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Fiscal Dominance and Monetary Dominance and Policy Instruments Used by the Bank of England for Inflation Targeting

1. Introduction.

The government often employs fiscal policy, monetary policy or a combination of both to sway the economy back to an equilibrium position. The manner in which the government employs both policies may result to either fiscal or monetary dominance. This paper is aimed at defining fiscal and monetary dominance so as to employ the distinction between the two policies to determine whether the Bank of England has enough policy instruments to control inflation. To achieve this objective, the IS/LM model will be employed to see how various policy measures affect the interest rate, national income and inflation rates[1]. We begin by defining fiscal policy, monetary policy, fiscal dominance and monetary dominance in section 2 below. The study later provides a description of the IS/LM model in section 3 and finally, an evaluation of the instruments used by the bank of England in controlling inflation is done in section 4.

2. Fiscal Policy, Monetary Policy, Fiscal Dominance and Monetary Dominance

2.1. Fiscal Policy

Fiscal policy refers to a situation whereby the government restores equilibrium in the economy by making changes to taxes or government expenditure on public goods and services[2]. When there is under-utilisation of capacity, the government can increase capacity utilisation by reducing taxes (that is through a reduction in tax rates or tax base) or by increasing spending on public goods and services as well as subsidising the production of certain goods and services[3]. Fiscal policy aimed at increasing money supply is referred to as easy fiscal policy[4]. On the other hand, when there is over-utilisation of capacity, the government either increases taxes (through and increase in tax rates or tax bases) or reduces spending on public goods and services[5]. It also reduces subsidies and transfer payments. This type of fiscal policy is referred to as tight fiscal policy[6].

2.2 Monetary Policy

Monetary policy is referred to as a means by which the central bank tries to sway the economy to equilibrium by influencing the supply of money[7]. This is achieved through four main approaches, which include: printing more money; direct controls over money held by the money sector; open market operations and influencing the interest rate. Both tight and easy monetary policies can also be identified. Like easy fiscal policy, easy monetary policy is one whereby the central bank embarks on a policy to increase the supply of money. On the other hand tight monetary policy is a policy whereby the central bank embarks on a policy to limit the circulation of money such as increasing interest rates.

2.3 Fiscal Dominance

Fiscal dominance occurs when government can determine the stock of debt, and the path of total expenditures and taxation[8]. Under these conditions, the government can influence the inflation rate, the future flow of monetary base by raising the permanent level of expenditures without at the same time raising taxes[9]. Fiscal dominance is therefore a scenario whereby monetary policy is driven by fiscal policy[10].

2.4 Monetary Dominance

Monetary dominance refers to a situa