An economy can be significantly impacted by the financial decisions made by households. For example, a household decision to consume more and save less can lead to an increase in employment, investment, and, ultimately, profits. Similarly, corporate investment decisions can have a significant impact on the real economy and corporate profits. Individual corporations, on the other hand, rarely have the ability to influence large economies on their own; the consumption decisions of a single household have a negligible impact on the overall economy.
Government decisions, on the other hand, can have a massive impact on even the largest and most developed economies for two main reasons. First, in most developed economies, the public sector employs a significant proportion of the population and accounts for a significant proportion of economic spending. Second, governments are the world’s largest debt borrowers.
The borrowing and spending activities of the government ultimately express government policy. We will identify and discuss two types of government policy that can affect the macroeconomy and financial markets in this reading: monetary policy and fiscal policy.
Both monetary and fiscal policies are used to control economic activity over time. Monetary policy refers to actions taken by central banks to influence the amount of money and credit in an economy. Fiscal policy, on the other hand, refers to decisions made by the government regarding taxes and spending. They can be used to either accelerate growth when an economy is slowing or to moderate growth and activity when an economy is overheating. It is also possible to redistribute wealth and income through fiscal policy.
The overarching goal of both monetary and fiscal policy is typically to create an economic environment with stable and positive growth and low inflation. Crucially, the goal is to steer the underlying economy away from economic booms that may be followed by extended periods of low or negative growth and high unemployment. Households can feel secure in their consumption and saving decisions in such a stable economic environment, while corporations can focus on their investment decisions, making regular coupon payments to bondholders, and making profits for their shareholders.
There are numerous obstacles to achieving this overarching goal. Not only are economies frequently buffeted by shocks (such as oil price increases), but some economists believe that natural economic cycles exist as well. Furthermore, there are numerous historical examples of government policies—whether monetary, fiscal, or both—exacerbating an economic expansion, resulting in negative consequences for the real economy, financial markets, and investors.
Monetary policy and fiscal policy are the two most well-known tools for influencing a country’s economic activity. Monetary policy, which is generally carried out by central banks such as the Reserve Bank of India, is primarily concerned with the management of interest rates and the total supply of money in circulation. Fiscal policy refers to the actions of governments in terms of taxation and spending. The executive and legislative branches of government in the United States determine national fiscal policy.
Monetary Policy
Central banks have traditionally used monetary policy to either stimulate or restrain an economy’s growth. The goal of monetary policy is to stimulate economic activity by incentivizing individuals and businesses to borrow and spend. Monetary policy, on the other hand, can act as a brake on inflation and other issues associated with an overheated economy by restricting spending and incentivizing savings. Monetary policy is a more blunt tool for influencing inflation and growth by expanding and contracting the money supply, and it has less impact on the real economy. Expansionary monetary policy can have a limited impact on growth by increasing asset prices and lowering borrowing costs, making businesses more profitable.
Tools under Monetary Policy
- Cash Reserve Ratio (CRR)
- Statutory Liquidity Ratio (SLR)
- Bank Rate
- Standing Deposit Facility (SDF)
- Marginal Standing Facility (MSF)
- Cash Reserve Ratio (CRR)
Pros and Cons of Monetary Policy
Pros
Interest Rate Targeting Controls Inflation- A small amount of inflation is beneficial to a growing economy because it encourages future investment and allows workers to expect higher wages. Inflation occurs when the overall price levels of an economy’s goods and services rise. Raising the target interest rate makes investment more expensive, slowing economic growth slightly.
Can Be Implemented Fairly Easily- Central banks can use monetary policy tools quickly. Often, simply indicating their intentions to the market can produce results.
Central Banks Are Independent and Politically Neutral- Even if monetary policy action is unpopular, it can be implemented prior to or during elections without fear of political consequences.
Weakening the Currency Can Boost Exports-
Increases in the money supply or reductions in interest rates tend to devalue the local currency. A weaker currency on global markets can boost exports by making these products more affordable to foreign buyers. Companies that primarily import would suffer a negative impact on their bottom line.
Cons
Effects Have a Time Lag: Even if implemented quickly, the macro effects of monetary policy generally take time to manifest. The consequences for an economy can take months or even years to manifest. Some economists believe that money is “merely a veil,” and that while it can stimulate an economy in the short run, it has no long-term effects other than raising general prices without increasing real economic output.
Technical Limitations: Interest rates can only be cut nominally to 0%, limiting the bank’s ability to use this policy tool when interest rates are already low. Maintaining extremely low interest rates for extended periods of time can result in a liquidity trap. Monetary policy tools are more effective during economic expansions than during recessions as a result. Some European central banks have recently experimented with negative interest rate policies (NIRP), but the outcomes will not be known for some time.
The Risk of Hyperinflation: When interest rates are set too low, it is possible to overborrow at artificially low rates. This can lead to a speculative bubble, in which prices rise too quickly and to absurdly high levels. The supply and demand principle means that adding more money to an economy carries the risk of inflation: if there is more money in the system, given the same level of demand, the value of every unit of money will decline, making the price of that money nominally higher.
Fiscal Policy
Most government fiscal policies aim to target the total level of spending, the total composition of spending, or both in an economy. Changes in government spending policies and changes in government tax policies are the two most commonly used methods of influencing fiscal policy.
When a government believes that there is insufficient business activity in an economy, it can increase the amount of money it spends, a practice known as stimulus spending. If there are insufficient tax receipts to cover the increased spending, governments borrow money by issuing debt securities such as government bonds, accumulating debt in the process. This is known as deficit spending.
Raising taxes drains money from the economy and slows business activity. Fiscal policy is typically used when the government wants to stimulate the economy. In order to stimulate economic growth, it may lower taxes or offer tax rebates. One of the central tenets of Keynesian economics is the use of fiscal policy to influence economic outcomes.
When a government spends or changes its tax policy, it must decide where to spend or what to tax. In doing so, government fiscal policy can favor or discourage production by targeting specific communities, industries, investments, or commodities—actions that are sometimes based on non-economic considerations. As a result, fiscal policy is frequently a source of contention among economists and political observers.
It is essentially aiming for aggregate demand. Companies benefit from increased revenues as well. However, if the economy is nearing full capacity, expansionary fiscal policy runs the risk of causing inflation. This inflation erodes the profit margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also erodes the funds of people on fixed income.
Pros and Cons of Fiscal Policy
Pros
Can Direct Spending To Specific Purposes: In contrast to monetary policy tools, which are broad in scope, a government can direct spending toward specific projects, sectors, or regions to stimulate the economy where it is perceived to be most needed.
Can Use Taxation to Discourage Negative Externalities: Polluters and over-consumers can be taxed to reduce their impact on the environment while increasing government revenue.
Short-Time Lag: The consequences of fiscal policy tools are far more visible than the consequences of monetary policy tools.
Cons
May Be Politically Motivated- Tax increases can be unpopular and politically risky to implement.
Tax Incentives May Be Spent on Imports- When tax breaks or government spending are spent on imports, rather than being reinvested in the economy, the impact of fiscal stimulus diminishes.
Can Create Budget Deficits- A government budget deficit occurs when it spends more money than it receives. If spending is high while taxes are low for an extended period of time, the deficit can balloon to dangerous proportions.
Fiscal and monetary policy both play an important role in economic management and have direct and indirect effects on personal and household finances. Fiscal policy entails government-set tax and spending decisions that affect individuals’ tax bills or provide them with employment through government projects. The central bank sets monetary policy, which can boost consumer spending by lowering interest rates on everything from credit cards to mortgages.