4.3 The combined use of monetary and fiscal policy

Up to now, monetary and fiscal policy have been analyzed separately in order to identify the effects of both policy measures. However, if monetary and fiscal policy are used in combination, one speaks of a policy mix that is intended to achieve a specific goal. Sometimes, the combined use of monetary and fiscal policy results from tensions or even conflicts between the government, which is responsible for fiscal policy, and the central bank, which regulates monetary policy. A typical scenario arises when the central bank considers an expansive fiscal policy to be dangerous for price developments and therefore counters it with a contractionary monetary policy. An example of this is Germany after the reunification in the early 1990s:
After the fall of the Berlin Wall, West and East Germany were reunited in 1990. Before the Second World War, they were at about the same level of development. After the reunification, however, West Germany was richer and more productive than East Germany, which was not competitive at all. Many companies located in the East were forced to close or urgently needed new production facilities. There was a significant increase in government expenditure, as money was needed to subsidize companies, provide social benefits for the unemployed, build new infrastructure and repair environmental damage. Part of the increased government spending was to be financed by a tax increase, but the greater part by a budget deficit increase. As a result of the reunification, aggregate demand augmented significantly. Thus, there was a severe rise in government spending and investment, which in the IS-LM model results in a significant rightward shift of the IS curve, caused by an expansive fiscal policy. The new equilibrium of money and financial markets and the goods market is at point $\mathit{Eq}$ with the equilibrium interest rate $i$ and the equilibrium income $Y$.
However, the Bundesbank then feared that the growth would be so high that the upward trend of prices would lead to inflation. This was to be counteracted with a contractionary monetary policy. The LM curve shifts upwards and the new equilibrium income $Y$ shifts back again while the new equilibrium interest rate $i$ continues to rise. The new equilibrium interest rate is higher than the interest rate that would have been reached if only the IS curve had shifted. The new equilibrium income $Y$ is lower. The independence of the central bank allowed to pursue a different objective (price level stability) than the government’s objective (economic growth).
However, if both policy instruments work together, monetary policy can support fiscal policy also without increasing the interest rate. An example would be the current economic stimulus packages (increase in government spending) with an accommodative monetary policy. If the controllers for money supply and government spending are increased at the same time, GDP rises sharply while interest rates hardly change at all.