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What Is the Relationship Between Fiscal Policy and Interest Rates?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 04 December 2014
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Fiscal policies are economic tools utilized by government to manipulate the level of total demand for final goods and services in an economy. The relationship between fiscal policy and interest rates is that interest rates are one of the economic factors used to influence the rate of consumption by consumers. Fiscal policies relating to interest rates may either be expansionary or aimed toward the contraction of demand for goods and services. Central banks or reserve banks of various nations usually play a chief role in decisions regarding any increases or decreases in interest rates.

Governments and economists usually monitor the economy of a country through the study of macroeconomic factors like inflation, aggregate demand, unemployment and supply. These factors are studied over the course of various economic cycles, which may be quarterly, annually or every four years. Usually, there is a target outcome that economists desire for the economy. When there is any marked departure from such an outcome like rising inflation some monetary and fiscal policies will be introduced to help stabilize the economy.

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One of the causes of inflation is excessive demand for services and goods, which causes a gradual or incremental increase in the price of such goods and services, pushed ever higher by a sustained increase in the demand that usually outweighs the supply. This is where the link between fiscal policy and interest rates can be seen because the central bank may try to control the rising inflation through the introduction of higher interest rates. Such an increase in the interest rate by the central bank will affect other banks in certain ways. First of all, the banks will be less willing to offer loans at previous rates and will increase the interest on any loan to customers and consumers. This will also affect the interest rate charged on credit cards and other related financial charges.

When this happens, the expected outcome is that the rate of consumption will drop due to the excessive interest charges on loans and the use of credit cards. All things being equal, this will bring the rate of demand and consumption down, leading to a decrease in demand-fueled inflation. Another relationship between fiscal policy and interest rates is the second major effect of an increase in interest rate by the central bank on other banks. Such banks usually encourage consumers to save more than they spend by increasing the interest rates paid on savings, even while they increase the interest rates on loans.

This relationship between fiscal policy and interest rates is twofold, because the central bank may also reduce the interest rates when the economy is sluggish with the hope that such an increase will encourage people to spend more money. In a reversal of their reaction when the central bank increases the interest rates, banks will reduce the interest paid on savings. This is also designed to encourage people to spend, rather than save their money.

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bluedolphin
Post 3

@literally45-- That's only true in countries where there is a free market and where the free market determines interest rates. In some countries, the government decides the interest rate through fiscal policies, regardless of other economic factors.

fify
Post 2

@literally45-- You're right. Government doesn't directly decide on interest rates, but the Federal Reserve is also a government agency. And how the Federal Reserve manages the economy has a lot to do with fiscal policies. What the Federal Reserve does is called monetary policy. Monetary policies are used foremost to deal with issues like low interest rates and high inflation. But when these policies fail, government will use discretionary fiscal policies to directly or indirectly change the direction of the economy.

The government may indirectly cause higher interest rates. For example, if the government predicts that the economy is heading towards recession and increases spending or lowers taxes, it will stimulate the economy. But if the global economy is not doing well, interest rates will probably increase.

literally45
Post 1

I don't think there is much of a connection between fiscal policy and interest rates, aside from the fact that the government keeps an eye on interest rates.

Interest rates are determined by the Federal Reserve in the United States. They decide whether to raise them or decrease them. Fiscal policies are decided on by Congress. They decide on taxes and government spending by evaluating the state of the economy. But fiscal policy doesn't determine interest rates.

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