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Suppose there is a recession, and the government aims to provide a fiscal stimulus. Assuming an independent CB, the government will issue treasury bills to borrow and finance the stimulus. Consider the simple case where all treasury bills have zero coupon, and have a face value of 100 to be received in a year. The market for such a bond would have a price. For example, the bond can be purchased for 95, and will give 100 in a year making the interest rate 5.2%. If these bonds flood the market, this price will go down. Consequently, the interest rate will increase.

At the same time, the CB which is independent, wants to boost the economy through a monetary stimulus. This is because this recession is one with very low rates of inflation. It does this by lowering the rates of borrowing so that people can borrow and purchase more.

How do we know that which of the effects will dominate? Are the monetary and fiscal policy working opposite to each other? What am I getting wrong?

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How do we know that which of the effects will dominate?

You would have to do empirical/statistical analysis to see which effect dominates.

Are the monetary and fiscal policy working opposite to each other?

Using your own assumptions (which are not consistent with standard macroeconomic models such as IS-LM AD-AS model) both policies work together, since they are both expansionary.

However, you are assuming your own special policy function for central bank, normally independent central bank following Taylor rule, would lean against expansionary fiscal policy because it is inflationary.

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  • $\begingroup$ Sorry I meant working opposite to each other in terms of the interest rate. Don't central backs lower interest rates in a setting where recession hits hard and prices fall? For example, if recession causes inflation to fall below the target of let's say 2%. $\endgroup$
    – user52932
    Commented Feb 26 at 13:13
  • $\begingroup$ @user52932 Recessions are by themselves inflationary, if you observe recession and deflation at the same time it usually due to some combination of other factors. The fact that during most recent great recession there was deflation is more of an exception to the rule since for example Romer (Advanced Macroeconomics ch 5) shows evidence most recessions (even unconditionally) are inflationary, and conditionally fall in output should virtually always be recessionary. This is why I said that what you propose would be typically inconsistent with CB behavior, if government increases spending that $\endgroup$
    – 1muflon1 ♦
    Commented Feb 26 at 16:35
  • $\begingroup$ will be inflationary, and central bank should lean against that. $\endgroup$
    – 1muflon1 ♦
    Commented Feb 26 at 16:38
  • $\begingroup$ Sorry, I am perhaps confused. Are you suggesting that in a recession the central bank will raise interest rates, to counteract the inflation that comes with the recession? This seems slightly crazy if true - won't the raise in interest rate deepen the crisis? I think this may be true for a cost push inflation and an aggregate supply shock. What if the shock is a climate disaster, which leaves firms unharmed but greatly impacts household income? $\endgroup$
    – user52932
    Commented Feb 26 at 21:39
  • $\begingroup$ @user52932 1. it will do that in response to expansionary fiscal policy that decreases unemployment but increases inflation. Central bank’s policy function under Taylor rule is given by the level of unemployment and inflation, if unemployment is low and inflation is high it will tighten. As mentioned in my answer you also assume away basic economic relations such as effect of fiscal policy on AD, due to shifts in IS curve, once you account for the relationship this becomes optimal CB response. 2. Also it won’t deepen the crisis, just cancels some of the effect of fiscal policy. $\endgroup$
    – 1muflon1 ♦
    Commented Feb 27 at 9:28

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