A total and clear separation between fiscal and monetary policy is next to impossible in any economy. There are always areas where they overlap. However, well-managed market economies attempt to keep these two policies separate and try to [direct] each policy toward the objectives for which it is comparatively more efficient.
The greater the separation between monetary and fiscal policies, the less likely governments will encroach on markets and the more likely that mercantile competition among them will enhance economic welfare. This can best be seen by examining, in historical perspective, how the changing conditions of money and credit in the United States influenced the capacity of different levels of government to borrow for current consumption. Beyond the American federalist experience, however, the principles involved are quite general.
A federal system of government can, potentially, come closer to meeting Vito Tanzi’s criterion of separating monetary from fiscal policy than can a unitary state. But each level of government in the federal system must be fiscally independent. That is, each must have its own tax base that more or less matches its expenditure obligations without significant intergovernmental transfers.
Suppose further that only the central government issues money, i.e., owns the central bank and effectively controls bank supervision, and that this money is the economy’s definitive means of settlement. Then, the more expenditure obligations devolve from the central government to lower-level ones, the greater the separation between fiscal decisions and the government’s use of the monetary system as a potential source of finance.
The macroeconomic benefits from this separation are well known. It is