Fiscal Policy

What is Fiscal Policy?

Fiscal policy is when a government tries to steer the economy in a desired direction by using tools such as taxation or adjusting government expenditure.

When a government tries to speed up the economy it resorts to Expansionary Fiscal Policy & when it wants to slow down an overheating economy it resorts to Contractionary Fiscal Policy.

Expansionary Fiscal Policy

Here, the government tries to expand the economy by cutting taxes so citizens have more money to spend. The government could also choose to subsidize the cost of essential commodities, or even increase the amount of money spent on basic infrastructure.

Contractionary Fiscal Policy

Here, the government develops policy meant to rein in an overheating economy by increasing taxes, removing subsidies, cutting down on government spending, selling bonds, etc. it is basically the opposite of expansionary fiscal policy.

Contractionary fiscal policy is usually employed by the government to fight inflation & lower it.

What is the Difference Between Fiscal & Monetary Policy?

Fiscal policy is the responsibility of the executive & legislative arms of government while monetary policy is the responsibility of central banks. Fiscal policy often gives rise to monetary policy.

An Example of Fiscal Policy & How It Affects Currencies

In 1979 Europe was preparing to adopt a common currency called the Euro. They developed something called an Exchange Rate Mechanism (ERM) which pegged all European currencies to the German Deutsche Mark (DEM).

Initially Britain did not join the ERM but in 1990 Britain’s government led by Margaret Thatcher introduced fiscal policy to allow Britain become a part of the ERM. This policy would have dire consequences for the British Pound.

Now, Britain’s plan when joining the ERM was that the pound will always exchange above 2.70 DEM to 1 pound, meaning the DEM should never be 2.70 times stronger than the pound. However, this proved impossible to sustain because inflation in Britain was higher than that of Germany etc.

To ensure the Pound DEM exchange rate didn’t fall below 2.70, The Bank of England had to increase interest rates to above 12%, to strengthen the Pound (this is an example of monetary policy).

However, speculators started circling the Pound & they argued that such high interest rates would only slow down the British economy & were a short term fix to a long term problem. Speculators believed that Britain was on a wild goose chase & would eventually realize this, devalue the Pound, and leave the ERM.

These speculators led by George Soros a hedge fund owner, began to short the pound to the tune of around 10 billion Pounds. Soros shorted the Pound by using borrowed Pounds to buy foreign currencies, thus causing a multiplier effect as other short sellers followed suit. This short selling began to weaken the pound.

Britain responded to the weakening Pound by further hiking interest rates to 15% so as to woo foreign investors but the Pound still weakened 25% to the dollar causing Britain to exit the ERM & devalue the pound.

Key Takeaways