Fiscal policy, or financial policy, is the method by which governments adjust their levels of spending and taxation to directly influence the economy. Fiscal policy goes hand in hand with monetary policy (how central banks influence money supply) to achieve various economic goals.
The financial policy gained popularity during the 1930s after it had been advocated by British economist John Maynard Keynes. He suggested that whenever a nation is in recession, putting more money in the hands of consumers could lead to economic growth. This could be done by reducing taxes or increasing government spending.
Various Fiscal Policies
The following are the three basic financial policies: neutral, expansionary, and contractionary.
Neutral – Government spending is roughly equal to its revenue.
Expansionary – Government spending is higher than its revenue.
Contractionary – Government spending is lower than its revenue.
Effects of Fiscal Policies on Exchange Rates
The effect of fiscal policy on the currency is highly dependent on the economic situation. Since each country is unique and the economic environment is constantly changing, it is very hard to tell exactly how fiscal policy will affect exchange rates.
Let’s say a government has a budget deficit due to an expansionary fiscal policy. To finance the deficit, the government can work with the central bank to print fresh currency (also known as quantitative easing).
The newly printed money can be used by the government in their economic development projects. The increase in money supply can end up being inflationary and lead to the weakening in the value of the domestic currency to foreign currencies.
Fiscal Policy vs. Monetary Policy
The government handles fiscal policy. It means using taxes and how much the government spends to boost or slow down the economy.
The U.S. Federal Reserve Board manages monetary policy. This is about controlling the amount of money available in the country. The goal is to keep employment high, prices stable, and interest rates reasonable, as instructed by Congress.
The Federal Reserve uses different tools to control the amount of money in circulation and how much people spend and borrow:
- Buying or selling securities on the open market
- Lending money to banks through its discount window
- Setting the discount rate
- Setting the federal funds rate
- Deciding how much money banks must keep in reserve
- Swapping money with other central banks
- Using overnight agreements for repurchasing assets.
In the United States, fiscal policy is managed by the government. The President and the Secretary of the Treasury in the executive branch play big roles in making money decisions. Sometimes, the President also gets advice from a group called the Council of Economic Advisers.
In the legislative branch, which is Congress, they make decisions about taxes and spending money. Congress has two parts: the House of Representatives and the Senate. They work together to discuss and approve fiscal policies.
Governments use fiscal policy tools to affect the economy. These tools mainly involve changing taxes and government spending. When they want to boost growth, they lower taxes and spend more money. Sometimes, they have to borrow money by selling government bonds to do this. When the economy gets too hot, they may raise taxes and cut spending to slow things down.
Sometimes, changes in how the government handles money don’t impact everyone the same way. It depends on what the people making the decisions want to achieve. For instance, if there’s a tax reduction, it might only help the middle class, which is often the largest group of earners. But if the economy is struggling and taxes are going up, the middle class might end up paying more than the wealthy.
Likewise, when the government decides to spend money differently, it affects different groups. For example, if they choose to build a new bridge, it creates jobs and more income for lots of construction workers. But if they decide to invest in a new space shuttle, it only benefits a small group of experts and companies. This wouldn’t do much to improve overall job opportunities.
Deciding how much the government should be involved in the economy and people’s money matters is a big challenge for policymakers. Throughout the history of the United States, the government has been involved in different ways. Generally, people agree that some level of government involvement is needed to keep the economy strong and to support the financial health of the population.
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