Fiscal Policy Explained

Fiscal Policy

• Fiscal policy involves how governments spend money and change taxation to affect aggregate demand and economic output.
• It can be active, passive, or discretionary.
• Expectations play a role in its effectiveness.

Fiscal Policy Tools

• Taxation: Includes taxes on income, property, and sales.
• Public Spending: Encompasses subsidies, transfer payments, and public works.
• Fiscal Deficit: When a government spends more than it earns.
• Fiscal Surplus: When a government spends less than it earns.

Fiscal Policy Objectives

• Aimed at boosting employment levels and economic development.
• Maintain the economy's growth rate.
• Raise the standard of living.
• Maintain equality in price levels and balance of payments.

Fiscal Policy Types

• Expansionary Policy: Stimulates economic growth by increasing spending or lowering taxes.
• Contractionary Policy: Slows the economic growth.

Monetary Policy

• Focuses on controlling the money supply
• Adjusts the fed funds rate.
• It works faster than fiscal policy
• Aims to maintain efficiency.

Monetary and Fiscal Policy in the Eurozone

• The European Central Bank (ECB) sets monetary policy for Eurozone nations, remaining independent from national policies.
• Eurozone countries control their fiscal policies, including government expenditure and taxation.

EU and the Eurozone

• The EU consists of 27 countries in Europe.
• 20 of these countries use the Euro as official currency, forming the Eurozone.
• All Eurozone countries are members of the European Monetary Union (EMU).

Eurozone Nations

• Austria, Belgium, Croatia, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Spain

EU Nations Without the Euro

• Bulgaria: Bulgarian Lev
• Czechia: Czech Koruna
• Denmark: Danish Krone
• Hungary: Hungarian Forint
• Poland: Zloty
• Romania: Romanian Leu
• Sweden: Swedish Krona

Convergence Criteria For Joining the Euro

• EU countries must align national legislation with EU law.
• Specific conditions ensure economic convergence, established in The Maastricht Treaty in 1992.
• Convergence criteria are macroeconomic indicators that focus on:
• Price stability: Inflation rate must be no more than 1.5 percentage points above the average of the three best-performing EU countries.
• Sound public finances: Debt-to-GDP ratio must be below 3%, and government debt below 60% of GDP.
• Exchange-rate stability: The country must participate in the Exchange Rate Mechanism (ERM II) for at least two years before adopting the euro.
• Long-term interest rates: Must be no more than 2 percentage points above the average of the three best-performing EU countries in terms of inflation.

Economic Stability and Growth Pact

• Monetary policy is set by the ECB for all Eurozone member nations.
• Eurozone countries have independence over fiscal policy, but the stability and growth pact sets rules for EU members.
• Total government debt must not exceed 60% of GDP
• Government deficit must not be more than 3% of GDP, except in certain circumstances.

Purpose of the Economic Stability and Growth Pact

• Discourage national governments from excessive deficit spending, to prevent destabilizing the common currency.
• Penalties: Apply for breaking the rules for more than three consecutive years, with a fine of up to 5% of the nation's GDP.

General Escape Clause - COVID-19

• It's a mechanism within the EU's Stability and Growth Pact (SGP) allowing member states to deviate from fiscal rules temporarily.
• The European Commission activated the GEC in March 2020 during the COVID-19 pandemic.
• The GEC enabled governments to respond to the crisis without strict EU budgetary limits by easing EU fiscal rules, allowing countries to exceed debt-to-GDP ratio by 3% and public debt to exceed 60% of a nation's GDP.
• The aim was to stimulate economic growth through increased government expenditure.
• It was activated in March 2020 and deactivated in 2024.

Case Study: Greece and the Eurozone

• In 1999, Greece was the only country in the EU not allowed to join the EMU due to not complying with convergence criteria
• Greece joined the EMU in 2001 with a debt-to-GDP ratio of 104.4%, above the 60% requirement because Greece's debt ratio had been declining since 1997, so the European Council made the decision in 1999 that Greece did not have an ‘excessive deficit' and was in compliance with the sound finance criteria.
• Benefited from the EU's low interest rates and easy access to credit, leading to higher public borrowing and growth in both economic growth and public debt levels

The Debt-GDP Ratio in Greece

• A higher debt-to-GDP ratio increases the risk of default.
• Dependence on debt to fuel its economy, creates a situation where the economy cannot afford to pay it back.
• Usually, nations that have independence over their monetary policy, can lead to fiscal dominance whereby monetary policy is determined by the level of government debt
• Was not possible in the case of Greece, as monetary policy is controlled by the ECB.

Case Study: Greece Debt Hair-cut

• Because Grease was unable to service its debts, investors didn't buy its bonds and banks didn't lend it money.
• In 2011, Holders of Greek debt were forced to accept a 50% haircut, reducing Greece's national debt by €100 billion.

Fiscal Dominance

• Fiscal Dominance is a situation where a central bank's ability to combat inflation is compromised by the fiscal decisions made by government.
• Can lead to central banks (ECB) deviating from monetary policy objectives to tackle government debt issues, endangering price stability.
• The growth and stability pact introduced debt rules for Eurozone governments, attempting to manage debt levels. Monetary and fiscal policy should be independent of each other.
• High government debt may lead central banks to engage in expansionary monetary policy to combat the negative impacts of government debt, which can lead to inflation or hyperinflation..

Monetary Policy EU - After the Crash

• Critics argued that the ECB reacted too slowly to the GFC, leading to a sovereign debt crisis from 2010 to 2015.
• Interest rates were kept high in 2008 (4.25%) amid inflation fears
• Other economies, like the US and UK, aggressively cut interest rates in 2008-2009.
• By 2009, the ECB had brought interest rates down to 1% to stimulate economic growth, but in 2011 they began to raise interest rates to 1.5%, followed by the Sovereign debt crisis.
• Quantitative Easing was not launched by the ECB until 2015, while the FED had already engaged in this unconventional monetary tool in 2008.

Sovereign Debt Crisis

• Eurozone countries faced a sovereign debt crisis between 2010 and 2015 after the Global Financial Crisis(GFC).
• This is when a country cannot repay or refinance its government debt, leading to potential default. The key causes of this crisis were:
• Excessive Government Debt:
• Many EU countries, particularly in Southern Europe, had borrowed heavily before the crisis.
• Countries mostly affected include: Greece, Portugal, Spain, Italy, and Ireland.
• 2008 Global Financial Crisis:
• An economic downturn led to lower tax revenues, increased government spending, and the need for bailouts.
• Banking Sector Vulnerabilities:
  • European banks held large amounts of government bonds so concerns over sovereign defaults threatened financial stability.
• Eurozone Structure Issues:
• Countries using the euro (€) couldn't devalue their currency or implement independent monetary policies to stimulate their economies. -Austerity Measures:
• EU-led and IMF-backed bailouts required strict budget cuts (austerity), which often deepened recessions in affected countries.
• During the sovereign debt crisis, the ‘PIIGS’ (Portugal, Italy, Ireland, Greece, and Spain) were the weakest economies.
• High levels of financial instability and government debt.
• Greece, Ireland, Portugal, and Spain were bailed out by the EU, The International Monetary Fund (IMF), and the ECB

Asymmetric Impacts of EU Monetary Policy

• Because the ECB dictates monetary policy for all Eurozone countries, member countries have no impact on monetary policy at a national level, therefore, individual nations had to abide by ECB interest rates
  • For stronger economies such as Germany and the Netherlands, higher interest rates were needed after the crash to prevent inflation from rising.
• On the other hand, countries in recession, such as the PIIGS, needed lower interest rates to stimulate growth in their economies.

IS/LM Model

• The IS/LM model represents the interaction of goods (IS) and financial (LM) markets.
• IS represents Investment/Savings.
• LM represents Liquidity Preference-Money.
• The model aims to evaluate how these markets interact with each other to determine interest rates and output in the short-run in an economy
• The underlying assumption is that interest rates and money supply is controlled by the Central Bank.
  • Interest rates and money supply are generally fixed, which leads to a horizontal LM curve.
• Changes in monetary policy will alter the interest rate while changes in fiscal policy will alter the aggregate supply

Simultaneous Fiscal and Monetary Expansion

• True, a simultaneous fiscal expansion and monetary expansion will lead to output levels increasing in the short run
• Fiscal expansion will lead to a shift in the IS curve to the right, encompassing an increase in Government expenditure or a decrease in taxation.
• Any change in fiscal policy will impact the IS (Interest/Savings) curve.
• Monetary expansion leads to a shift in the LM downwards, and may include an increase in money supply or a decrease in the interest rate.
• The ECB controls monetary policy including the money supply and interest rate levels, implying that any change will impact the LM (Liquidity/Money) curve.

Fiscal Expansion – IS/LM Model

• The LM curve remains static because the central bank will need to hold the money supply and interest rate fixed
• As a result, the interest rate is maintained at the same level as before the fiscal expansion, and output in the economy increases.
• Fiscal expansion will cause a shift to the right for the IS curve (from IS1 to IS2).

Monetary Expansion – IS/LM Model

• If a monetary expansion policy is introduced, it will cause the LM curve to increase and move downwards, while the IS curve remains unchanged. -Because the increase in money supply increases liquidity in the market, the interest rate falls, and the market is brought back into equilibrium.
• Equilibrium output rises because of the fall in interest rates.

Simultaneous Fiscal and Monetary Expansion

• A positive shift will be seen in both the IS curve and the LM curve, if both fiscal and monetary expansion are experienced in a country
• An increase in the money supply via monetary expansion will lead to the LM curve shifting downward.
• Fiscal expansion will lead to a rightward shift of the IS curve.
• Original equilibrium occurs at point 'A' where the LM curve cuts the IS curve, after an expansion in both policies, then there will be a move to a new equilibrium where the interest rate is decreased which allows output in the economy to increase.

Contractionary Monetary Policy and the IS-LM Model

• In detail what effect a contractionary monetary policy will have on: (1) the LM curve; (2) the IS curve; (3) output; (4) investment; (5) consumption.
• Contractionary policy occurs when the economy is overheating and the Central bank reduces inflation.
• This may be done by increasing the interest rate or reducing the money supply.
• The goal for the ECB: To maintain inflation rates between 0% and 2%, using interest rates.

Expansionary Fiscal Policy to counteract the affect of contractionary monetary Policy

• 3. Suppose that the government increases its spending. Based on your understanding of the IS-LM model, describe graphically the effects of this policy on the equilibrium level of output and the equilibrium interest rate. With reference to the IS-LM relation, explain the effects of this policy on investment and consumption. -. If Government expenditure is increased, this is a form of expansionary fiscal policy, so there is also a positive impact on the IS curve. There is no changes to the money supply. Therefore, there will need to be higher rates of interest to stimulate expansion in all levels of production

Housing Market Crash & IS-LM Model

• A housing market crash would lead to a decrease in wealth.
• This can be defined in the IS side. IS focuses on the impact relating to goods and services and how it directly relates to aggregate demand in the overall economy

How can banks influence the money supply?

• Banks can influence the supply of money supply through 3 key ways, with their goal, central banks, such as the ECB, influence the money supply to control inflation, and in turn, economic output in an economy:
  • Open-Market operations: Buying/Selling government bonds. Central banks buy bonds by giving money to national banks, increasing the money supply while
  • When central banks sell bonds, they take money out of the system, reducing the money supply.
• Reserve requirements: The percentage of deposits banks have to keep while they lend out the remainder in the dorm of loans. Lower when increasing money supply and higher when reducing money supply.
• Refinancing rate: Rate at which National banks borrow from the ECB. Higher when reducing money supply, lower when increasing money supply.

Quantitative Easing (QE)

• Quantitative Easing occurs in the context when monetary policies are ineffective in stimulating economic activity.
• Quantitative Easing can be considered a last ditch option where conventional methods are not working to create investment and consumption.
• Central Banks will introduce new money into the economy to boost the economy out. It involves the central banks purchasing bonds and security in an attempt to reduce interest rates, increase money supply in the economy and drive more lending to investors and consumers, by stimulating higher level of lending, there is a greater goal to reduce all round inflation levels in the EU market.

What are the costs and benefits of Quantitative Easing:

• The goal of Quantitative easing is to achieve higher consumption and business spending. - - The introduction of money causes the cash reserves to increase substantially and therefore lower the cost of investment.
• Increase Inflation with quantitative easing Quantitative Easing seeks to increase all round inflation levels What does quantitative easing achieve: Aims to increase bank lending leading to higher investment, should stimulus all round inflation levels.

Risks of Quantitative Easing (QE):

1. Over stimulate the bank balance sheet
2. Too higher levels of debt = hyperinflation
3. Economic output remains unchanged = stag deflation

Measures of Money Supply:

• MO = Currency notes + coins + bank reserves
• M1 = MO + demand deposits
• M2 = M1 + marketable securities + other less liquid bank deposits
• M3 = M2 + money market funds
• M4 = M3 + least liquid assets.
• MO reflects the most liquid money supply as M increases, it reflects less and less liquid assets
• M4 would contain the longest term assets which are least liquid

Determinants of Money Supply:

• The European Central Bank (ECB).
• The ECB controls the money supply using monetary policy whereby they adjust interest rates and the supply of money
• The supply of money can be influenced by: Open market operations – buying/selling of bonds and adjusting reserve requirements

Policy Rates

• Policy Rate: This is a short-term reference rate set by the Central Bank. There are three different policy rates; refinancing rate, deposit rate of return, and the marginal lending rate. This main one is the refinancing rate, this is the rate at which commercial banks can borrow money from the Central Bank.
• Policy rates are a powerful tool to control the inflation level and economic activity within a country or geographical area

Monetary Policy During Crises

• During any economic downturn: Such as The Pandemic expansionary monetary policy increase the money supply and reduce economic growth to prevent any further economic collapse.
• Short turn response to is by cutting interest rates, however, in some crises this policy responses is inadequate in stimulating economic growth, a long-term approach is requires

The Zero Lower Bound

• Refers to the boundary where nominal interest rates cannot be less than 0 This leads to a liquidity trap when expansionary monetary policy Fails to stimulate economic activity

Keynes

• Keynes argued that during a liquidity trap, monetary policy alone is insufficient and expansive and fiscal policy is requires to prevent total economic halt

Steps in Quantitative Easing

• The initial process relies on the Central Bank creating money electronically and can be more likened to printing money, there it is mostly electronically allocated to help the reserves maintain a better cashflow. Money creation.
• All the banks purchase government, corporate or mortgage back securities from others
• The purchase of bonds in practice injects money into the backing market and raises both economic spending and higher investment.