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Fiscal Policy & Monetary Policy | Here’s Why They Affect Markets
A country’s government can influence markets via fiscal policy and monetary policy.
What’s the difference?
Fiscal policy is the use of government spending and taxation to influence macroeconomic indicators.
Monetary policy is the use of interest rate, money supply and exchange rates to influence macroeconomic indicators.
Most economists think the economy works best when left alone; however, there are many instances when this is not true and government intervention becomes mandatory. Take, for example, the discovery of novel coronavirus in 2020, which as led to the destructive COVID-19 disease pandemic. Anybody can see that government intervention than no intervention in a case like this.
However, a more day-to-day example is taxation. Taxes may seem annoying to most individuals, but how would roads be built if we didn’t pay taxes? Private roads exist, but have you seen the state most private roads are kept in? With a private roan, joint owners have the incentive to free ride, as they’d prefer if the other owners of the road paid for maintenance and repairs.
Mandatory government tax solves this problem, as the government now takes responsibility for maintenance, repair and building of new roads.
Another example is markets where there seems to be no competition. Natural monopolies often occur when the cost to enter a market is too high and the reward too relatively low. Established firms have the monopoly position, and very few would dare enter the market for fear of failure. Take, for example, the national postal service. The cost of opening up a national post service would be huge; post boxes would have to be installed in all towns and a delivery network would have to be thoroughly organised. This would cost billions in start-up costs.
Because of this lack of competition, the government can act within the markets to ensure that there are competitive practices being followed, for the benefit of society as a whole.
There are 2 primary ways in which a government affects the market.
1. Fiscal Policy – governments can adjust their spending, and adjust taxation. Expansionary fiscal policy is when the government spends more and/or taxes less. An example would be the building of a new highway.
2. Monetary Policy – the government can directly influence the amount of currency in circulation or adjust the interest rate on the loans banks receive from the central bank. However, in some countries (like the UK), the central bank is a separate entity to the government and has its own objectives.
If interest rates are lowered, then the cost of borrowing across the country goes down. This means loans are cheaper and saving is discouraged. Businesses are more likely to borrow money to invest into their companies or even start new companies. Consumers are also more likely to borrow to spend. This affects the market positively as it encourages more aggregate demand, and therefore GDP.
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