Analysis of Alan Reynolds' "The Fiscal-Monetary policy mix"


There are two kinds of policies that can be used in a macroeconomic view, the monetary policy that is implemented by the Central Bank and Fiscal Policy that is implemented by the Government. One of the most important debates of all times in macroeconomics is about the effectiveness of monetary and fiscal policy. Which is more effective the fiscal or the monetary policy?

One of the economists who is a supporter of Monetary Policy is Alan Reynolds. He is a supply-side economist. In his paper (Reynolds, 2001) he tries to explain the significance of the Central Bank policies and criticizes the so called fiscalists.

He begins with a short overview of the macroeconomics opinion during the postwar era. At that time monetary policy was not seen as an important tool that could be used to solve the macroeconomic problems of countries. The main function of this institution was to keep the interest rates low enough to enable the government to borrow money. The inflation could be fought only with fiscal policy, with surtaxes and the control of wages and prices.

One interesting thing is the difference between Tobin and Mundell ideas. The higher tax rates and fast money growth during the 70s produced stagflation. This increased the attention in monetary policy. Tobin developed a theory, called the "funnel theory". This theory has the name "funnel theory" because according to Tobin the use of monetary or fiscal stimulus would cause a faster growth of nominal GDP. If the economy is below the full employment the faster growth of nominal GDP will cause faster growth of real GDP. If the economy is above the full employment, the workers will demand higher wages and this will be a pressure for increasing inflation. This will require the control of wages and prices.

The Keynsianists approach to increase the level of national income was to stimulate demand. The Keynsianists approach for the inflation was to curb the demand. These two things are incompatible with each other. Thus Robert Mundell proposed that the inflation targeting should be assigned to the Monetary Policy. The fiscal policy should be used in a microeconomic view of supply side.

The debate between Mundell and Tobin was present during the Clinton administration. Tobin's funnel theory says that monetary and fiscal policies are interchangeable. Thus if we have a fiscal restraint and a monetary stimulus we should have no real impact on real GDP growth. Because the inflation was caused by the high growth, there would be no impact on inflation. Before, a fiscal stimulus meant budget deficit. The Government sells more bonds to the public. People would have more money in their hands and will increase their spending. Fiscal surpluses were considered the inversion of this policy.

Monetary stimulus is defined as the extent of the purchases of Treasury Bonds by the Central Bank. This expands the monetary supply. On the other hand a monetary stimulus could be defined as the Fed efforts to keep the interest rates low.

As Alan Reynolds says, the monetary and fiscal stimuli are not interchangeable. The budget deficit cannot be financed by issuing new money. If we use "easy money" this will cause inflation regardless we have a deficit, a surplus or a balanced deficit. If we have a restrictive monetary policy this will cause deflation. One important conclusion of Alan Reynolds is that "Inflation and deflation are monetary phenomena, not fiscal or real".

One of the fiscalist that thinks that monetary policy is ineffective is Tom Sargent. He tries to explain the old idea that monetary and fiscal theory is interchangeable.

A new theory called the theory of "twin deficits" emerged in the early 90s. This theory says that the countries with large budget deficits must have large trade deficits and that the countries with large budget surpluses must have large trade surpluses. This is again a fiscalist theory that tries to explain everything about the economy with the budget deficits.

Clintonomics is called the economic policy during the presidency of Bill Clinton. The main idea behind this policy was that the budget surplus caused a high economic growth. Thus, according to them, the budget surplus was a stimulus for the economy. Budget surpluses increased national savings as a share of GDP and therefore pushed the real interest rates down. The reduction of real interest rates increased the investments.

But the fact gives different conclusions. The interest rates rose when the national savings rate was highest and fell when the saving rates were the lowest. In addition the reduction in budget deficit was offset by a reduction in private savings.

The national saving can rise because of increasing investments that stimulates the corporate income.

Sargent(1988), one of the supporter of the idea that the monetary and fiscal policy are interchangeable stated that monetary policy is impotent to influence the real interest rate. On the other hand, some other fiscalists go on with the idea that the budget surpluses reduce real interest rates. But Reynolds (2001) used the data of real fund rate and real GDP over the years. He sees that the Central Bank "raises or lowers the real funds rate only in response to what has been happening to real GDP growth over the past year or so". This change has nothing to do with the budget deficit or budget surplus. This is shown in this figure (Reynolds, 2001):

The declarations of the Central Bank are often about the level of unemployment, stock prices, the gap between potential and real GDP and things related to the fiscal policy. But many of these topics are not part of the Central Bank's objectives.

Reynolds is against the classical Phillips curve. Based on actual data the results are reversed. The move of inflation is in reverse of that is shown in the Phillips curve. Greenspan, the former Chairman of the Federal Reserve, bases his ideas on the logic of this curve. In his analysis he uses the productivity increase. An increasing productivity can be inflationary and a decreasing productivity can also be inflationary. The conclusion of Greenspan is that is needed a lower rate of economic growth but that doesn't aggravate the productivity growth. But, as Reynolds says (Reynolds, 2001, p. 274), the slowing in real output growth would slow the real productivity growth. Fed should not put limits to the productivity growth.

The conclusion is that the price stability should be assigned to the monetary policy and the fiscal policy should be focused in a microeconomic view of the economy.

Analysis of "Fiscal-Monetary Policy Mix"

Alan Reynolds tries to explain and to defend his ideas based on the real data. He doesn't use any mathematical model as others do. All his conclusions are derived from the time series of inflation, real GDP growth, FED real fund rate, GDP gap etc.

The fiscalists use a mathematical model and their conclusions are derived from these models rather than the actual data. But, according to the actual data the conclusions are different from those of fiscalists.

We will begin with the model under which the fiscalists build their ideas and then we will try to give a reason why this model has problems.

Along the paper we saw that the approach of Clintonomics was that the surpluses increased the national savings which on the other way decreased the real interest rate.

We know that:

Y = C + I + G + NX

Or Y = C + I + G if we assume that NX=0.

Then we have:

Y - C - G = I (from the above identity)

Thus we have that National Savings equal Investment.

If we add and subtract taxes T in the left hand side we have:


Thus, the national savings have two parts:

Private Saving=Y-T-C


Public Saving=T-G

Equilibrium occurs when national savings equal national investments.

If we have a budget surplus we will have an increase in the public saving and thus an increase in the national saving. The curve of national spending will move to the right. The interest rate will decrease and the investment will increase (Figure 3). This will happen if we use the above relation.

Based on this system of identities, the fiscalists explained the economic boom during the presidency of Clinton and the importance of Fiscal Policy in the economy, especially its effect in the real rate of interest. But Reynolds, using the real data, saw that the budget surplus had no impact in the national savings rate. He explained this with the logic that the federal deficit was fully offset by a reduction in private savings and vice versa (Reynolds, 2001, p. 268).

We can explain the data using the Ricardian view of budget deficits.

As we know, there are two approaches for the effect of a budget deficit, the standard model and the Ricardian Model.

The standard model approach says that "desired private saving rises by less than the tax cut, so that desired national saving declines. It follows for a closed economy that the expected real interest rate would have to rise to restore equality between desired national saving and investment demand. The higher real interest rate crowds out investment, which shows up in the long run as a smaller stock of productive capital." (Barro, 1989).

In the Ricardian approach we have that the desired national saving does not change and the real interest rate does not have to rise in a closed economy to maintain balance between desired national saving and investment demand. Hence, there is no effect on investment (Barro, 1989).

Ricardian view is the most successful approach for the effects of budget deficits in the economy.

As Barro(1989) says: "Overall, the empirical results on interest rates support the Ricardian view. Given these findings it is remarkable that most macroeconomists remain confident that budget deficits raise interest rates."

He reaches this conclusion using the empirical evidences for the US economy. Thus, "Charles Plosser (1982, p. 339) finds for quarterly U.S. data from 1954 to 1978 that unexpected movements in privately-held federal debt do not raise the nominal yield on government securities of various maturities" (Barro, 1989). Also, the evidences in the Alan Reynolds' paper agree with this view.

The fiscalists are wrong because the people in US act as described in the Ricardian Approach.

Alan Reynolds is a supply side economist. This means that he supports the idea that the Government should intervene only in the microeconomic aspect.

What does it mean to intervene in the microeconomic aspect?

The Government should lower the taxes to stimulate the supply of firms. One other aspect is the intervention in the case of Natural Monopolies. The Government should use subsidies in order to increase the production and lower the price. Fiscal Policy effects on inflation are minimal. Public debt should not be much considered by the Central Bank policy.

Evidence in Albania

Unlike USA that has a big economy; Albania has a small open economy. We saw that in the case of United States, the approach developed by Reynolds was true.

We can see the data provided from the Albanian Institute of Statistics and the Bank of Albania to derive a conclusion about the effectiveness of Monetary Policy and Fiscal Policy.

Albania has relatively a new Central Bank in the conditions of capitalism (20 years). Before, the central bank had quite different goals from the actual Central Bank.

The ricardian view says that the budget deficit has no real impact in economy. The increase of the budget deficit leads to an increase of the private savings.

If we use the data of the budget deficits and private savings in Albania from the first quarter 2000 to the last quarter of 2007 we can see the pattern shown in figure 4. The budget deficit and the private savings are shown in percent of nominal GDP.

The logic is evident: The higher the budget deficit, the higher the private savings. The reduction in the budget deficits gives a reduction in the private savings. Thus, the ricardian approach is evident again here. The influence in the interest rate is minimal.

The Central Bank should not base too many its declarations on the budget deficit size. This institution must concentrate itself in the inflation targeting. Inflation, as Reynolds (2001) said is a monetary phenomenon. Government in Albania should adopt a microeconomic view of the economy and stimulate the supply of producers. It hasn't been done a lot on this direction.

We use again quarterly data, from the first quarter of the year 1996 to the before last quarter of 2009. The result of this data is the graphic shown in figure 5. It's evident that the conclusions of Reynolds apply here too. There's a perfect pattern. If the GDP is below the potential product, the inflation will be high and vice versa.

We don't have a positive relationship between "overheating" and inflation. Looking at the graphic we can see that high inflation occurred during expansive monetary policy and that slow GDP growth occurred during government problems periods.

Thus we have inflation only when we have "overcooling" and not "overheating".

The periods of "overheating" in Albania were during the year 1996 and the year 2008.

Stagnation occurs because of inefficient government policies and lower productivity. During the years 1997-1998-1999 the inflation was highest because a main part of the budget was financed by the Central Bank and because of lower productivity (Another important point is the productivity that is explained below). Inflation occurs by the monetary supply and the stagnation because of ineffective fiscal policy.

The central Bank has another instrument, the changing of the repo rate. This is an important instrument that affects the real interest rate and the economy growth. Let's see the historic data of Albania real repo rate and GDP growth from the first quarter of 1996 to the before last quarter of 2009. This is shown in Figure 6. When the repo real rate is higher, the GDP growth rate is higher and when the repo real rate is lower the GDP growth rate is lower. The explanation of this fact is related to the lag impact of the real repo rate on the real GDP growth.

The data used for the graphics are listed in the appendix.

So far we've seen that the Keynsianist view of fiscal effectiveness on the economy is not true. Another important point about inflation is the productivity. With a fixed Labor Supply an economic growth can arise only from an increase in productivity. But an increase in productivity cannot be inflationary because this will reduce the costs of production. With the same logic, with a fixed Labor Supply, a decrease in the productivity will increase the costs and will be a pressure for the inflation. "Overheating" is not inflationary.

Thus the inflationary periods in Albania were due to high Money Supply and very low productivity.


Inflation is a monetary phenomenon. It is not related to the fiscal policy and thus should be assigned to the monetary policy. Unemployment, real GDP growth are related to the fiscal policy. The government should stimulate the supply of firms through the tax incentives, subsidies in the case they are needed to stimulate the supply (natural monopolies). The government should not try to influence the inflation because this is not part of its goals.

The size of the budget deficit does not affect the size of the national savings, and thus, does not affect the real interest rate. The Central Bank should not consider very much the budget deficit or surplus impact on the economy.

The inflation and the GDP gap are not related to each other. The main cause of high inflation is related to the money supply. The GDP gap is related to the level of supply, the effectiveness of fiscal policy.


Reynolds, A. (2001) The Fiscal-Monetary Policy Mix, Cato Journal, Vol. 21, No. 2.

Barro, R. J. (1989) The Ricardian Approach to Budget Deficits, The Journal of Economic Perspectives, Vol. 3, No. 2.

Bank of Albania (2009), Time Series,,3,4,0,0

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