Revision Sheet

Monetary &

Fiscal Policy
Economic & Social Issues
Revision Notes

for RBI Grade B Exam

Monetary Policy & Fiscal Policy ESI Revision Sheets

RBI GRADE B REVISION SHEETS

ESI SECTION
MONETARY POLICY & FISCAL POLICY

Monetary Policy vs. Fiscal Policy: An Overview

Fiscal Policy
There are two basic components of fiscal policy:
Government spending and tax rates. Fiscal policy varies in response to changing
economic indicators. In general, an expansionary approach is used when the economy
slows down or enters a recession and unemployment rises. Under these conditions,
policymakers try to stimulate economic activity by increasing spending, cutting taxes or
by doing both. These strategies put more money into the hands of consumers and
businesses.
Government Spending As Fiscal Policy
One of the tools used in fiscal policy is spending that is designed to stimulate the
economy. This is often accomplished through public funding of useful projects such as
improvements in infrastructure.
Tax Cuts as Fiscal Policy
Generally speaking, the aim of most government fiscal policies is to target the total level
of spending, the total composition of spending, or both in an economy. The two most
Monetary Policy & Fiscal Policy ESI Revision Sheets

widely used means of affecting fiscal policy are changes in government spending
policies or in government tax policies.
• If a government believes there is not enough business activity in an economy, it
can increase the amount of money it spends, often referred to as stimulus
spending. This is referred to as deficit spending.
• When a government spends money or changes tax policy, it must choose where
to spend or what to tax. In doing so, government fiscal policy can target specific
communities, industries, investments, or commodities to either favor or
discourage production—sometimes, its actions are based on considerations that
are not entirely economic.

Fiscal Policy Advantages

• Unemployment Reduction – When unemployment is high, the government can
employ an expansionary fiscal policy. This involves increasing spending or
purchases and lowering taxes.
• Budget Deficit Reduction - A country has a budget deficit when its expenditures
exceeds revenue. Since the economic effects of this deficit include increased
public debt, the country can pursue contraction in its fiscal policy. It will,
therefore, reduce public spending and increase tax rates to raise more revenue
and ultimately lower the budget deficit.
• Economic Growth Increase - The various fiscal measures a country employs
facilitate expansion of the national economy. For example, when the
government reduces tax rates, businesses and individuals will have a greater
incentive to invest and steer the economy forward.
Monetary Policy & Fiscal Policy ESI Revision Sheets

Fiscal Policy Disadvantages

• Conflict of Objectives -- When the government uses a mix of expansionary and
contractionary fiscal policy, a conflict of objectives can occur. If the national
government wants to raise more money to increase its spending and stimulate
economic growth, it can issue bonds to the public.
• Inflexibility - There are usually delays in the implementation of fiscal policy,
because some proposed measures may have to go through legislative processes.
A good demonstration of implementation delays is illustrated by the Great
Recession. Even when the government increases its spending, it takes some time
before the money trickles down to people's pockets.

Negative Consequences of Expansionary Fiscal Policy

When a country's economy is struggling, its government may attempt to stimulate
economic growth through expansionary fiscal policy. This is done by lowering tax rates
and by increasing government spending. A government should consider a fiscal
expansion only after reviewing the negative consequences of this policy. These issues
include increased debt, the crowding out of private investment, and the possibility of
an ineffective recovery.
Recognition Lag
It takes time for a government to realize its economy is having problems. A recession
is not officially recognized until there have been at least two quarters of consecutive
negative growth. It also can take the government a considerable amount of time to
create, discuss and enact an expansionary fiscal policy. The problem of recognition lag
is that by the time a government recognizes and acts on a recession, the recession has
already self-corrected. The fiscal expansion then may overheat the economy and set
the nation up for another market crash.
Crowding Out
The theory of crowding out states that expansionary fiscal policy could lead to
reduced investment in the private sector. Investors prefer government debt over
corporate debt because it is considered safer. Government debt usually pays a lower
interest rate than corporate debt.
Rational Expectations
Expansionary fiscal policy is used to provide a temporary boost to a lagging economy
to increase consumption and investment to pre-recession levels. This fiscal expansion
is often financed through borrowed funds that will need to be paid back. The theory of
rational expectations states that consumers and businesses will realize that at some
Monetary Policy & Fiscal Policy ESI Revision Sheets

future date the government will raise taxes to repay the fiscal expansion's borrowed
funds. The private sector will increase its savings level to prepare for a future tax
increase. This will prevent the economy from growing and make the fiscal expansion
useless.
Increased Deficit Levels
An expansionary fiscal policy financed by debt is designed to be temporary. Once a
country's economy recovers, its government should increase taxes and reduce
spending to pay off the expansion. This can be difficult to accomplish. Consumers may
become accustomed to lower tax rates and higher government spending and vote
against changing either. A risk of a temporary fiscal expansion is it becomes
permanent due to political pressure. This higher level of spending could lead to a
worsening deficit and a long-term debt issue.

Monetary Policy
Monetary policy refers to the actions taken by a country's central bank to achieve its
macroeconomic policy objectives.

Advantages of Monetary Policy

• It is a way to effectively control inflation in the economy.
• It is a policy that is fairly easy to implement.
• It provides multiple tools to use so that the goals of monetary policy are
achievable.
• It comes from a position of political neutrality.
• It can boost the export levels for the national economy.
• It offers a way to promote transparency in the economic system.
• It offers financial independence from government policies.

Disadvantages of Monetary Policy

• It comes with the risk of hyperinflation.
• It takes time for the changes in monetary policy to occur. (Monetary
transmission lag)
• It comes with some specific technical limitations.
• It can boost the import levels for the national economy.
• It can impact the national economy with one decision.
• It cannot guarantee economic growth.

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