Fiscal dominance refers to a macroeconomic situation where a central bank’s monetary policy decisions are heavily influenced or constrained by a government’s fiscal policy and budget requirements.
This limits the central bank’s ability to achieve its own inflation and economic goals.
What is Fiscal Dominance?
Fiscal dominance occurs when the fiscal authority such as the treasury or finance ministry of a government, faces large current deficits and debt burdens that leave little room for additional borrowing.
To fund spending, the government then turns to the central bank to help finance the deficits through money printing.
In regular circumstances, the central bank is independent and pursues monetary policy objectives like inflation targeting, emploament stabilization or exchange rate management.
But the government’s funding pressures and budget constraints force the central bank to subordinate its policy goals to help accommodate the government’s financing needs through loose monetary policy.
How Does Fiscal Dominance Occur?
Some ways fiscal dominance can emerge are:
- Large Budget Deficits – Sustained high fiscal deficits require increased government borrowing and debt issuance, which then depends on central bank support.
- High Debt Levels – High existing public debt diminishes a government’s fiscal space and ability to fund further deficits, again relying on the central bank.
- Financial Crises Bailouts – Governments may run huge deficits and take on massive public debt due to banking sector bailouts or economic stimulus programs in times of crisis. This expands financing needs.
- Implicit Government Control – Even without large deficits or debt, government influence over appointments and operations may sway central bank decision making.
What are the Consequences of Fiscal Dominance?
Fiscal dominance can have several implications:
- Higher Inflation – Money printing to fund deficits risks high inflation which the central bank would otherwise try to prevent.
- Interest Rates Distortion – Accommodating government borrowing can keep rates too low for too long rather than based on economic conditions.
- Currency Depreciation – Expanding the money supply this way stokes currency depreciation pressure.
- Constrained Policy Space – Fiscal needs limit the central bank’s ability to use monetary policy flexibly to achieve its macroeconomic objectives.
- Debt Monetization – Excessively monetizing debt undermines confidence in the government’s commitment to fiscal prudence.