What is Fiscal Policy?

A nation's fiscal policy is the collection of economic instruments that the government uses to maintain economic stability and accomplish macroeconomic objectives. Tax rates and public spending are regulated under this policy in order to stimulate the economy and encourage growth.

The main tools of fiscal policy are tax policies and public expenditures. To encourage economic growth, the government might reduce tax rates and increase public spending. These expansionary measures stimulate consumption and investment, driving economic recovery.

However, the government may also choose to raise taxes or reduce public spending to keep the budget deficit under control. These contractionary fiscal policies are used to manage inflation and ensure budget balance.

Who Handles Fiscal Policy?

Fiscal policy is typically shaped and executed by the Ministry of Finance, the Treasury, and other related government institutions responsible for economic management. However, all branches of the government, particularly the legislative branch (parliament or assembly), are responsible for the formation and implementation of fiscal policy.

The primary authority for determining fiscal policies in a country is the executive branch, represented by the government. The government aims to achieve its economic objectives by setting public spending levels and tax rates. The Ministry of Finance is the main institution responsible for designing and implementing these policies. It prepares the national budget, tracks the balance between revenues and expenditures, and develops appropriate policies based on economic indicators.

If we take the United States as an example, fiscal policy is managed by Congress and the President. In the U.S., the Department of the Treasury is responsible for preparing the federal budget. However, for the budget and tax policies to become law, Congressional approval is required. 

The House of Representatives and the Senate thoroughly review the budget proposal submitted by the President and either approve or reject it. Additionally, Congress determines tax rates and makes final decisions on public spending.

In the United States, fiscal policy decisions are often made to control inflation, lower unemployment, and encourage economic growth. For example, the U.S. government adopted expansionary fiscal policies to increase public expenditure in order to improve the economy during the global financial crisis of 2008. For the sake of economic activity, a number of stimulus plans and tax breaks were implemented during this time.

Fiscal Policy Types

Fiscal policy can be categorized based on its approach to managing the economy, each serving specific objectives and addressing different economic conditions.

Expansionary Fiscal Policy

Expansionary fiscal policy is implemented during periods of economic slowdown or recession. Under this policy, the government aims to stimulate consumption and investment by increasing public spending and reducing tax rates. Such policies can revitalize the economy by boosting growth rates and reducing unemployment.

For example, a government investing more in infrastructure projects or lowering individual income taxes is an example of expansionary fiscal policy.

The advantage of expansionary fiscal policies is that they accelerate economic activities. However, these policies can also lead to increased budget deficits and rising inflation. Therefore, expansionary fiscal policies need to be applied carefully and in a balanced manner.

Contractionary Fiscal Policy

When the economy is overheated and inflation heightens, contractionary fiscal policy is implemented. The government raises tax rates and decreases public spending with this program. Reducing demand and maintaining price stability are the objectives. Such measures are essential for keeping the budget balanced and avoiding economic overheating.

Contractionary fiscal policy involves measures such as increasing indirect taxes or reducing social expenditures. While these policies help lower public debt and control inflation, they may also lead to higher unemployment and slower economic growth.

What are The Goals of Fiscal Policy?

• Governments use fiscal policy by increasing public spending and lowering tax rates, encouraging investment and consumption to drive long-term growth.
• Expansionary fiscal policies create new job opportunities, helping to lower unemployment and raise employment levels.
• Contractionary fiscal policies aim to manage inflation and maintain price stability, reducing economic uncertainty and cultivating a favorable investment environment.
• Through tax policies and social spending, fiscal policy helps reduce income inequality and achieve a more equitable income distribution.
• Fiscal policy generates resources to fund essential public services such as education, healthcare, and infrastructure, improving citizens' quality of life and supporting economic development.
• Another key goal is to control budget deficits by balancing revenues and expenditures, ensuring a sustainable fiscal framework.

What are the Tools of Fiscal Policy?

Fiscal policy tools cover various areas such as public expenditures, taxation, and borrowing policies. Governments use these tools to implement either expansionary or contractionary policies depending on economic conditions.

Below are the main tools of fiscal policy:

• Public Expenditures: Government spending on infrastructure projects, education, healthcare, and security services can boost economic growth and employment. Public expenditures are often used as a tool of expansionary fiscal policy during periods of economic slowdown.
• Taxation: Adjusting tax rates directly influences consumption, investment, and savings. Lower taxes encourage spending and investment, while higher taxes raise government revenue and help maintain fiscal balance.
• Borrowing Policies: Public borrowing is used to finance government activities, especially during economic crises. Borrowed funds enable increased public spending to support recovery and growth.
• Incentives and Subsidies: Governments provide incentives and subsidies to encourage specific sectors or projects. These policies can accelerate economic growth and increase investments in targeted industries.
• Transfer Payments: Social assistance and support payments to individuals or businesses help reduce income inequality, improve distribution, and maintain economic stability by supporting those in need.

How Does Fiscal Policy Affect Traders?

Fiscal policy is an important economic tool that directly and indirectly impacts financial markets, shaping traders' strategies. Changes in tax rates, public spending, and government borrowing influence market liquidity levels, traders’ risk appetite, and the values of different asset classes.

For example, expansionary fiscal policies can create more liquidity in the market by increasing public spending and lowering taxes. This can lead to upward movements in stock markets and higher return potentials. Traders may take advantage of such periods by shifting towards riskier assets to maximize their gains. Expansionary fiscal policies also reduce borrowing costs, enabling companies to invest more and improve profitability, which, in turn, can boost stock prices.

Contractionary fiscal policies are generally implemented to control inflation and maintain budget balance by reducing public spending and increasing taxes. These policies lower market liquidity levels, prompting traders to adopt a more cautious approach. In particular, rising interest rates can increase returns in the bond market and drive demand for safer assets. In such cases, traders may prefer to move towards lower-risk investments.

Fiscal policy decisions can have indirect effects on exchange rates. Expansionary fiscal policies, in particular, can weaken the local currency. Increased public spending and tax cuts lead to a higher money supply in the market, which may cause the local currency to depreciate.

Contractionary fiscal policies, on the other hand, can strengthen the local currency by reducing public spending and increasing taxes. By decreasing the government's borrowing needs, these policies can attract foreign capital inflows, leading to an appreciation of the currency. In this case, Forex traders may take long positions on the local currency to capitalize on potential gains.

Fiscal policy also significantly impacts commodity prices. Expansionary fiscal policies, through increased public spending and tax reductions, can boost economic growth and increase demand for commodities. Public spending on infrastructure projects, for example, can drive up the prices of oil, steel, and other industrial commodities.

Conversely, contractionary fiscal policies can lower commodity prices. Reductions in public spending and higher tax rates can slow economic growth, reducing the demand for commodities.

Fiscal Policy vs Monetary Policy

Fiscal policy is implemented by the government through tax rates and public spending, while monetary policy is used by central banks to regulate the money supply and interest rates. Although both policies share common goals, such as promoting economic growth, controlling inflation, and increasing employment, they differ in their methods and impacts:

• Fiscal policy is implemented by the government and the Ministry of Finance, whereas monetary policy is managed by the central bank.
• The tools of fiscal policy include tax rates, public spending, and borrowing policies. The tools of monetary policy include interest rates, open market operations, and reserve requirements.
• Fiscal policy focuses on supporting economic growth, financing public services, and balancing income distribution. Monetary policy aims to control inflation, ensure price stability, and maintain financial stability.
• Fiscal policy requires the approval of the legislative body and generally has more long-term effects. Monetary policy can be implemented more quickly by the central bank and typically has short-term impacts.
• Fiscal policy directly affects demand through public spending and tax rates, while monetary policy influences financial markets and liquidity through interest rates and credit conditions.

FAQ

How Do Exchange Rates Get Affected by Fiscal Policy?

Fiscal policy decisions can indirectly impact exchange rates. Expansionary fiscal policies, such as increased public spending or tax cuts by the government, may accelerate economic growth and strengthen the local currency. Additionally, increased public spending can lead to higher inflation, prompting the central bank to raise interest rates. Higher interest rates attract foreign traders, leading to an inflow of foreign currency and appreciation of the local currency. However, risks such as high budget deficits and increasing public debt can put pressure on the local currency, causing it to depreciate.

What Opportunities Do Fiscal Stimulus Packages Offer for Traders?

Fiscal stimulus packages involve increased public spending or tax cuts implemented by the government to stimulate the economy. These packages can positively impact stock markets by boosting consumption and investment. For instance, increased public spending on infrastructure projects or social assistance payments can enhance revenues for certain companies and drive up their stock prices. Furthermore, stimulus packages that increase consumer spending can create growth opportunities in sectors such as retail, construction, and manufacturing.

What Market Opportunities Arise During Fiscal Tightening Periods?

Fiscal tightening refers to the government's efforts to reduce budget deficits by cutting public spending or raising tax rates. These policies typically slow down economic growth and reduce demand. However, during such periods, demand for safer assets, such as government bonds, may increase. Fiscal tightening can also impact exchange rates. Reducing the government’s borrowing needs may positively affect the local currency. However, if fiscal tightening leads to an economic slowdown, traders may shift away from riskier assets and move towards safe havens.

Which Financial Asset Classes Are Affected by Rising Public Debt?

Rising public debt generally leads to an increase in a country's risk premium and higher bond yields. As a result, government bonds may lose value. Additionally, increasing public debt raises the likelihood of future tax hikes or spending cuts, creating uncertainty in the stock market. In the forex market, rising public debt can cause the local currency to depreciate, especially if the debt levels pose a risk to sustainability. However, some traders may seek short-term opportunities in such scenarios by taking risky positions to profit from rising public debt.