Short-term interest rates are set by the central bank while the fiscal strategy manifests in tax and spending decisions by the government. Whereas the non-government sector cannot directly influence the interest rate target being set, it does, ultimately, determine the size of the fiscal deficit at any point in time.
Answer: True
The answer is True.
So the fundamental principles that arise in a fiat monetary system are as follows.
Accordingly, debt has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the private sector to have less liquid purchasing power.
The central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate swapping government debt for bank reserves.
So the private domestic sector cannot directly influence the central bank's capacity to set interest rates. Clearly the central bank considers developments in the private domestic sector but that is a different matter.
However, the private domestic sector does, ultimately, determine the fiscal balance associated with fiscal policy.
The fiscal balance has two conceptual components. First, the part that is associated with the chosen (discretionary) fiscal stance of the government independent of cyclical factors. So this component is chosen by the government.
Second, the cyclical component which refer to the automatic stabilisers that operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the fiscal balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments).
When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The cyclical component is not insignificant and if the swings in private spending are significant then there will be significant swings in the fiscal balance.
The importance of this component is that the government cannot reliably target a particular deficit outcome with any certainty.
This is why adherence to fiscal rules are fraught and normally lead to pro-cyclical fiscal policy which is usually undesirable, especially when the economy is in recession.
While the short-term interest rate is exogenously set by the central bank, economists consider the fiscal outcome to be endogenous - that is, it is determined by private spending (saving) decisions.
The government can set its discretionary net spending at some target to target a particular fiscal deficit outcome but it cannot control private spending fluctuations which will ultimately determine the final actual fiscal balance.
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