Fiscal and Monetary Policies: Key Concepts and Definitions

Posted on Dec 12, 2024 in Economy

Keynesian vs. Classical Economics

Keynesians reject the assumption that the economy is free to reach full employment of productive resources. They recommend state intervention through monetary and fiscal policies.

Classical economists rely on the free play of market forces and believe that government intervention should be reduced to a minimum.

Fiscal Policy

Fiscal policy refers to government decisions on the level of public spending and taxes.

Transfers are payments for which those who receive them have not given any good or service in return. Examples include Social Security and unemployment benefits.

Taxes are imposed by the public sector on individuals, households, and businesses. They require a certain amount of money to be paid in relation to specific economic events.

Expansionary Fiscal Policy

Expansionary fiscal policy involves the government increasing public spending and/or reducing taxes. This can significantly influence aggregate demand, shifting it to the right. Consequently, production and employment will increase, potentially leading to higher prices.

Restrictive Fiscal Policy

Restrictive fiscal policy can be used to contract aggregate demand. This involves reducing public spending and/or increasing taxes. Expansionary policy causes a shift in the aggregate demand curve to the right.

Public Sector Budget

The public sector budget is a description of its spending plans and the revenue it must obtain to finance them within a given period. Revenues minus expenses equal the public sector budget.

Government revenues are the funds going to the public sector to meet objectives and cover expenses. Public spending is the set of payment obligations by the public sector as a result of its actions as an economic agent.

Public debt is the total value of bonds or debt securities issued by the state and held by the public.

Flow vs. Stock Variables

A flow variable is one that flows over time. A stock variable is one that measures a quantity at a specific point in time.

Money Supply and Monetary Aggregates

The money supply is the sum of cash in public hands (the amount of money held by individuals and businesses) plus deposits in banks.

Monetary aggregates are variables that quantify the existing money in an economy. Central banks usually define them for analysis and to make monetary policy decisions. The three main monetary aggregates are:

  • M1: Currency in circulation and demand deposits.
  • M2: M1 plus time deposits and savings deposits.
  • M3: M2 plus repurchase agreements, shares in money market funds, money market instruments, and fixed-income securities.

Structural and Cyclical Budgets

Structural budget: Estimated income, expenditure, and deficit. The cyclical budget is the difference between the actual and structural budget.

Discretionary Policy and Automatic Stabilizers

Discretionary policy is one in which the government changes tax rates or spending programs through legislative action. A drawback of discretionary fiscal policy is that an automatic stabilizer is any feature of the economic system that tends to mechanically reduce the strength of recessions and/or expansions of demand.

The eviction or displacement effect occurs when government spending reduces the amount of business investment.

Types of Money

Commodity Money

Commodity money is an asset that has the same value as a commodity and as a currency unit.

For goods to be used as money, they must be:

  • Enduring: People will not accept something that deteriorates quickly.
  • Transportable: If people have to deposit large sums of money, it must have a high value relative to its weight.
  • Divisible: It should be possible to subdivide it into smaller parts without loss of value.
  • Homogeneous: Any unit of the good in question must be equal to the others.
  • Limited supply: If it does not have a limited supply, it has no economic value.

Fiat Money

Fiat money is a commodity that has very little value as a commodity but maintains its value as a medium of exchange.

Full Content Paper Money

Full content paper money were paper certificates that were backed by gold deposits equal to the value of the certificates issued. When an economy uses gold as money, it is said that the economy is driven by a gold standard.

Pay Money

Pay money is a means of exchange used to pay debts of a company or person.

Bank Money

Bank money is a debt from a bank, which must give the depositor an amount of money whenever they request it. It functions as a medium of exchange.

Legal Currency

Legal currency is the token money issued by an institution that monopolizes its issuance and takes the form of coins or bills. Money is made up of legal money (cash = coins + notes) plus cash or bank deposits. Deposits can be:

  • View: Current account with total availability to the holder.
  • Savings: In a savings book and similar to demand deposits.
  • Term: Funds that cannot be withdrawn within a specified period.

Liquidity

The liquidity of an asset is related to the ease and certainty with which it can be converted into cash without loss.

Functions of Money

  • It is a generally accepted medium of exchange throughout the world.
  • It is used as a unit of account.
  • It is a store of value, capable of carrying value over time. It is a way of keeping wealth.