Fiscal policy, or financial policy, is the method by which governments adjusts its levels of spending and taxation to directly influence the economy. Fiscal policy goes hand in hand with monetary policy (the means by which central banks influence money supply) to achieve various economic goals.
Fiscal policy gained popularity during the 1930s after it had been advocated by British economist John Maynard Keynes. He suggested that whenever a nation is in recession, putting more money in the hands of consumers could lead to economic growth. This could be done by reducing taxes or increasing government spending.
Various Fiscal Policies
The following are the three basic financial policies: neutral, expansionary, and contractionary.
Neutral – Government spending is roughly equal to its revenue.
Expansionary – Government spending is higher than its revenue.
Contractionary – Government spending is lower than its revenue.
Effects of Fiscal Policies on Exchange Rates
The effect of financial policy on the currency is highly dependent on the economic situation. Since each country is unique and the economic environment is constantly changing, it is very hard to tell exactly how financial policy will affect exchange rates.
Let’s say a government has a budget deficit due to an expansionary financial policy. To finance the deficit, the government can work with the central bank to print fresh currency (also known as quantitative easing).
The newly printed money can be used by the government in their economic development projects. The increase in money supply can end up being inflationary and lead to the weakening in value of the domestic currency in relation to foreign currencies.