Fiscal and Monetary Policies

Fiscal Policy

What happens when the classical theory of laissez-faire economics doesn’t work?
John Maynard-Keynes called for the need for FISCAL POLICY.

Fiscal Policy: the use by a government of its powers of expenditure, taxation and borrowing to
alter the size of the circular flow of income in the economy so as to increase consumer demand,
employment, and reduce inflation

Keynes advocated for increased government expenditures and lower taxes to stimulate
demand and pull the global economy out of the depression.

Fiscal Stabilization Policy:

Government attempts to affect the circular flow of the economy to increase consumer demand,
raise employment, and control inflation through measures taken on expenditure, taxation and
borrowing.
Discretionary fiscal policy - deliberate actions through legislation to alter government
spending or taxation policies to influence level of spending and employment. There are two
policies:

1. Expansionary fiscal policy - during times of recession, characterized by high

unemployment, and little or no growth in GDP. The government will attempt to increase
aggregate demand through various components of the GDP equation. E.g. tax cut,
increased government spending
2. Contractionary Fiscal Policy - This policy is used during times of high inflation, high
employment and high GDP growth to decrease aggregate demand. E.g. tax hikes,
decreased government spending

Recall the Business Cycle phases:

 Tools of Fiscal Policy
1. Changes in spending
a. normal budgetary programs
b. Infrastructure - underlying economic foundation of goods and services that
allows a society to operate. Creates an outward shift of the production
possibilities curve
2. Changes in Taxation
a. Personal or corporate income taxes
b. Tax exemptions/tax credits
c. Tax incentives
3. Automatic Stabilizers
a. Stabilizers built into the economy, already legislated to automatically increase
or decrease aggregate demand when needed.
b. Progressive tax - based on income levels

Government Budget Options:

1. Deficit budget - government spending is higher than tax revenue → must borrow money
to cover the shortfall

2. Surplus budget - government spending is lower than tax revenue → money is left over

3. Balanced budget - government spending is equal to tax revenue

Monetary Policy

The Origins of Banking and Money Supply:

● Goldsmiths created the earliest form of money and banking
● Trusted with people’s gold and silver for safekeeping in exchange for paper receipts of
their deposits.
● Goldsmiths saw an opportunity to make money by giving loans out from deposited
gold/silver by issuing paper certificates
● Fractional reserve banking - only a fraction of money deposited for safekeeping needed
to be kept on reserve, with the balance lent in the form of paper.
● “run on the banks” - during times of financial crisis

Monetary Policy: A process by which the government affects the economy by influencing the
expansion of money and credit
● Government uses monetary policy to adjust interest rates in order to adjust the supply of
money
● A successful monetary policy will increase/decrease the money supply needed to avoid
periods of inflation or deflation

Role of Interest Rates:

Higher interest rates
Lower interest rates
● Encourage consumers and
businesses to spend less and
encourages saving
● Attracts more foreign investors
increasing the demand for the
Canadian dollar, exchange rate rises
● Increases government spending on
debt interest, less money for social
programs
● Banks look to increase supply so as to
generate interest income
● encourage consumers and
businesses to spend more.as people
are more inclined to borrow
● Deters foreign investors, decreases
the demand for the Canadian dollar,
exchange rates fall
● Decreases government spending on
debt interest, more money for social
programs
 Tools of Monetary Policy
Easy Money → to stimulate economy
- Initiated when inflation falls to 1%
- Decreases short-term interest rates
- Decrease reserve requirements
- Buying bonds
- low interest rates, easy availability of
credit, growth money supply
- Used in recessionary periods to
lessen effects of recession
Tight Money → to stabilize economy
- Initiated when inflation rises above 3%
- Increases short-term interest rates
- Pulls inflation downward
- high interest rates, more difficult
availability of credit, decrease in the
money supply
- Sell bonds
- Increase reserve requirements
- Used in expansionary periods to
restrain an overheated economy and
keep prices from soaring
- **Goal is slow growth, not end it