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Introduction to Fiscal and Monetary Policy

Fiscal policy is the government’s policy on taxation, public borrowing and public spending.

In the UK, the Public Sector Net Cash Requirement (PSNCR) is the official denomination of the government’s budget deficit; i.e. how much the government must borrow in order to fulfil its financial obligations.

The government can intervene in the economy through a few ways, such as:

  • Spending money and financing it through loans

  • Collecting more taxes and not increase spending

  • Collecting more taxes and increase the spending, to funnel the money of the economy from one sector to another.

There are two main types of taxes: direct taxes, which are taxes on individuals and companies, and wealth – such as income tax; and indirect taxes, which are the ones on products and services – such as VAT. I will not go into too much detail on taxes right now as they will be covered in more extensive detail on a future article, so make sure you subscribe to F.S. Finance in order to get an update on it in the future!

Governments can be used to manipulate the economy such as affecting inflation rates; but it can also be used to reduce unemployment and create more jobs. This can be done through collecting more taxes and increasing the spending on capital projects, training schemes, or even reducing taxes to companies who hire more employees.

Fiscal policy is a long process and takes a long time to take effect. Other factors usually change during this time which complicates the process even more so. Therefore, governments will balance fiscal policy on how it affects the Nation – from savers, to investors, to companies. As the fiscal policy of a country typically follows an annual cycle, the UK makes its changes in Autumn every year through its budget – although a pre-budget is delivered by the Chancellor of the Exchequer in Spring.

Fiscal policy is an important thing to take into consideration as taxes and government expenditure affect our everyday lives very severely. For example, if income tax is lowered (which is a fiscal policy measure) you will have more disposable income to spend on goods and services. Likewise, if income tax is raised, you will have less to spend on goods and services – but if simultaneously the government spends more money on public infrastructure, you could be driving in nicer roads, walking around more modern buildings, etc.

Reading into fiscal policy on a yearly basis will help you better plan for your annual budget, which you should be doing already now that I have covered budgets on a previous article!

On the other hand, monetary policy focuses on changes in the money supply – this is the amount of money that is in circulation – and with interest rates – which are changes in the price of money. Monetary policy is paramount as it influences the cost of personal loans and the reward for saving. You can read more on Interest Rates in a PREMIUM article I wrote which you can find in the link below:

The Bank of England has a group of people that sets the base rate (which is also known as the short-term benchmark repo rate, and yes, we hate this name too). This impacts the interest rates of lenders and has the principal aim of meeting inflation targets. This group is called the Monetary Policy Committee, or MPC for short.

The MPC meets eight times a year; each of these times receiving detailed updates on the economy from staff. Nine members get informed about latest trends and data on the economy, with extensive analysis of a variety of issues including business ones. From here, the MPC has a total of 3 meetings which then set the base rate of the Bank of England, completely impacting the whole of the UK.

Although interest rates have a strong impact in inflation, there are other factors at play. Economic research states that the level of prices in a country is determined by the interaction of aggregate demand and aggregate supply. This is, the supply and demand of the country as a whole. As such, there can be demand-pull inflation or cost-push inflation – all of which based on this interaction.

Whilst demand-pull inflation is usually connected to a booming economy, cost-push inflation is connected to rise in costs. Both can occur simultaneously, forcing both the aggregate demand curve to shift to the right and the aggregate supply curve to shift to the left; ultimately leading to a rise in prices.

The importance of fiscal and monetary policy lies with controlling the largely unpredictable movements of the economy and stabilising it as much as possible to ensure long-term sustainable growth. It is something that deeply impacts your personal finances – as seen through the Global Financial Crisis – and something you should be knowledgeable about.

Hopefully this short article has been able to bolster your familiarity with certain economic concepts that impact your day-to-day finances. Make sure to subscribe to our Newsletter for more updates, to our Paid Membership for access to all our content, and to our YouTube channel for the latest videos! You are also welcome to email me with any questions and make sure you do!

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