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Instruments to respond to economic imbalances: fiscal and monetary policies 

The final aim of economic policymaking is to intervene in the general imbalance.  To try to achieve this objective, the State’s two main instruments are its fiscal and monetary policies.

Fiscal policy: this is the most relevant State intervention when trying to influence the aggregate demand. It can be defined as the policies employed to balance public income and spending. Public spending is defined by the sum of:

  • The current expenses:  those destined to the remuneration of the personnel working to  service the public sector, the acquisition of goods and services, and current transfers.
  • Public investment: those with which the public sector contributes to gross capital formation in the economy or capital transfer resources to other sectors. 
  • Financial expenses: those destined to meet the interests and the burden of public debt.

Naturally, public expenditures must be financed. Public income can be gathered in three ways: 

  • With the income from the sale of goods and services produced by public companies,
  • Through coercive measures (mainly through taxes), 
  • Raising public debt.

By managing the variations in the two components of the fiscal policy (income and spending), Governments generate changes in economic activity in different ways:

  • Aggregate demand can be expanded by increasing public spending.
  • Personal disposable income can be increased  —and with it, consumption and aggregate demand— by lowering taxes.
  • Investment can be incentivized through tax credits or by reducing the tax pressure on profits.

Monetary policy: this is the set of interventions carried out by the Central Bank of a country to influence the existing amount of money creation and thus contribute to the achievement of the general objectives that have been set. Governments control the monetary policy by determining the key interest rates to stimulate or slow down the deposit money creation of banks and thus the investment and consumption enabled by loans.

The starting point of monetary policy is to influence the amount of money in circulation by making changes in interest rates in the money market: when the money supply increases, the interest rate decreases and vice versa. The interest rate fluctuations influence, on the one hand,  the money creation of the banks (with low interest rates banks have more incentives to give loans) stimulating the real economy by increasing investment or consumption; and on the other hand, rates influence individual behaviour (as low interest rates discourage saving already existing deposit money) also with the purpose of impacting the real economy once more by stimulating consumption. 

In both ways (directly influencing consumption, saving and investment, or facilitating credit), changes in interest rates can affect aggregate demand and, consequently, the level of production and income and employment. However, the fiscal policy is considered to be the most direct option as it intervenes directly in the real economy while monetary policy intervenes initially in the money market and only afterwards in the real economy, resulting in a less direct and therefore less effective impact on the economy. Furthermore, monetary policy is considered as a less direct instrument since the intention to stimulate  the economy by lowering the interest rate in order to stimulate the private sector to ask their banks for loans (that would – for sure – be used for investment and consumption), leaves the decision on the somewhat recalcitrant private sector. For companies and households the interest rate is only one factor among others which determines spending choices – and not even the most important one. 

The fiscal policy in contrast is directly creating new money to be spent into the economy. It’s transferred directly from the government to the bank accounts of the private sector, ready to create demand. No other decisions are needed from the private sector. And above all, it works when the key interest rate is no longer able to help the situation (for example when they can’t be lower than zero) and the whole private sector acts pro-cyclical.

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