The government has two macroeconomic policy arms available - fiscal and monetary policy. However, it only has control over monetary policy
Answer: True
The answer is True.
First, this question relies on an understanding that the treasury and central bank are both part of the consolidated government sector.
Please read my blog post - The consolidated government - treasury and central bank (August 20, 2010) - for more discussion on this point.
In terms of monetary policy, the fundamental principles that arise in a fiat monetary system are as follows.
Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending. Debt might also be issued if the government wants the non-government sector to have less purchasing power.
Further, the idea that governments would simply get the central bank to "monetise" treasury debt (which is seen orthodox economists as the alternative "financing" method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the national government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, 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 without issuing debt.
So the non-government sector cannot directly influence the central bank's capacity to set interest rates. Clearly the central bank considers developments in the non-government sector but that is a different matter.
However, the non-government sector does ultimately determine the fiscal balance associated with fiscal policy (including how much tax revenue the government receives for a given set of tax rates and how much spending the government will provide for a given welfare structure).
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.
So the best answer is true.
The following blog posts may be of further interest to you: