Fiscal Policy

Fiscal Policy vs. Monetary Policy

Fiscal policy addresses taxation and government spending, and it is generally

determined by government legislation. Monetary policy addresses interest rates and the
supply of money in circulation, and it is generally managed by a central bank.
Fiscal measures are frequently used in tandem with monetary policy to achieve certain
goals. In the Philippines, this is characterized by continuous and increasing levels of
debt and budget deficits, though there have been improvements in the last few years.

FISCAL MONETARY
POLICY POLICY
Expansionary
Expansionary
monetary
fiscal policy
policy

Contractionary
Contractionary
monetary
fiscal policy
policy

Expansionary fiscal policy increases the national deficit (and national debt) and
causes crowding out. The demand for loanable funds increases (or the supply
decreases), and interest rates increase.

Contractionary fiscal policy decreases the national deficit. The demand for loanable
funds decreases (or the supply increases), and the interest rate decreases.

Monetary policy has the opposite effect on interest rates as fiscal policy. Expansionary
monetary policy decreases interest rates while contractionary monetary policy
increases interest rates.

Fiscal Policy

Fiscal policy refers to the "measures employed by governments to stabilize the economy,
specifically by manipulating the levels and allocations of taxes and government
expenditures.”

There are two main types of fiscal policy:

•Expansionary fiscal policy, designed to stimulate the economy, is most often used
during a recession, times of high unemployment or other low periods of the business
cycle. It entails the government spending more money, lowering taxes or both.

•Contractionary fiscal policy is used to slow economic growth, such as when inflation
is growing too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal
policy raises taxes to cut spending. As consumers pay more taxes, they have less money
to spend, and economic stimulation and growth slow.
Tools (role) of Fiscal Policy

The government has two primary fiscal tools to influence the economy. They are revenue
tools and spending tools.

Revenue tools
Revenue tools refer to the taxes collected by the government in various forms. The taxes
can be direct or indirect. Direct taxes are taxes levied on the income or wealth
individuals and firms. This includes income tax, wealth tax, estate tax, corporate tax,
capital gains tax, social security tax, etc. Indirect taxes are taxes levied on goods and
services. This includes sales tax, value added tax, excise duty, etc.

Spending Tools
Spending tools refer to increasing or decreasing government spending/expenditure to
influence the economy.
Government spending can be in the form of transfer payments, current spending and
capital spending.
Current spending includes expenditure on essential goods and services such as health,
education, defense, etc. Capital spending is the public investment in infrastructure such
as roads, hospitals, schools, etc.
The above two also include subsidy or direct provision of merit goods and public goods,
which would otherwise be underprovided.
Transfer payments are the redistribution of income from taxpayers to those requiring
support, for example, unemployment benefits. It also includes interest payments on
government debt.

How does fiscal policy affect interest rates and investment?

A fiscal expansion will raise interest rates and “crowd out” some private
investment, thus reducing the fraction of output composed of private investment. In an
open economy, fiscal policy also affects the exchange rate and the trade balance. Fiscal
policy affects aggregate demand through changes in government spending and taxation.
Those factors influence employment and household income, which then impact
consumer spending and investment.

Interest Rates
What are interest rates?
Generally, interest rates are prices. It refers to the amount charged by a lender
to a borrower for any form of debt given, generally expressed as a percentage of the
principal. The asset borrowed can be in the form of cash, large assets such as vehicle
or building, or just consumer goods. In the case of larger assets, the interest rate is
commonly referred to as “lease rate.”

What is the Nature of Interest Rate?

Interest rates are directly professional to the amount of risk associated with the
borrower. Interest is charged as compensation for the loss caused to the asset due to
use. For instance, the lender may use the money or asset in investments that generates
income. Thus, in return for these lost opportunities, interest rates are applied as
compensation.

Types of Interest

• Simple Interest
This type of interest is calculated on the original or principal amount of loan. The
formula in calculating simple interest is:

𝐼 = 𝑃𝑟𝑇

Where,
I = amount of interest
P = principal amount
r = interest rate
T = time duration

Example:
A lent P1,000 to B at the rate of 5% payable in 6 months. Compute for the amount of
interest.

I = PrT
I = 1,000 × 0.05 × 6
I = 300

• Compound Interest
It is calculated not just on the basis of the principal amount but also on the accumulated
interest of previous periods. This is the reason why it is also called “interest on interest.”
The formula for compound interest is as follows:

𝑟 𝑛𝑇
I = 𝑃(1 + )
𝑛

Where,
I = amount of interest
P = principal
r = interest rate
n = number of interest is compounded per year
T = time (in years)

Example:
A lent P100,000 to B at the rate of 5% compounded quarterly, payable in 2 years.
Compute for the amount of interest.

𝑟 𝑛𝑇
I = 𝑃(1 + )
𝑛

I = 100,000 [(1 + 0.05 / 4)^(4 × 2)]

I = 100,000 (1 + 0.0125)^8
I = 100,000 (1.0125)^8
I = 100,000 (1.10449)
I = 110,449

How do we benefit from interest rates?

These increasing interest rates will affect the way you save, spend and invest. When
interest rates rise, it's generally good news for savers, as rates on deposit accounts and
other savings vehicles tend to rise. But for those paying debts or making large
purchases, it might make borrowing more expensive.

What Is the Overall Effect of Interest Rate Changes?

As interest rates increase, the cost of borrowing money becomes more expensive.
This makes buying certain goods and services, such as homes and cars, more costly.
This in turn causes consumers to spend less, which reduces the demand for goods and
services. By raising rates, the Fed makes it costlier to take out a loan, causing people to
borrow and spend less, effectively pumping the brakes on the economy and slowing
down the pace of price increases.
However, high interest rates encourage more people to save because they receive
more on their savings. Demand falls and companies sell less. When there is less money
circulating in the economy, the economy slows down.

Investment
Investment
Is an asset acquired or invested in to build wealth and save money from the hard-earned
income or appreciation. Investment meaning is primarily to obtain an additional source
of income or gain profit from the investment over a specific period of time.
It is also the dedication of money to purchase of an asset to attain an increase in value
over a period of time. Investment requires a sacrifice of some present asset, such as
time, money, or effort. In finance, the purpose of investing is to generate a return from
the invested asset.

There are three broad types of investments- stocks, bonds, and cash equivalents and
it is important to weigh each type before investing.

1. Stocks

Companies sell shares of stock to raise money for start-up or growth. When you invest
in stocks, you’re buying a share of ownership in a corporation. You’re a shareholder.

There are two types of stock:

• Common stock
Shareholders have a percentage of ownership, have the right to vote on issues affecting
the company and may receive dividends.

• Preferred stock
Investment returns and risks for both types of stocks vary, depending on factors such
as the economy, political scene, the company's performance and other stock market
factors.

2. Bonds

When you buy a bond, you’re lending money to a company or governmental entity, such
as a city, state or nation. Bonds are issued for a set period of time during which interest
payments are made to the bondholder. Bonds are considered a more stable investment
compared to stocks because they usually provide a steady flow of income. But because
they’re more stable, their long-term return probably will be less when compared to
stocks. Bonds, however, can sometimes outperform a particular stock’s rate of return.

3. Cash equivalent

Cash equivalent investments protect your original investment and let you have access
to your money. Examples include:

Savings accounts
Money market accounts
Certificates of deposit (CDs)
These different types of investments generally deliver a more stable rate of
return.

Why do people invest?

Investing is an effective way to put your money to work and potentially build
wealth. Smart investing may allow your money to outpace inflation and increase in
value. The greater growth potential of investing is primarily due to the power of
compounding and the risk-return tradeoff. Sometimes people know that savings and
investing are similar to each other but it's not. Saving can also mean putting your money
into products such as a bank time account (CD).

Investing

Using some of your money with the aim of helping to make it grow by buying
assets that might increase in value, such as stocks, property or shares in a mutual
fund. Investing' is more than building a rainy day savings.
On a practical level, saving involves putting aside money today for use in the
future. It’s what economists describe as ‘forgone consumption’. In other words, rather
than spending all your money, you tip some into a savings account for another time.
Savings is a sensible starting point in investing because it provides the funds you need
to purchase a range of different assets. However investing goes one step further, helping
you achieve personal goals with three significant benefits.