Understanding Money, Fiscal Policy, and Taxation in the Economy
Understanding Money, Fiscal Policy, and Taxation
Money Aggregates
Money aggregates are variables that quantify the existing money in an economy. They are used by governments and central banks for making decisions and performing economic analysis. Here’s a breakdown:
- M1 (Narrow Money): Includes currency in circulation (banknotes and coins) and overnight deposits. It’s the sum of these two components.
- M2 (Intermediate Money): Encompasses M1, deposits with an agreed maturity of up to two years, and deposits redeemable at notice of up to three months. These deposits can be converted into components of narrow money.
- M3 (Broad Money): Consists of M2 and marketable instruments issued by the Monetary Financial Institutions (MFI) sector.
Functions of Money
Money serves several crucial functions in an economy:
- Medium of Exchange: Used for buying and selling goods and services or paying off debts.
- Store of Value: Money received today can be used in the future, making it a financial asset.
- Standard of Value: Money measures the worth of goods and services.
Money Demand
Two primary variables influence money demand:
- Real Income: Higher household income leads to a greater demand for money.
- Opportunity Cost (O.C.) of Money: If interest rates rise while other variables remain constant, money demand decreases as the opportunity cost increases.
Government Spending
Government spending is a fiscal policy tool that can influence real GDP. It includes social security and welfare. It can be categorized as:
- Current Expenditures: Recurring spending on goods and services that are used up quickly.
- Capital Expenditures: Spending on assets that will last a long time.
- Transfer Payments: Money transferred by the government based on need.
Taxation
Taxation is a fiscal policy tool that affects average consumer income. It aims to achieve different types of equity:
- Horizontal Equity: Individuals with similar incomes and the ability to pay should pay the same amount of tax.
- Vertical Equity: Individuals with higher incomes should pay more taxes than those with lower incomes because they have a greater ability to pay.
Types of Fiscal Policy
- Expansionary Fiscal Policy: Boosts aggregate demand (shifting the AD curve to the right) by increasing government spending and lowering taxes. This can lead to increased economic growth and reduced unemployment but may also increase inflation.
- Deflationary Fiscal Policy: Reduces aggregate demand by decreasing government spending or increasing taxes. This can reduce economic growth and increase unemployment but may also lower price levels and improve the current account of the balance of payments.
Types of Taxes
- Income Tax (IRPF): A progressive tax levied on an individual’s income from work, capital, or other sources (e.g., rents, publications).
- Business Tax (IS): Paid by companies on their profits. The amount paid is proportional to the profit earned.
- Value Added Tax (VAT/IVA): Paid in most economic transactions, both between companies and between companies and individuals. The payable amount is a percentage of the value of the goods or services purchased.
Other Key Concepts
- Opportunity Cost (O.C.) of Money: The interest forgone by holding money instead of other assets or investments.
- Barter: The act of exchanging one good or service for another.
- Eurozone: Member countries of the European Union that use the euro as their common currency.
- Minimum Reserves: The amount banks are obligated to hold to meet client withdrawals and comply with security measures (cash in banks, funds deposited in the central bank).