In the last section, we saw two ways governments use to control the flow (supply) of money in order to stimulate or slow down the economy through the Central Banks, which re Monetary Policy and Foreign Exchange Reserve control.
Now, we will go over the third level the Government has to manage the economy: Fiscal Policy.
Fiscal Policy refers to government spending and tax actions in order to influence the level of economic activity. It is part of the “demand-side management” of the economy and is probably the most direct way to stimulate or to slow the economy. Decreases in government spending directly reduce the demand for goods and services. Similarly, increases in tax rates immediately affect household incomes and result in decreases in consumption.
Purpose of Fiscal Policy
Governments increase or decrease taxation and spending to accomplish these three objectives:
- Stimulate the economy in a recession.
- Control inflation (maintain it at a stable target, typically around 2%)
- Stabilize economic growth:
- Avoid huge booms
- Bust the economic cycle
Fiscal policy is often used in conjunction with monetary policy. In fact, governments often prefer monetary policy for stabilizing the economy.
Main Types of Fiscal Policy
Governments can take on of two general stances on fiscal policy depending on the state of the economy at the time and on their political views:
Expansionary Fiscal Policy
Also known as “loose”, expansionary fiscal policy involves increased government spending and a reduction on taxes, which is intended to increase consumer spending due to higher incomes.
This measure is taken to stimulate the economy in times of recession and it tends to worsen the government budget deficit (the government will increase its expenses while reducing its revenues from taxes, which can get tricky if it’s not controlled). This normally causes governments to increase borrowing through monetary policy.
Examples of Expansionary Policy
Probably the best examples of expansionary fiscal policy are the Economic Stimulus Act of 2008 and the CARES Act in 2020. In these two cases, the economy suffered severe contractions and the US government stepped in to boost the economy by sending checks directly to US taxpayers in order to bolster consumer spending. In 2008, the total cost was about $152 billion, while in 2020, there was a package for the amount of $2 trillion.
In addition, multiple tax cuts and rebates were put in place for lower to mid-income families and other help programs were put in place.
Contractionary Fiscal Policy
Also known as “tight” or “deflationary”, contractionary fiscal policy involves decreasing spending and increasing taxes in order to control booming economies. This tends to reduce consumer spending and overall economic activity.
This method normally helps government budgets deficit reductions since they are spending less and generating more from taxes.
Example of Contractionary Policy
In the 1990s, the contractionary policy was used in the US by cutting government spending in several key areas, welfare spending was reduced and income taxes were raised for high-income taxpayers.
Criticism of Fiscal Policy
Even though it has proven somewhat effective in the past, fiscal policy is far from a perfect lever of economic control:
- Increasing government spending takes time. It can take several months for decisions to be made and even longer for actions to be taken.
- Some economists believe that increased government spending may be inefficient. Money is wasted by not being allocated to the right projects or the most beneficial activities.
- It can actually increase the cost of borrowing and derail inflation in some circumstances.
Nevertheless, as you can imagine, fiscal policy has huge implications in the performance of all asset classes. Therefore, it is important to keep an eye on it to get a hint of where the economy is going and to position your investments accordingly.
in the next section, we will introduce the idea of market sentiment and we will see how markets react to economic information.