Fiscal and Monetary Policies: Impact on the Economy
Fiscal Policy as an Economic Stabilizer
In fiscal policy, an automatic stabilizer is a tool that works automatically, with no need for the government to take further steps. It acts when certain circumstances occur, affecting the level of income, employment, or prices. One example is the withholding tax.
- a) To increase the rent, the amount withheld increases and slows the increase of money in public hands, which can slow the increase in demand by withdrawing liquid money. It is automatic and does not require any additional action.
- b) The lower the income, the less the deductions will be paid. If a progressive approach is followed, those who earn more pay more. By deducting withholding, there is more money in the hands of the public, which means that demand does not fall. It’s automatic.
Expansionary Fiscal Policy
Expansionary fiscal policy consists of a reduction in taxes and withholding taxes. By paying less, there is a greater amount of money held by the public, which makes demand increase. With increasing demand, consumer demand increases. With increasing consumption, demand also increases due to increased production, and output increases employment. The only drawback of this policy is that when it reaches a certain level of employment and production, it can raise prices.
Restrictive Fiscal Policy
A restrictive fiscal policy should be performed in times of stress or a booming economy when inflation looms. Supply and production at full employment cannot increase, and there is a price increase. At this stage of the cycle, high retentions are used, so there is a withdrawal of money in public hands and less money for consumption, production, and price pressures.
Public Deficit in the State Budget
When state revenues are lower than the expenditure made by the state through public expenditure allocated in the budget, there is a deficit. The state spends more than it deprives the taxpayers, putting more money into public hands through spending in the various ministries.
- Income – expenditure > 0 (surplus)
- Income – expenditure < 0 (deficit)
- Revenue – expenses = 0 (balanced budget)
Expansionary Monetary Policy
Expansionary monetary policy is based on increasing the amount of money held by the public. There are two ways to do this:
- Interest rate reduction, so people ask for more money from the bank and invest more.
- Reduction of reserve requirements of banks, so they can pay more and therefore put more money in the hands of consumers and investors.
The objectives of an expansionary monetary policy are to increase the amount of money in the hands of the public.
Restrictive Monetary Policy
Restrictive monetary policy involves:
- An increase in interest rates.
- An increase in reserve requirements.
- Reducing public spending, which can lead to a budget surplus.
The overall goal is to slow down demand by decreasing the money in the hands of the public or making money more expensive, reducing demand and production, and easing pressure on prices.
Examples of Automatic Policy
- Existing tax deductions: Unmodified, they act on income. If income increases, more is retained, slowing demand. If income decreases, demand decreases less, and more money is retained to spend.
- Taxes: The income collected increases when income is slowing the expansion process.
Examples of Discretionary Policy
- Monetary policy: Raising interest rates to curb inflation increases the cost of money, diminishing the possibility of inflation.
- Fiscal policy: Tax increases: When taxes are raised, more is collected, and there is less money in the hands of the public.
Money
Money is any generally accepted legal instrument of exchange and payment that serves as a measure of the value of things and can thus hoard wealth. Its functions are as an instrument of payment transactions, a change in the measured value of goods and services, and an instrument that can be treasured as wealth.
Kinds of Money
- Commodity money: Worth what it is embodied in (e.g., a gold doubloon).
- Token money: Worth by convention, based on the economy behind it, and not supported by its intrinsic value.
- Legal money: In circulation in the hands of the public and in deposit accounts.
- Bank money: Created by the banking system to lend part of the deposits received.
Commodity money is worth the goods in which it is materialized, e.g., a silver dollar.
Law of Diminishing Returns
The law of diminishing returns, or variable proportions, is said to arise when, holding constant the technology and all factors of production minus one, as you add increments of a variable factor, the resulting rate of increase in the product will decrease after some extent. The aim is to describe the operation and the site of action of the company or other unit of production through a production function that is purely technical, without the intervention of prices or other economic variables.
Production Function and its Relation
The production function is the relationship between the product obtained and the factors of production employed. It relates the amount of hours worked with the capital.
Production Function in the Real Sector in the Neoclassical Model
It is determined by three equations:
- Production function: Y = F (N, Ko)
- Capital: W = W’ / P = (ΔY / ΔN)
- Number of hours worked: N = n (W)
Theory and Quantitative Variables
Assuming we are at the peak of the economic cycle, i.e., at full employment, according to the quantity theory of money, the neoclassical model lists four variables:
- “M”: The amount of money in circulation.
- “V”: The velocity of movement (the number of times it changes hands).
- “P”: Price.
- “T”: The number of transactions.
It maintains two of these variables constant (V and T). Therefore, increasing the amount of money in circulation increases demand. This causes production not to increase because it is at 100%. Therefore, the price increases (and the product would go to the person who offered more money), and this increase in the final price is inflation, leading to falling demand.
Limit Public Expenditure
This accounts for state intervention, and the neoclassical model wants the state to intervene as little as possible.
Inflation
Inflation is when the value of money is reduced continuously. The consequence is that we need more money to acquire assets, i.e., that the goods are worth more.
Instruments for Measuring Inflation
The CPI is an indicator of the prices of a basket of goods and services; it indicates the amount of expenditure of a normal family. There is also the deflator.
Types of Taxes
- Direct taxes: Paid directly by the taxpayer, are of a personal nature, dictated by circumstances, and are subjective, taking into account personal circumstances, family income, etc. (e.g., Personal Income Tax).
- Indirect taxes: Paid by the taxpayer but through an intermediary named substitute, who collects the tax and finances it. They are said to be real because they tax things, not people (e.g., VAT).
Economic Cycle
The economic cycle can be defined as oscillations that exist within a country’s economic activity, with its moments of expansion and moments of depression or contraction. These oscillations, which exist in economic activity, are not equal, and thus, as a function of time, one can distinguish short-wave cycles, medium-wave cycles, and long-wave cycles.
- Short-wave cycles are completed in a year and are due mainly to seasonal variations that cause increases and decreases.
- Medium-wave cycles are given in time periods between eight and eleven years. They normally affect all economic activity.
- Long-wave cycles are usually included in time periods ranging around 50 years.
Phases of the Economic Cycle
Business cycles have four distinct phases that follow the same order but with very dilute limits, making it difficult to see the exact moment of transition from one moment to another. The four stages are:
- Depression or recession
- Recovery
- Peak or boom
- Crisis or descent