing, to influence inflation levels. Thus, to influence households and corporations to spend more now and not to postpone consumption.
Inflations expectations, together with the risk premium and the real rate built into the nominal rate. The way monetary policy influences inflation expectations is key to current economic developments.
On the other hand, fiscal policy deals with how governments manage taxation and spending. One of the most important characteristics of fiscal policy is that it redistributes income.
As central banks in most developed countries act independently of the governments, the two policies are separated. Thus, monetary policy sits in the central bank’s hands, while fiscal policy in the hands of the government.
In harsh economic times, like the COVID-19 crisis, both entities act together. When you are forced to close an economy due to an exogenous factor (i.e., a factor), the government must spend so that the households’ income stream is unaffected or remains at a minimum level for survivorship. If the government has no money, it turns to financial markets and borrows. Because central banks already did their job and slashed the interest rates to zero or below plus vow to keep them there for a long time, the interest rates paid on borrowing are ridiculously small. Therefore, the burden on the tax-payer is smaller than otherwise would be the case.
This is an example of how the two policies worked hand in hand as a response to the crisis. Sure, more can be done. Political games, bureaucracy, lack of proper legislation – are just a few reasons why the proper response fails sometimes.
However, the better the two authoritative bodies, the government, and the central bank, work together, the easier for the country and the population to cope with an economic recession.