FISCAL POLICY, MONETARY POLICY & EXCHANGE RATES
a) Fiscal Policy = “Tax & Spend” Policy
This is the Chancellor’s responsibility (Osborne currently in the UK).
If amount of tax gathered is less than Govt. expenditure, the central government is running a Budget Deficit (currently about £100 bn per year). In this case, Govt. has to borrow – by selling “Treasury” Bills and Bonds. (“Bills” are short term, 3 month borrowings; “Bonds” are longer term – up to 20 years or indeed forever!) The investors buying them will be both foreigners and UK citizens/institutions.
On the other hand, if tax gathered is more than is being spent by the govt., there will be an annual Budget Surplus (very rare). In this case, Govt. will be selling fewer bills/bonds than are maturing.
If Govt. is running an annual Budget Deficit, it will be adding to the National Debt (currently about £1 trillion) whereas if they are running a Budget Surplus, it will be reducing it.
If the economy is in recession (or weakening) Govt. will usually choose to run an annual deficit – because an annual govt. deficit “pumps” demand into the economy. That should result in more spending, more jobs & more output (& stop rising unemployment). On the other hand, if economy is “over-heating” and inflation (the price level) is increasing faster than seems desirable, Govt. will usually choose to run an annual surplus – which “sucks” demand out of the economy (cooling it down).
b) Monetary Policy (Interest Rates & the Supply of Money to the Economy)
This is the responsibility of the central bank (Bank of England here, the Federal Reserve Bank in the USA)
Essentially, this is the use of Interest Rates to either encourage a bit more Economic Growth (GDP) or to slow it down. The central bank sets SHORT TERM Interest Rates – raising them to make credit dearer and slow down the economy; cutting them to make credit easier and encourage economic growth.
The central banks do not control ALL interest rates – only short term rates. The “Markets” determine longer term interest rates – if investors want UK (govt) debt they will only require a low interest rate whereas if they are not very keen, they will require a high interest rate (to tempt them to buy). These rates – the long term ones that the central bank cannot control – are the rates that determine most interest rates paid by businesses, consumers and governments for long term funds (including mortgages).
However, private sector banks (e.g. Barclays) can always borrow short term from the central bank (which is why it is called the “lender of last resort” – it will see them through short term difficulties and – as now – lend them money so cheaply that they will want to take it and lend it on). Sometimes, of course, the central bank may fear “overheating” and reckless lending by the private banks and will only lend them short term funds at a penal rate.
The central bank (viz. the B of E or the “Fed”) also supplies “money” to the economy. It can choose to increase that supply or decrease it. This is usually done via “open market operations” (originally a US term). In both the UK & the USA, the central banks have been increasing the money supply by “Quantitative Easing” – that is buying bonds from the private sector banks (mostly old govt, bonds) in order to give those banks loads of cash, which they will then, hopefully, lend to businesses/individuals. In effect, the central banks are just inventing money (with the stroke of a pen or the click of a mouse) and pushing it out into the economy. They will go doing that until they are satisfied with the growth of the economy. One day (presumably) they will start selling those bonds back to the market when they want to slow things down – thus taking cash back out of private banks’ balance sheets (and making lending less profitable and credit harder to get).
NOTE: when a govt. is running a Budget Deficit, it has to sell Bonds/Bills to the market; if it wants – at the same time