Fiscal and monetary policy are two powerful budgetary policy tools made by the constituted authorities in the government and the Federal Reserve use to steer a country’s economy in the right direction.
Typically, the overarching goal of both monetary and fiscal policy is to create an economic environment with stable and positive growth and low inflation. The goal, crucially, is to steer the underlying economy away from economic booms that may be followed by extended periods of low or negative growth and high unemployment. In such a stable economic environment, households can feel confident in their consumption and saving decisions, while corporations can concentrate on their investment decisions, making regular coupon payments to bondholders and profits for their shareholders.
The rest of this article provides a detailed understanding of fiscal, monetary policy and budgetary policy as well as their types and examples.
What is Budget Policy?
A budget policy outlines the planned expenditures of government programs as well as the expected revenues from tax systems for a given fiscal year. The budget typically includes a list of specific programs (such as health, agriculture, and security) as well as tax sources (income tax, social insurance taxes, company tax etc.).
Thus, a budget can be defined as a financial plan that serves as the foundation for spending decisions and subsequent control. In reality, the budget could be either surplus or deficit.
Types of Budgets
There are three types of budgets:
- Balanced budgets
- Surplus budgets
- Deficit budgets.
1. Balanced budget
A balanced budget is one in which the government’s estimated expenditures are equal to or greater than its estimated receipts or revenue in a given fiscal year. This budget type aims to live or spend within one’s means and is often referred to as an ideal budget by economists. A balanced budget requires the government to spend only what it has budgeted for the year. However, due to economic fluctuations, inflation, and other unprecedented external or internal factors, adhering to a balanced budget can be difficult, if not impossible. This budget is doable in theory, but it is difficult to implement in practice. If properly implemented, a balanced budget ensures economic stability and limits government spending. On the other hand, it may not solve some recurring problems, such as unemployment, and may limit economic growth.
2. Surplus budget
A surplus budget is one in which the government’s projected revenue or receipts exceed the projected expenditure in a given fiscal year. In simpler terms, the government earns more money in a year than it spends on public or other projects, primarily through taxes, import/export duties, fees, and other revenue.
On the surface, a surplus budget makes a country appear prosperous. Because the government has additional financial reserves, it can pay off outstanding debts and reduce its pending loans, interest burden, and debt. However, debt reduction can lead to deflation and affect consumer behavior. Also in a surplus budget scenario, consumers will have less money to spend if the majority of their money is spent on taxes. Less spending can harm businesses and investments, slowing the economy.
3. Deficit budget
A deficit budget is one in which the government’s estimated expenditures exceed the fiscal year’s expected revenue/receipts. A budget deficit occurs when the government spends more money than it receives in revenue. As a result, it may incur additional borrowings and debt. The government may use its surplus reserve or raise tax rates to bridge the fiscal deficit. If the deficit is kept within reasonable limits, a deficit budget can be beneficial to developing countries like India. For example, government spending on public projects in infrastructure, healthcare, pension programs, and other areas is the first indicator of a deficit budget. It can also lower taxes and increase employment during a recession. As the government takes steps to increase employment opportunities, the total demand for goods and services will rise indirectly. This, in turn, can help a slowing economy. However, just as a sustained surplus budget has drawbacks, so does a sustained deficit budget.
Budget Policy Functions
The major functions of budget policy can be divided into three categories:
- Resource allocation
Resource efficiency and attaining economic stability and growth
The allocative function or activity arises from the failure of the market mechanism to adjust the outputs of various goods in accordance with societal preferences in order to maximize per capita real income. The process of dividing total resource use between private and social goods and selecting the mix of social goods is referred to as the allocating function. This is accomplished through fiscal policy. The budget policy ensures that resources are allocated optimally, resulting in the production and determination of public and private goods in the optimal quantity or level. It will also result in the removal of the price mechanism’s flaws.
Budgetary policy influences income distribution in the community. The tax and spending policies are designed to alter the existing distribution in order to reduce economic inequalities. In this way, optimal income distribution is achieved. Budgetary policy can ensure resource distribution as well as the optimal distribution of income and wealth. Such steps can be taken by the government in order to redirect resources to the poor and depressed segments of society. To address inequalities, the government primarily levies high taxes on the income of the wealthy and provides subsidies for basic necessities such as food, housing, education, and health care.
Budgetary policy can also be used to maintain a high level of employment, a reasonable degree of price level stability, an appropriate rate of economic growth, and balance-of-payments stability. The performance of the economy is visible in the stabilization function of budget policy. This function, traces the measures that can be taken to achieve the goals of full employment. This function also ensures that inflation and deflation are under control, and that the GDP growth rate is higher or stable.
What is Fiscal Policy?
Fiscal policy refers to the government’s budgetary policy, which involves the government controlling the economy’s level of spending and tax rates. Governments use fiscal policy as a tool achieve the allocative function of a budget policy and to manage the economy as a whole. Fiscal policy is significant because it influences how much money consumers take home. Households cannot spend as much as they used to due to lower income levels, affecting demand and thus jobs in the broader economy. Government spending is an important component of fiscal policy as well. For example, governments frequently use it to stimulate the economy and create jobs. This is accomplished by borrowing now in the hopes of stimulating the economy and increasing tax revenues later. Monetary policy, which involves the banking system, interest rate management, and money supply in circulation, is frequently used in conjunction with fiscal policy. The primary goals of fiscal policy are to achieve and maintain full employment, to achieve a high rate of economic growth by maintaining GDP growth at a high or stable level, and to keep prices and wages steady.
Types of Fiscal Policy
Fiscal policy is primarily concerned with raising or lowering taxes, as well as increasing or decreasing spending on various projects or areas. However, depending on the signals from the current state of the economy, fiscal policy may be more focused on limiting economic growth (often done to moderate inflation) or attempting to expand economic growth by lowering taxes, encouraging borrowing and spending, or spending on projects to stimulate the economy or increase employment. Fiscal policies that can achieve this include:
1. Fiscal Neutral Policy
A neutral policy, also known as a balanced budget, is the first type of fiscal policy. This is the point at which the government collects enough taxation to cover its expenditures. Governments are restricted in what they spend based on what they bring in under a neutral fiscal policy. In a similar vein, this is what the majority of households do. It is difficult to predict how much tax will be collected from one year to the next with a neutral fiscal policy. As a result, governments frequently forecast tax receipts year after year and plan accordingly.
2. Expansionary Fiscal Policy
Expansionary fiscal policy means that the government spends more than it collects in taxes. This could include lowering taxes, increasing spending, or a combination of the two. As a result, it results in a budget or fiscal deficit.
During recessions, a budget deficit is unavoidable. This is because rising unemployment means lower income from tax receipts, which account for roughly half of government revenue.
Governments want to ensure full employment at the same time. As a result, it must choose between increasing the budget deficit further and attempting to combat the recession. At the same time, governments are being forced to pay higher unemployment and other social security benefits, thereby increasing government spending while lowering tax revenue. Reduced taxes mean more money in consumers’ pockets to spend and stimulate the economy.
At the same time, increased government spending has the potential to boost aggregate demand. It can create many new jobs if it embarks on an investment project. As a result, these employees will have more money to spend, boosting the economy.
3. Contractionary Fiscal Policy
Contractionary fiscal policy is defined as the government collecting more taxes than it is spending. A government might want to do this for a variety of reasons. Its primary purpose is to help control inflation. For example, as governments tax more, consumers have less disposable income. This, in turn, reduces aggregate demand, which may appear to be a bad thing, but it aids in the reduction of inflation. As a result, a contractionary fiscal policy will deprive consumers of money as they place less demand on individual businesses. This then indicates to those businesses that demand is beginning to fall which in turn will make them to reduce the rate of inflation by slowing down price increases.
What Is Monetary Policy?
Monetary policy is a set of tools available to a country’s central bank to promote long-term economic growth by controlling the overall supply of money available to banks, consumers, and businesses. The goal is to keep the economy running at a steady but not too fast pace. The central bank may raise borrowing rates to discourage spending or lower borrowing rates in order to encourage more borrowing and spending. Its primary weapon is the nation’s money. The central bank determines the interest rates at which it lends money to the country’s banks. When the Federal Reserve raises or lowers interest rates, all financial institutions adjust the rates they charge all of their customers, from large corporations borrowing for large projects to home buyers applying for mortgages.
What Goes Into Policy Decisions
Monetary policy is developed using data from a variety of sources. The monetary authority may examine macroeconomic figures such as GDP and inflation, as well as industry and sector-specific growth rates and associated figures. Geopolitical developments are also being closely monitored. Oil embargoes and the imposition (or removal) of trade tariffs are two examples of actions that can have far-reaching consequences.
Concerns from groups representing specific industries and businesses, survey results from private organizations, and input from other government agencies may also be considered by the central bank.
Types of Monetary Policies
Monetary policies are either expansionary or contractionary:
1. Expansionary Monetary Policy
If a country is experiencing high unemployment as a result of a slowdown or recession, the monetary authority can pursue an expansionary policy aimed at boosting economic growth and expanding economic activity. The monetary authority frequently lowers interest rates as part of expansionary policy in order to encourage spending and make saving unappealing.
Increased market money supply aims to boost investment and consumer spending. Lower interest rates allow businesses and individuals to obtain loans on more favorable terms.
Since the 2008 financial crisis, many leading economies worldwide have maintained an expansionary stance, keeping interest rates at or near zero.
2. Contractionary Monetary Policy
A contractionary monetary policy is used to reduce the economy’s money supply. It is possible to achieve this by raising interest rates, selling government bonds, and increasing bank reserve requirements. When the government wants to keep inflation under control, it employs a contractionary policy.
In conclusion, balancing the budget through fiscal or monetary policy, or any combination of the two, would cause hardship for the people. This is the most difficult and contentious issue in public finance. Every government is heavily criticized by social and political organizations for public spending and taxation. In an inflationary environment, fiscal policy seeks to reduce total spending; however, this task is complicated by the wage-rate problem; the reduction in total spending must be accomplished in such a way that the additional pressure placed on wages and thus on prices from the cost side is minimized.
However, it is a mistake to believe that the government must present a balanced budget every year without taking into account the overall state of the economy. When a country is heavily in debt, the government frequently pays off her debts by collecting more taxes. A surplus budget is desirable in such circumstances, but collecting taxes in excess of expenditures to reduce the debt is highly deflationary.
In a full employment and inflationary situation, rational fiscal policy calls for deficits when an expansionary stimulus is desired, and surpluses and debt reduction only when fiscal constraints are required. From the preceding discussion, it is clear that increased employment, increased public welfare, and a balanced budget have no mutual relationship and cannot be achieved simultaneously.