The microscale and macroscale of economies are under the heavy influence of two major entities that can adjust the trajectory and momentum of the economy using various tools.
These two entities are the central bank of any country and of course the government. And the tools implemented to adjust the economy, especially the macro economy, are the policies set by these two entities.
The policies set by the central banks are known as monetary policies. While the policies set by the government are called fiscal policies.
Also Read: Central Bank Policy definition
Such government policies can at times be even more important and effective than monetary policies.
In this article we want to analyze the policies that are set by the government in order to impact the economy and the market.
How Can the Government Impact the Economy?
There are many ways in which the government will be able to exert its influence on the economy. Such different measures can be anything from lobbying for new rules and regulations, raising public awareness and various public programs, subsidies, embargoes, investments, allocation of the budget available, and many other ways.
However, the most important tool for any government to impact the economy in different ways is the use and application of fiscal policies.
What exactly are fiscal policies? What is their influence? And what types of fiscal policy are there?
What Are Fiscal Policies?
Fiscal policies are a collection of policies that might even be quite wide ranging at times, that can impact the economy.
The fundamental and founding notions behind government policies, specifically fiscal policies, have to do with the fact that it is argued recession and inflation, two of the major plagues of the economy, come down to a number of factors.
Such factors can be related to consumer spending, interest rates, money circulation, tax rates and tax brackets, etc. Therefore, through the manipulation of these factors, the outcome will be the manipulation of inflation and recession, among other economic indicators.
So, through these policy settings the manipulation of the economy can take place by the hands of the government. Of course, these adjustments are made to set the course of the economy right. In the following sections, we will see how these adjustments are made, how they are enforced, and what their outcome is.
How Are Fiscal Policies Set by the Government?
As was mentioned earlier in this article, fiscal policies are often contrasted with monetary policies. Of course the former is set by the government and the latter is set by central banks. Both sets of policies are extremely crucial in any economy and we will draw a comparison between them further down.
However, here we want to mention a rather peculiar similarity between them. These sets of policies are set through the tools that are at the disposal of governments or central banks.
They have control over certain areas and mechanisms and by controlling those mechanisms they are able to exert their influence or in other terms, they are able to set and enforce such policies so that they can fully manifest in the economy.
Monetary policies are set by central banks through adjustments in a number of things, namely interest rates, reserve requirements for commercial banks, and of course liquidity or money circulation.
On the other hand, fiscal policies that are set by governments can be said to be the result of adjustments in the amount of government spending or expenditure as well as tax rates or taxation.
Therefore, fiscal policies are set by adjusting government expenditure and also tax rates.
Definition of Corrective Fiscal Policies
In order to define the corrective feature of fiscal policies, let’s draw another similarity between fiscal and monetary policies.
The main objective of all these economic policies, whether fiscal or monetary, is to take corrective action in order to bring back the economy when it goes astray.
So, imagine a straight line where the economy must head down. Now, imagine the steering wheel of economy doesn’t work well at times and so it goes off to the side a little bit. If not stopped and brought back, it could go off by a wide margin in the long run.
This is why any time the economy skews from the straight line, it is brought back by nudges. These nudges are these economic policies set by governments or central banks.
This is why fiscal policies are said to be corrective.
For example, when the private sector is spending too much money and there is way too much optimism, the government needs to correct this course and slow down the speed so it doesn’t get out of hand. Therefore, it can increase taxation and lower government spending.
Furthermore, there are times when the private sector is not doing so hot and consumer spending decreases heavily. At times such as this when things seem bleak, the government needs to offset the pessimism. It does so by lowering taxation and increasing expenditure.
These two varying and opposing courses of action are in fact the two different types of fiscal policies known as expansionary and contractionary.
What Are Expansionary Fiscal Policies?
Expansionary fiscal policies are set at times of economic recession.
Recession is when consumer trust in the economy is low and the general feeling toward the economy is pessimistic.
Therefore, during such times, the government will attempt to expand the economy and stop it from shrinking any further. But how?
Expansionary fiscal policies include tax stimuli. Although, they can go as far as even defining temporary tax brackets. Clearly, the idea behind tax stimuli is that consumers and also businesses can pay less taxes or even be altogether exempt from paying taxes for a certain period of time.
This period of time will give them an opportunity to have more capital for expenditure. This expenditure can boost the economy in many different ways. If the consumers have more chances of spending money, it means the demand will rise.
On the other hand, when businesses have a bit more liquidity around, they can expand their or save their own businesses, which leads to halting layoffs or even new hiring. Therefore, ameliorating the unemployment rates or even adding to the employment.
What Are Contractionary Fiscal Policies?
Of course, the other side of the fiscal policy coin are contractionary policies.
Contractionary fiscal policies are implemented during times of inflation.
When there is more than necessary spending in the private sector and by consumers, inflation might get out of hand. This is where the government enters with contractionary policies in order to slow down this negative process.
Contractionary policies mostly revolve around increasing tax rates and decreasing government spending. Both of these actions will reduce circulation of unnecessary liquidity in the economy.
However, as it seems on the face of it, contractionary policies are not very popular among the general public. But this doesn’t make them any less necessary.
Government policies can have a huge impact on the economy, financial markets, including micro and macro finances.
The economic policies set by the government are known as fiscal policies.
Fiscal policies adjust variables such as tax rates and government spending. Thus being able to directly and indirectly impact the economic conditions, whether recession or inflation.
Fiscal policies set by governments, together with monetary policies that are set by central banks, make up the most important financial policies in any economy.