Fiscal and monetary policies

Fiscal and monetary policies are the main tools governments use to manage the economy across different stages of the trade cycle.

Fiscal policies

Definitions

Fiscal policy

Government policy that uses taxation and government spending to influence the level of economic activity in an economy.

Fiscal policy is mainly carried out through:

• Government spending
• Taxation

Government spending

Let’s focus first on government spending, as it plays a key role in influencing aggregate demand and managing economic activity across the trade cycle.

Budget surplus

A budget surplus is most likely to occur during a boom. In this phase, aggregate demand is high relative to aggregate supply, and employment and incomes tend to rise.

In this situation, the government may aim to reduce inflationary pressure by lowering demand. At the same time, higher incomes typically lead to increased tax receipts. If government revenue exceeds government spending, the result is a budget surplus.

Budget deficit

A budget deficit is more common during a recession, trough, or early recovery, when the government aims to stimulate economic activity.

To achieve this, the government may:

• Borrow money (incur debt) to fund spending in the domestic economy
• Increase spending on support such as employment benefits (for example, grants)
• Reduce taxes so households have more disposable income to spend

These actions are intended to increase aggregate demand.

Taxation

Definitions

Taxation

The process by which a government collects revenue from individuals and businesses, mainly through direct and indirect taxes.

Taxation is a key tool of fiscal policy, influencing disposable income and, in turn, affecting the level of aggregate demand in the economy.

Changes in tax rates can be used to:

By adjusting tax rates, governments can influence economic activity and achieve key objectives within the economy.

1. Change spending patterns of consumers:
   The government may lower taxes on certain products or in certain industries to encourage demand, which promotes spending, and it can increase taxes in certain industries to discourage spending in that sector. Industries like food often have lower tax rates, making them more affordable in almost every country (even a child can afford to buy a chocolate), while industries like alcohol may face higher taxes to discourage excessive consumption that could be harmful.

2. Generate government revenue:
   Taxation can be used as a source of finance. In the boom phase of an economy, the government may aim to achieve two objectives at once: reducing demand through higher taxes while also increasing revenue. This additional income can be used to fund public services or repay national debt. However, to successfully raise revenue, taxes are often applied to inelastic goods, which are less responsive to changes in price.

3. Change the distribution of wealth:
   Changes in taxation can affect income distribution. An increase in direct taxes reduces the income of higher earners, while an increase in indirect taxes tends to have a greater impact on those with lower incomes.

Types of tax rates

Proportional tax: The proportion of tax remains constant as income rises.
For example, 20% of income is payable regardless of how much a householder earns.

Progressive tax: The tax rate increases as income rises.

Example: in South Africa some salaries are not taxed if they fall below the threshold. As income increases, higher portions are taxed at higher rates (e.g., $6,000 = 0%, $6,000$–$15,000$ at $15\%$, $15,000$–$25,000$ at $20\%$).

Regressive tax: The proportion of income paid in tax decreases as income rises.

Monetary policy

Definitions

Monetary policy

Actions taken by a central bank to control the money supply and interest rates in order to achieve economic objectives such as stable inflation and economic growth.

Monetary policy is implemented through two main tools:

• Money supply
• Interest rates

We will begin by examining the role of the money supply.

Money supply

Definitions

Money supply

The total amount of money circulating in an economy, including cash and electronic money.

Money supply refers to how much money is available in the economy. Because money is used to buy goods and services, changes in the money supply can affect spending, prices, and overall economic activity.

You might wonder why a government cannot simply create large amounts of money so that everyone becomes richer. The key issue is that money must retain its value to be useful. If too much money is created, prices can rise rapidly, and money can lose its purchasing power.

Real-world example:

Zimbabwe experienced very high inflation, where extremely large amounts of Zimbabwean dollars were needed to buy basic items like bread. When money loses value like this, people may stop trusting it, and the country may end up relying on other currencies.

Sidenote

Remember this!

This is why managing money supply is a major responsibility of government and central banks.

Money supply can be managed by the following:

• Increasing and decreasing interest rates which either increase or decrease the demand for money in the economy.
• Printing notes and coins to increase the circulation of money in the economy
• Buying or selling the government bonds e.g. when a government sells its bonds the market will buy them and the government will get the money, which means it is taking money out from the market, that’s decreasing money supply, and when the government buy back its bonds its releasing money into the market there by increasing the circulation of money in the economy.
• Buying and selling government reserves e.g. when the government sells reserves it means the foreign nations have to pay in the local currency, that’s increasing money in the country, but if the government buy reserves, it means it is selling the local currency to buy foreign currency which reduces the money at hand in the country.

Interest rates

Definitions

Interest rates

The cost of borrowing money or the return earned on savings, usually expressed as a percentage.

Interest rates are another major tool of monetary policy.

What are the effects of the changes in interest rates on the economy?

1. Increase or decrease in borrowings and savings:
   If interest rates are raised then borrowings will be more expensive meaning that consumers will borrow less, thereby decreasing demand which decrease revenues and profits for firms, but on the other hand, when interest rises consumers will save more due to high interest returns on deposits. If the interest rate falls, borrowings will rise and savings will fall, which encourages more spending, which leads to higher sales revenue and profits for firms.

2. Government spending rise or fall:
   When interest rate increases, the government will find it harder to borrow, meaning its public expenditure will fall, but if interest rates fall, the government will find it easier to engage in public expenditure, which will be positive for the economy.

3. Investments falls or rise:
   If the interest rates fall the cost of capital will be lower for businesses meaning that they will borrow to fund their projects, but it’s difficult when interest rates rise because for a project to be taken up, it will need to generate more NPV to cover the increase in cost. These effects will have an impact on the economy, negatively or positively.

Effects on business evaluations

Higher interest rates increase the cost of capital, which affects how businesses are valued. Since the cost of capital is used in valuation, a higher cost of capital tends to reduce business value.

If interest rates fall, the opposite tends to happen: the cost of capital falls, and business values tend to rise.

Hot money
This is a term used to describe money that moves from one country to another in a matter of minutes or hours (through investment in the money markets). When interest rates rise, a country will attract hot money into the economy, but the opposite will happen if interest rates fall. Its overall impact is often limited because these flows are temporary.

Example:

Investors may quickly move funds into a country offering higher interest rates, then withdraw them just as quickly if rates fall or better opportunities appear elsewhere.

Asset values
Items like bonds are inversely affected by movements in interest rates. A decrease in interest rates makes bonds more attractive, so their value rises. An increase in interest rates makes bonds less attractive, so their value falls (as consumers choose investments with higher returns, such as bank deposits).

Example:

If interest rates fall, existing bonds offering higher returns become more valuable. If interest rates rise, investors may prefer bank deposits, causing bond prices to fall. :::

How can a firm manage interest rate movements?

Firms can manage interest rate risk using hedging techniques, which are designed to protect against unfavorable changes in interest rates.

Forward rate agreement (FRA)

Definitions

Forward rate agreement (FRA)

A fixed, legally binding, short-term hedging technique used to protect against adverse movements in interest rates.

An FRA allows a firm to lock in certainty by fixing:

• A specific interest rate
• A specific future date for the transaction

Firms typically use FRAs when they expect interest rates to move against them:

• Borrowers: want to avoid a rise in interest rates
• Lenders: want to avoid a fall in interest rates

However, because an FRA is binding, the firm cannot benefit if interest rates move in its favour.

Example:

KTA enters into an agreement with a bank to borrow $\$1,000,000$ on 5 January 2025 at an agreed interest rate of $11\%$. If the market interest rate on that date rises to $13\%$, the company benefits by borrowing at the lower agreed rate of $11\%$. If the market interest rate falls to $9\%$, the company is still required to borrow at $11\%$, as the agreement is binding.

Interest rate options

Definitions

Interest rate option

A derivative that gives the holder the right, but not the obligation, to borrow or lend at a specified interest rate.

An interest rate option is a derivative that gives the holder the right, but not the obligation, to borrow or lend at a certain interest rate under the contract. Unlike a forward rate agreement, an option allows the firm to benefit if interest rates move in its favour (this is what’s meant by upside potential).

Example:

KTA can enter into in an agreement with a bank to borrow at $11\%$ on 5 January 2025, and if the prevailing rate on that date was $9\%$, the company can let the contract lapse and borrow at the prevailing rate, but if the prevailing rate was $13\%$, then the company can exercise its right to borrow at $11\%$ agreed on the date of signing.

Interest rate futures

Definitions

Interest rate futures

Standardized contracts that allow firms to hedge against changes in interest rates by buying or selling in organized markets.

Interest rate futures are similar to forward rate agreements, but with two key differences:

• They are sold in standard contract sizes
• They can be traded (bought and sold) in the market

More details on these instruments are covered in F3 under the risk section of the syllabus.