Foreign Policy Association | Mon, Dec 21, 2020
by Paul J. Sheard
The COVID-19-triggered economic shutdown has precipitated the second collapse in economic activity and surge in unemployment in 12 years. The resulting monetary and fiscal policy responses have been dramatic and necessary, and have underscored the need to make the macroeconomic policy framework fit for 21st-century purposes.
Macroeconomic policy aims to keep the economy operating at full employment (so that whoever wants to work can) and to keep inflation low and stable (so that the purchasing power of people’s savings is preserved over time). An ancillary aim is to maintain financial stability, because a market economy is prone to financial crises, which can wreak havoc on employment and price stability.
While institutional details vary by country, the existing macroeconomic policy framework has two pillars: “monetary policy” and “fiscal policy.” Monetary policy aims to guide economic activity and inflation by influencing interest rates and other financial conditions, and is the responsibility of the central bank. Fiscal policy involves budgetary matters (changes in government spending, taxation, and transfers), and is the responsibility of the government of the day and its treasury.
Monetary policy is seen as being separate from fiscal policy; it is viewed as being the primary tool of macroeconomic (aggregate demand management) policy; and the independence of the central bank from the political sphere is taken to be critical, if not sacrosanct.
This framework needs to be made more robust to a range of economic challenges. It is well adapted when high inflation is the main threat to price stability and government spending needs to be held in check. It is not optimally designed when the proximate policy challenge is a large or persistent shortfall in aggregate demand, chronic deflation, or a very low real equilibrium rate of interest (what Harvard economist Larry Summers calls “secular stagnation”).