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Government actions have a significant impact on economies because they are usually the largest employers and largest borrowers in world debt markets. Governments (and central banks) make voluntary changes in spending, taxes, borrowing, etc. to dampen short-term fluctuations resulting from booms and busts, and encourage stable growth and stable and low inflation.
The monetary policy represents the actions of central banks aimed at influencing the quantity of money and credit in the economy.
In understanding how monetary policy works, it is important to understand the role of money and credit creation in an economy. In a barter economy, goods and services can be purchased with other goods and services, but this is not convenient because it requires a double coincidence of wants, many goods are indivisible and perishable and there is more than one price for a particular good.
Fiscal policy involves the use of government spending and taxes to affect the level of aggregate demand in an economy, distribution of income and wealth, and allocation of resources within an economy. It often focuses on changes in government spending and taxes instead of their absolute level.
Fiscal policy is important because taxes and government spending makes a very large portion of a country’s GDP. For example, governments can increase spending to provide stimulus to an economy in what is called an expansionary fiscal policy. During the boom, governments can adopt a contractionary fiscal policy by reducing their spending and/or raise taxes. Any excess (shortage) of government spending over revenues is called budget deficit (surplus).
$$ Budget\ Deficit\ (Surplus) = G – T + B $$
Where G is government spending, T refers to taxes and B stands for transfer payments.
Change in the budget deficit or surplus tells us whether the fiscal policy is getting tighter or looser. There is a certain involuntary change in budget deficit/surplus arising from cyclical movements. For example, during recessions, social insurance and unemployment benefits increase which increases aggregate demand. Hence, changes in unemployment benefits is an automatic stabilizer. Change in budget deficit/surplus in addition to automatic stabilization is called discretionary fiscal policy.
These notes are intended to help you prepare LOS 16a of Level 1 of the CFA program.
by Obaidullah Jan, ACA, CFA on Sat Feb 08 2020
This article can help you prepare for Reading 16 LOSa.