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Monthly Economic Indicators

Special Topic: The interaction between fiscal and monetary policy

In setting monetary policy, the Reserve Bank will take account of the stance of fiscal policy

In Budget 2014, the Government announced a modest increase in its provision for new spending (or revenue reduction) in future Budgets.[1] The Public Finance Act requires the Government to have regard to the interaction between fiscal policy and monetary policy when formulating its fiscal strategy. This special topic focuses on the implications of changes in government revenue and spending for monetary policy.

Economic growth continues to strengthen, supported by accelerating construction spending, historically elevated export prices and a recent increase in net migration. At the same time, ongoing fiscal consolidation has been removing demand pressure from the economy, providing some offset and allowing monetary policy to be more stimulatory than it would be otherwise.

Assessing the impact of changes in government revenue and spending on monetary policy requires assumptions about how the government’s revenue, spending and debt interact with other parts of the economy. There are essentially three broad steps to reach a view on the impact:

  1. The fiscal impulse - how large, what type and when it will occur?
  2. Macroeconomic conditions - the degree of spare capacity in the economy and what other shocks are affecting the economy?
  3. Structural relationships in the economy - how do households, firms and the central bank behave?

Different ways of measuring the fiscal impulse

There are two broad approaches to assessing the fiscal impulse, which measures whether government fiscal policy decisions are adding to, or subtracting from, aggregate demand pressures in the economy.  

The first approach to measure the fiscal impulse is to use a fiscal aggregate such as the overall budget balance. The Treasury’s fiscal impulse indicator is defined as the change in the cyclically-adjusted cash balance. This indicator is used as a measure of the discretionary stance of fiscal policy, although it can be affected by fiscal and economic factors that are not directly related to policy decisions. It indicates the first-round impact of fiscal policy on aggregate spending in the economy.

Figure 1 shows the Treasury’s fiscal impulse indicator. [2] It shows a positive fiscal impulse in the latter half of the 2000s, particularly in 2008/09-09/10 due to a large fiscal easing involving both higher government spending and personal tax cuts that coincided with domestic and global recession.  A further positive fiscal impulse occurred in 2010/11 at the time of the Canterbury earthquakes. Fiscal tightening began in 2011/12 as the budget deficit began to reduce. The Treasury’s Budget Update forecast further fiscal tightening of 2.1% of GDP over the five years to June 2018. This is smaller than the fiscal tightening of 2.8% of GDP that was forecast for the same period in December’s Half Year Update. Thislargely reflects higher operating allowances from Budget 2015. 

Figure 1 - Fiscal impulse indicator
Figure 1 - Fiscal impulse indicator.
Source: The Treasury

The second broad approach is to identify the fiscal cost of new tax or spending initiatives.

For future Budgets, the cost of discretionary policy initiatives is managed through operating and capital allowances. Budget allowances are a device for managing Budget decisions and are not a measure of the fiscal impulse per se.

Markets and the central bank will already have some information about the future stance of fiscal policy. Therefore to assess the impact of a potential change in the stance, it makes sense to look at revisions to the level of future Budget allowances. Revisions to these allowances occur from time to time to ensure that Budget tax and spending initiatives are consistent with the Government’s overall fiscal strategy.

Figure 2 shows the level of new operating allowances since 2003. Over the last decade, operating allowances have varied within a range of about 0 to 4% of GDP. Lifting future operating allowances by $500 million a year is equivalent to about 0.2% of GDP per Budget - a comparatively modest revision relative to historical variation in operating allowances.

Figure 2 - New operating allowances in each Budget (final year impact)
Figure 2 - New operating allowances in each Budget (final year impact).
Source: The Treasury

Limited spare capacity

Although it is difficult to forecast the shocks that may occur in the future, the economy is expected to be operating at, or above, its potential level of output over the forecast horizon.[3] In this context, the Reserve Bank is expected to continue to withdraw monetary stimulus consistent with its price stability objective. The Official Cash Rate (OCR) is currently 3.25% and expected to increase further over the next two years.

Demand-side effects expected to dominate in the short run

In the short run, a positive fiscal impulse would be expected to add to domestic spending - whether through direct government purchases, transfers to households or tax reductions. However, the private sector response will likely differ depending on the type of fiscal instrument (eg, tax cuts may have a smaller impact on aggregate demand than government spending depending on the saving response of households).

The Treasury looked at several macroeconomic models to give some indication of the implications of changes in fiscal policy. In these models, the demand-side effects dominate in the short run. Higher government expenditure (or reductions in tax revenue) would increase aggregate demand and therefore inflationary pressures. The Reserve Bank would be expected to respond to this by setting interest rates higher than otherwise so that it can achieve its inflation target. The exchange rate would be expected to be higher than otherwise, reflecting a higher spread between domestic and foreign interest rates.

Empirical analysis also supports the view that fiscal policy will have effects on interest rates. A model estimated using New Zealand data from 1983-2010 found that a positive government spending shock is associated with a rise in the government’s long-term bond yield.[4]

While there is uncertainty about the effects of fiscal policy, the Treasury’s advice was that increasing Budget operating allowances from $1 billion to $1.5 billion a year was around the upper limit for increased spending (or revenue initiatives) before they begin to materially affect interest rates. This analysis used as a threshold for materiality the magnitude of one additional increase in the OCR (ie, 25 basis points). [5]

But supply-side effects are important

Tax or spending initiatives may affect the productive capacity of the economy depending on their effects on labour supply, investment and productivity. Improving the supply side of the economy is perhaps the most important means of sustaining economic growth beyond the cyclical upswing expected over the next few years.

Fiscal settings can have important implications for the structure of the economy - for example, the tax and transfer system involves resource transfers across individuals, life cycles and generations. Therefore, fiscal structure may impact on national saving and the medium-term equilibrium interest rate.

Muted market reaction to the Budget

We can also look at market pricing on the day of the Budget (15 May 2014) to see whether there was a financial market reaction to news of higher future operating allowances. There are limits to what this information can tell us. The effects of changes in the future fiscal stance may take some time to be felt. The release of the Budget also includes other news in addition to changes to the fiscal strategy - a new set of Treasury economic forecasts and announcements about the bond programme. Global sentiment and international data releases may also affect domestic financial markets on the day.

Interest rate pricing on Budget day implied minimal change to the expected path of the OCR. The TWI exchange rate drifted down slightly on May 15 (counter to what theory would suggest for an increase in spending).

This provides further support for the Treasury’s judgement that the change in operating allowances is around the level at which macroeconomic impacts are likely to be modest.


  • [1]The 2014 Fiscal Strategy Report signalled higher operating allowances from Budget 2015. The operating allowance is the amount included in the forecasts to provide for the operating balance (revenue and expenses) impact of policy initiatives, changes to demographics and other forecasting changes expected to occur over the forecast period.
  • [2]For the Core Crown plus Crown entities excluding EQC and Southern Response payments.
  • [3]Potential output is defined as the maximum level of real GDP that can be achieved while maintaining stable inflation.
  • [4]Oscar Parkyn and Tugrul Vehbi (2013) "The Effects of Fiscal Policy in New Zealand: Evidence from a VAR Model with Debt Constraints." New Zealand Treasury Working Paper 13/01.
  • [5]See Treasury Report T2014/223
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