Fiscal policy

Monetary policy
Fiscal policy involves the government changing the levels of taxation and government spending in
order to influence aggregate demand (AD) and the level of economic activity.

 AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of Fiscal Policy
 Stimulate economic growth in a period of a recession.
 Keep inflation low (the UK government has a target of 2%)
 Fiscal policy aims to stabilize economic growth, avoiding a boom and bust economic cycle.
Fiscal policy is often used in conjunction with monetary policy.In fact, governments often prefer
monetary policy for stabilizing the economy.
It is a critical tool that governments use to stabilize their economies. It involves the management of
government revenue and expenditure to achieve specific economic objectives, such as controlling
inflation or reducing unemployment. By making changes in taxes, public spending, and borrowing,
fiscal policies aim to influence the overall health and performance of an economy.
Government Revenue & Expenditure
At its core, fiscal policy revolves around how the government collects money (revenue) and how it
spends that money (expenditure). Governments generate revenue through various means, including
taxes on individuals and businesses, tariffs on imported goods, fees for public services, and income
from state-owned enterprises. On the other hand, government expenditure encompasses a wide range of
areas such as infrastructure development, education, healthcare, defense spending, social welfare
programs, and more.
Economic Objectives
The primary purpose of implementing fiscal policies is to achieve specific economic goals. These
objectives can vary depending on the prevailing economic conditions and priorities set by the
government. Some common goals include:
Controlling Inflation
When prices rise too quickly across an economy (inflation), it can erode people's purchasing power. Fiscal
policies can be used to curb inflation by reducing government spending or increasing taxes.
Reducing Unemployment
High levels of unemployment can be detrimental to both individuals and the overall economy. Governments
may implement expansionary fiscal policies that involve increasing public spending or decreasing taxes to
stimulate job creation.
Promoting Economic Growth
Fiscal policies play an important role in fostering economic growth by investing in infrastructure projects or
providing tax incentives for businesses.
Stabilizing Business Cycles
Economies go through periods of expansion (boom) followed by contraction (recession). Fiscal policies can
help smooth out these cycles by adjusting government spending levels during different phases.
Tools Of Fiscal Policy
To implement fiscal policy effectively, governments have several tools at their disposal. These tools
allow them to influence the economy and achieve their desired objectives. The key tools include:
Taxation
Governments can adjust tax rates or introduce new taxes to influence consumer behavior, stimulate
economic activity, or generate revenue.
Government Spending
By increasing or decreasing public spending, governments can directly impact various sectors of the
economy and drive growth.
Borrowing
Governments may borrow money by issuing bonds or taking loans from international organizations to
finance projects or cover budget deficits
Objectives Of Fiscal Policy
Fiscal policy plays an essential role in shaping the overall economic health and stability of an economy.
Its primary objective is to promote macroeconomic stability by managing government spending and
taxation. Let's delve into the specific objectives of fiscal policy and understand how they impact the
economy.
Promoting Macroeconomic Stability
One of the main goals of fiscal policy is to achieve macroeconomic stability. This entails maintaining a
balance between economic growth, low inflation, and stable employment levels. To achieve this, fiscal
policy can be used to stimulate demand during periods of economic downturn or curb inflationary
pressures when the economy is overheating.
Achieving Full Employment
Another key objective of fiscal policy is to strive for full employment within an economy. By
implementing measures that stimulate demand, fiscal policy aims to create more jobs and reduce
unemployment rates.
Conversely, during times of high inflation or labor market imbalances, fiscal policy may be used to rein
in excessive demand and stabilize employment levels.
Income Redistribution
Fiscal policy also serves as a tool for income redistribution within society. Governments can use taxation
policies to collect revenue from higher-income individuals or corporations and allocate it towards
programs that benefit lower-income groups. By doing so, fiscal policy aims to reduce income inequality
and promote economic equity.
Promoting Economic Equity
In addition to income redistribution, fiscal policy seeks to promote overall economic equity within an
economy. This involves ensuring that all individuals have equal access to education, healthcare, and
infrastructure development. Through targeted spending on social welfare programs and public goods,
governments can address disparities in opportunities and improve living standards for all citizens.
Achieving Full Employment
Another key objective of fiscal policy is to strive for full employment within an economy. By
implementing measures that stimulate demand, fiscal policy aims to create more jobs and reduce
unemployment rates.
Conversely, during times of high inflation or labor market imbalances, fiscal policy may be used to
rein in excessive demand and stabilize employment levels.
Income Redistribution
Fiscal policy also serves as a tool for income redistribution within society. Governments can use
taxation policies to collect revenue from higher-income individuals or corporations and allocate it
towards programs that benefit lower-income groups. By doing so, fiscal policy aims to reduce income
inequality and promote economic equity.
Promoting Economic Equity
In addition to income redistribution, fiscal policy seeks to promote overall economic equity within an
economy. This involves ensuring that all individuals have equal access to education, healthcare, and
infrastructure development. Through targeted spending on social welfare programs and public goods,
governments can address disparities in opportunities and improve living standards for all citizens.
Ensuring Long-Term Sustainability
Sustainable growth is a critical goal of fiscal policy. Governments need to ensure that their expenditure
does not lead to unsustainable levels of debt or deficits over time. By carefully managing spending
patterns and revenue collection, fiscal policy aims to maintain a healthy balance between short-term
economic objectives and long-term fiscal sustainability.
Types Of Fiscal Policies
Fiscal policies are strategies implemented by the government to manage the economy. These policies play
a vital role in influencing economic growth, stabilizing inflation, and addressing unemployment. There
are different types of fiscal policies that governments can employ based on their economic goals and
challenges.
Expansionary Fiscal Policies
Expansionary fiscal policies are designed to stimulate economic growth during periods of recession or
slow economic activity. The primary objective is to increase aggregate demand and boost consumer
spending. This is achieved through two main approaches:
 This involves increasing AD.
 Therefore, the government will increase spending (G) and cut taxes (T). Lower taxes will increase
consumers spending because they have more disposable income (C)
 This will tend to worsen the government budget deficit, and the government will need to increase
borrowing.
A budget deficit occurs when a government spends more in a given year than it collects in revenues, such
as taxes. As a simple example, if a government takes in $10 billion in revenue in a particular year, and its
expenditures for the same year are $12 billion, it is running a deficit of $2 billion
Increased Government Spending
Governments may choose to increase their expenditure on various sectors such as
infrastructure development, education, healthcare, or defense. By injecting more
money into these areas, it aims to create more jobs and stimulate economic activity.
Tax Cuts
Another way to implement expansionary fiscal policy is by reducing taxes for
individuals and businesses. When people have more disposable income due to lower
tax burdens, they tend to spend more on goods and services, which helps stimulate
the economy. Expansionary fiscal policies can be beneficial in jump-starting an
economy that is experiencing a downturn or recession. By increasing government
spending or reducing taxes, these policies encourage consumer spending and
business investment
Contractionary Fiscal Policies
Contractionary fiscal policies are employed when there is a need to control inflation or address
excessive aggregate demand that could lead to an overheated economy. Governments utilize
two main methods for implementing contractionary measures:
 This involves decreasing AD.
 Therefore, the government will cut government spending (G) and/or increase taxes. Higher taxes will reduce
consumer spending (C)
 Tight fiscal policy will tend to cause an improvement in the government budget deficit.
 Increased Government Spending
 When the government increases its spending, it uses tax revenue to increase aggregate demand. If the government’s
 budget is balanced at the outset of spending, an increase in spending creates a deficit (in this case, spending in
excess of
tax revenue).
Reduced Government Spending
During periods of high inflation or excessive aggregate demand, governments may opt to cut spending in
various sectors. By reducing government expenditure, they aim to decrease the overall demand in the
economy.
Increased Taxes
Another approach is to raise taxes on individuals and businesses. Higher tax rates reduce disposable
income, which can help curb excessive spending and dampen inflationary pressures. Contractionary fiscal
policies are often used as a means of reigning in an overheated economy or controlling inflation.
 Figure 5-1 illustrates the effect of government spending on aggregate demand
 .
Figure 5-5 illustrates what happens to aggregate demand when the government chooses to implement contractionary fiscal policy.
Aggregate demand decreases and the price level is stabilized as a result of the government’s restrictive spending and/or increased tax
rate.
If the government implements a contractionary fiscal policy—raising taxes and/or restricting spending—its goal is to reduce aggregate
demand to prevent demand-pull inflation. Figure 5-5 illustrates a decrease in aggregate demand as a result of decreased government
spending and/or increased taxes. The aggregate demand curve shifts to the left; the price level and real GDP decrease.
expansionary fiscal policy:
fiscal policy that increases the level of aggregate demand, either through increases in
government spending or cuts in taxes

contractionary fiscal policy:

fiscal policy that decreases the level of aggregate demand, either through cuts in
government spending or increases in taxes
Monetary policy refers to the actions taken by a central bank or monetary authority to manage the supply of
money and interest rates in an economy, with the aim of promoting economic growth and stability.
Monetary policy involves using interest rates and other monetary tools to influence the levels of consumer
spending and aggregate demand (AD). In particular monetary policy aims to stabilise the economic cycle –
keep inflation low and avoid recessions.
Aim of monetary policy
Low inflation. UK target is CPI 2% +/-1. Low inflation is considered an important factor in enabling higher
investment in the long-term.
Stable economic growth. Monetary policy is also concerned with maintaining a sustainable rate of economic
growth and keeping unemployment low.
Take the case of Brazil in 2015. The country was facing high inflation, which was eroding people's
purchasing power and destabilizing the economy. In response, the Central Bank of Brazil raised its
benchmark interest rate, to a record high of 14.25%. This move made borrowing more expensive, thus
discouraging excessive spending and reducing the money supply in the economy. Over time, this policy
helped to ease inflationary pressures in Brazil.
How Does it Work?
The central bank of a country manages the economy and ensures financial stability. It
considers inflation, employment, and economic growth to make decisions.
If the economy is not doing well, the central bank boosts activity and creates jobs while keeping
prices stable. The central bank encourages borrowing, spending, and investment to help achieve
these goals. They might lower interest rates, buy government bonds, or increase bank reserves to
stimulate spending and investment.
However, if these measures are not controlled properly, it can lead to negative effects like budget
deficits and inflation. The central bank carefully monitors the economy and adjusts policies to
prevent these negative effects.
Objectives of Monetary Policy
The primary objectives of monetary policies are the management of inflation or unemployment and
maintenance of currency exchange rates
1. Inflation
Monetary policies can target inflation levels. A low level of inflation is considered to be healthy for the
economy. If inflation is high, a contractionary policy can address this issue.
2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an expansionary
monetary policy generally decreases unemployment because the higher money supply stimulates business
activities that lead to the expansion of the job market.
3. Currency exchange rates
Using its fiscal authority, a central bank can regulate the exchange rates between domestic and foreign
currencies. For example, the central bank may increase the money supply by issuing more currency. In
such a case, the domestic currency becomes cheaper relative to its foreign counterparts.
4.Full Employment
During world depression, the problem of unemployment had increased rapidly. It was regarded as
socially dangerous, economically wasteful and morally deplorable. Thus, full employment assumed as
the main goal of monetary policy. In recent times, it is argued that the achievement of full employment
automatically includes prices and exchange stability.
According to their version, full employment means absence of involuntary unemployment. Therefore, it
implies not only employment of all types of labourers but also includes the employment of all economic
resources.
Economic Growth:
In recent years, economic growth is the basic issue to be discussed among economists and statesmen
throughout the world. “Economic growth as the process whereby the real per capita income of a
country increases over a long period of time.” It implies an increase in the total physical or real output,
production of goods for the satisfaction of human wants.
In other words, it means utilization of all the productive natural, human and capital resources in such a
manner as to ensure a sustained increase in national and per capita income over time.
In other words, monetary authority should follow an easy or tight monetary policy to suit the
requirements of growth. Again, monetary policy in a growing economy, has to satisfy the growing
demand for money. Thus, it is the responsibility of the monetary authority to circulate the proper
quantity and quality of money.
Types of monetary policy
There are two main types of monetary policy:
Expansionary monetary policy: The goal of an expansionary monetary policy is to boost
the money supply and promote economic expansion. Lowering interest rates, expanding
the money supply and easing reserve requirements can all be used to achieve this.
Contractionary monetary policy: It aims to decrease the money supply and control
inflation. Raising interest rates, reducing the money supply and boosting reserve
requirements can all be used to achieve this.
Tight monetary policy implies the Central Bank (or authority in
charge of Monetary Policy) is seeking to reduce the demand for
money and limit the pace of economic expansion. Usually, this
involves increasing interest rates.
The aim of tight monetary policy is usually to reduce inflation.

With higher interest rates there will be a slowdown in the rate of

economic growth. This occurs due to the fact higher interest rates
increase the cost of borrowing, and therefore reduce consumer
spending and investment, leading to lower economic growth

 Expansionary monetary policy aims to increase aggregate

demand and economic growth in the economy.
 Expansionary monetary policy involves cutting interest rates or
increasing the money supply to boost economic activity.
 Lower interest rates make it cheaper to borrow; this encourages
firms to invest and consumers to spend.
Lower interest rates reduce the cost of mortgage interest
repayments. This gives households greater disposable income and
encourages spending