Level 1 CFA® Exam:
Monetary policy is a central bank activity aimed at influencing the quantity of money in an economy. Expansionary monetary policy is about increasing the money supply, while contractionary policy consists in reducing the money supply in an economy.
Fiscal policy refers to changes in the level of government spending and taxes in order to impact the national economy.
We can say that the government should implement fiscal policy to influence the aggregate demand and stabilize the economy. Because the political cycle affects the fiscal policy and its timing to a great extent, not always do governments use fiscal policy to stabilize the economy.
Very often fiscal policymakers take actions that contradict the real interests of the economy, for example, to win the upcoming elections the government may cut income taxes which may be detrimental to the economy at this particular point in time.
We should also mention here that in the economy there are also automatic processes that adjust the level of aggregate demand. The term for these automatic processes is automatic stabilizers.
However, in this lesson, we will mainly focus on the government’s actions.
Thus, first, we will talk about the objectives of fiscal policy. Then, we will describe fiscal policy tools and after that, we will discuss the process of implementing fiscal policy. We will also try to answer the question: Is the size of the national debt important and why? Finally, we will analyze how fiscal and monetary policy interact with each other.
Fiscal policy is meant to:
- influence the level of economic activity,
- redistribute income, and
- allocate resources in an economy.
To achieve its objectives, the government can use fiscal policy tools.
We divide fiscal policy tools into 2 groups, which are:
- spending tools, and
- revenue tools.
Spending tools include:
- transfer payments,
- current government spending, and
- capital expenditure.
Revenue tools cover:
- direct taxes, and
- indirect taxes.
Direct taxes are levied on income and wealth. So, they are mainly used to redistribute income.
On the other hand, indirect taxes are levied on goods and services. For example, they can be used to reduce the consumption of certain goods and services.
As you probably know, the implementation of fiscal policy is about changing the amount of taxes and government spending.
Expansionary fiscal policy is when government spending increases relative to tax revenues, which means that the budget deficit increases or the budget surplus decreases.
Contractionary fiscal policy is when government spending decreases relative to tax revenues. In this case, the budget deficit decreases or, if we are dealing with the budget surplus, the budget surplus increases.
Difficulties in executing fiscal policy include:
- the recognition lag, which is the time required to diagnose problems in the economy,
- the action lag, which is the time required to implement specific actions (such as discussions, voting, etc.),
- the impact lag, which is the time between the implementation of a particular action and its real impact on the economy,
- the crowding-out effect, which is when the expansionary fiscal policy “crowds out” private investment, because an increase in debt-financed government expenditure results in an increase in interest rates and a decrease in private investments.
- supply shortages, which refer to a situation when the poor condition of the economy is the result of limited access to factors of production, and
- multiple targets, which refer to a situation when fiscal policy is implemented as a response to a variety of targets and consequently doesn’t serve its function. For example, it is very hard to simultaneously decrease inflation and unemployment.
Is the size of national debt important or not?
In other words, what we are asking is whether an economy will have a problem if the ratio of national debt to GDP is big?
Before we answer this question let’s focus our attention on two terms:
- government deficit, and
- national debt.
As you know both fiscal and monetary policy could be either expansionary or contractionary.
Thus, let’s have a look at 4 possible variants:
- Expansionary fiscal policy and expansionary monetary policy,
- Contractionary fiscal policy and contractionary monetary policy,
- Expansionary fiscal policy and contractionary monetary policy,
- Contractionary fiscal policy and expansionary monetary policy.
When we are dealing with expansionary fiscal policy and expansionary monetary policy, then:
- aggregate demand increases,
- interest rates decrease, and
- inflation increases.
When we are dealing with contractionary fiscal policy and contractionary monetary policy, then:
- aggregate demand decreases,
- interest rates increase, and
- inflation decreases.
Expansionary fiscal policy and contractionary monetary policy will lead us to higher output because of the impact of the fiscal policy and to an increase in interest rates as the result of higher government spending and lower money supply. Therefore, the activity of the private sector will decrease and the ratio of government spending to private sector spending will rise.
Contractionary fiscal policy and expansionary monetary policy will lead us to lower interest rates because of lower government spending and increased money supply. In this situation, consumption and production levels go up. The activity of the private sector will increase and the ratio of government spending to private sector spending will fall.
- Monetary policy is a central bank activity aimed at influencing the quantity of money in an economy.
- Fiscal policy refers to changes in the level of government spending and taxes in order to impact the national economy.
- Objective of fiscal policy: influence the level of economic activity, redistribute income, and allocate resources in an economy.
- We divide fiscal policy tools into: spending tools and revenue tools.
- Spending tools include: transfer payments, current government spending, and capital expenditure.
- Revenue tools cover: direct taxes and indirect taxes.
- Expansionary fiscal policy is when government spending increases relative to tax revenues.
- Contractionary fiscal policy is when government spending decreases relative to tax revenues.
- Difficulties in executing fiscal policy include: the recognition lag, the action lag, the impact lag, the crowding-out effect, supply shortages, and multiple targets.
- Government deficit is the difference between government revenues and government spending in a given year, whereas national debt is the sum of all government deficits from the previous years.