Forex: Fiscal and Monetary Policies
Fiscal policy is the arm of government policy that is concerned with changes to the economy through the budget and taxes, welfare payments and other government expenditure.
It is the government's strategy for managing revenue and expenses. Monetary policy is the branch of economic policy with the behavior of the money supply, interest rates and overall financial conditions. It also focuses on the amount of money that is printed and in the system.
The fiscal policy for a responsible government should entail a balance in income from taxes and other raisings, and expenditure through wages and benefits.
Modern governments tend to adopt the populist approach of running a continuous deficit with expenditure chronically in excess of income. The deficit is covered through borrowing either domestically or from overseas.
Theoretically, a large domestic deficit, particularly when coinciding with a balance of payments outflow on the net current account, should indicate a lack of demand for currency, and consequently, a weak exchange rate. However, the theory does not always translate into reality. For example, the strength of the U.S. dollar in the early 1980s was an example of an economic theory that was confounded by sentiment. Overseas investors ignored the large U.S. deficit and worsening current account because they expected the position to reverse when the world economy improved.
With the world keen to invest in the country, the U.S. was able to enjoy a large and growing deficit, falling interest rates and a strong currency.
The U.S. dollar peaked in March 1985 at overpriced rates because the government deficit financed a high level of consumer spending on imported goods. The deficit was allowed to continue to grow in the name of 'continuing to stimulate the world economy'; but in fact, it was merely a result of lack of political will in the U.S.
Despite a high deficit and a weakening currency, U.S. inflation was kept low and interest rates at moderate levels because the Japanese were offloading the large current account surplus that they, in turn, had obtained from selling their goods to U.S. consumers.
The monetary policy hinges on government control of the volume and pricing of money printed and circulating in the system. Money supply was highly disciplined in the days of the gold standard, because the reserves of gold were limited.
Unlimited money-supply growth, without due attention to a country's reserves, indicates an irresponsible attitude by government and, theoretically, leads to a negative view of the country's currency.
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