What are Fiscal Policy and the Money Market?

Fiscal policy is one of the important tools that is used by the government to control inflation or aggregate demand in the economy. Under this policy, there are two rules which are used by the government, one is the expenditure of the government and the other is the taxation or income of the government which it collects from the public. 

Aim for Fiscal Policy

The fiscal policy is formulated and implemented by the government of a country to regulate the money supply during inflation or even during the situation when aggregate demand is extremely low in the economy that ultimately leads to lesser growth of the country. 

Money Market

The money market is one of the most important parts of economic development. It is mainly concerned with the part of the financial system where the exchange or trade of the short-term fund takes place for all time periods which is less than a year. 

There are some of the important functions that the money market in an economy has to perform: 

  • Execution of monetary policy: With the help of the money market instruments, monetary policies are brought into action whenever needed in an economy. In the case of India, the Reserve Bank of India effectively manage is the execution of the monetary policy with the help of the money market instruments. 
  • Keeps a balance between the demand and supply of capital: Whenever the savings are converted into an investment, it is the money market that grants the permission of the money to be used in such a way that there should always remain a balance between the capital which is being deposited by the individuals that are the savings and the supply of capital which is being used as loan by the ones who needs it. 
  • Using money in its most efficient manner: The most important function of the money market is to ensure that the money is being used effectively. 

There are mainly four kinds of money market instrument that exist in an economy: 

  1. Promissory notes: As the name says it is a note of promise that is written by one individual to another individual to pay a certain amount of money within a given time period that has been mentioned on the note. Usually, the promissory note is signed for a time limit of 90 days, and extra 3 days is given as the grace period. The promissory note must be done by the debtor and it has to be acknowledged by the bank of the debtor so that the creditor gets the discounted value or the discount rate directly from the bank on the due date. 
  2. Commercial paper: Commercial paper is usually the short time liability that is being issued by companies to its borrowers for the current amount of money that has been received from them. 
  3. Certificate of deposits: Certificate of deposit is regarded as the receipts which are being issued by the financial institution for a certain time period and also at a certain fixed level of interest rate. 
  4. Treasury bill: The central government usually issues the treasury bills as short-term capital to the market. The treasury bills are one of the most important instruments of the money market that are issued for a period which is less than one year. When it comes to the bank, they may convert their statutory liquidity ratio that has been held as the treasury bill into cash whenever there is the need for it.

Monetary Policy

Monetary Policy refers to the policy that is undertaken by the Central Bank of a country to control the money supply in the economy and also achieve the desired economic goals. For example, if inflation persists in the economy (inflation is the consistent rise in the price level of goods and services in the economy), then the Central Bank reduces the money supply so that the aggregate demand reduces a little and there is an excess supply which ultimately reduces the price level.

Fiscal Policy takes the form of Government Spending

The IS curve can be derived from the aggregate demand (AD) curve. The IS curve shows the goods market equilibrium and the aggregate demand curve implies the relationship between the total desired quantity of output that is bought by all consumers in the economy at each possible price level. When with an expansionary fiscal policy, the government spending increases, the AD curve shifts to the right, and accordingly the IS curve also shifts outward. The rate of interest increases in the economy along with the increase in the national income.

The LM curve can be derived from the money market equilibrium. It is assumed that the money supply is fixed in the economy, so the supply curve for money is a vertical straight line parallel to the vertical axis and the demand curve for money is downward sloping. From the intersection of these two curves, one will get the LM curve.

Suppose that the government enacts fiscal expansion and raises government spending which will higher the aggregate demand. It is seen that the demand for money also increases. So, this increases the money demand associated with a higher interest rate value. From the increase in interest rate, it is seen that loans become more expensive to borrow, and thus investment decreases. The decrease in investment leads to lower aggregate demand. A fall in aggregate demand will also mean that less money is demanded in the economy and the interest rates fall. Fall in investment crowds out the government spending. This is known as the crowding-out effect. However, it is noted that even though there is a fall in investment in the economy, there is still have a greater value than at the initial rate.

Reaction in Money Market due to change in Monetary Policy

If the Central Bank of the country increases the money supply (M), the real money supply line shifts outward and the LM curve shifts outward accordingly. The immediate result is that the interest rate drops from its original position. This is based on the assumption that the money market adjusts quickly. At this point, the money market is in imbalance because the point is on the LM curve, but the interest rate is too low for the goods market to be in equilibrium. At this point, there is excessive demand for goods. As money market adjusts quickly to the increased income, an increase in income increases the demand for money and in turn, increases the interest rate. So, the policy for increasing the money supply lowers the interest rate in a higher level of national income results. 

 In conclusion, it can be said that the workings of fiscal policy and the money market which is the monetary policy are extremely important in regulating the economy in conditions of extreme inflation or even extreme deflation. The government or the Central Bank or the Federal Reserve of any country should take action accordingly through the money supply increase or decrease for controlling the inflation or deflation. To encourage borrowers to borrow money from the bank, the lending process of the bank is enhanced by reducing the interest rate which can be done only by increasing the money supply because the cost of borrowing or the cost of lending is known to be the interest rate.

This is done in the cases of deflation when money needs to be circulated in the economy to boost the aggregate demand in the economy to bring some kind of growth to the country. Therefore, it can be said that through the instruments of monetary policy and fiscal policy or even the money market the economy of a country can be regulated entirely based on the situation that it is facing.  The interest rates play an extremely important role in determining the policy rates which is done by the policymakers of a country.

The fiscal and monetary instruments should be used very carefully for the sole purpose of boosting the growth of an economy. The expansionary monetary policy also plays an important role just like the fiscal policy in an economy whenever there is inflation or deflation. The government should use the instruments of the money market and the tools of the fiscal policy efficiently for the smooth functioning of the economy. It can use expansionary fiscal policy whenever needed during the deflationary period and also it can use the expansionary monetary policy whenever required during the period of inflation. The expansionary monetary policy can be used either by increasing the money supply in the market or by regulating some of the instruments in the money market. 

Context and Applications   

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for 

  • BA in economics
  • MA in economics
  • B.B.A
  • MBA

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