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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: 22 June 2015
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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. 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.

In most basic terms, fiscal policy is government spending and taxation. How much the government decides to spend and tax rates, make up the government's fiscal policy. When government spending is less than government revenue, it is said that a contractionary fiscal policy is in place. If the government is spending more than the revenue, it is said to be engaging in expansionary fiscal policy.

There is general consensus among economists that fiscal policies may and often do have an effect on interest rates. However, there are differing opinions on what this effect is, the significance of the effect and how different factors impact the relationship. One of the most prevalent ideas about the relationship between fiscal policies and interest rates is that fiscal expansion raises interest rates. So when the government is spending more than its revenue, interest rates will go up.

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A 2013 IMF working paper found that fiscal policy, together with global monetary policy, account for more than 60% of variances in long-term interest rates. Those who carried out this study argue that the relationship between national fiscal policy and interest rates is weaker if one does not count for global fiscal factors. Another paper, written by the Research Institute of Applied Economics in 2008, argues that large deficits have significant effects on interest rates but some factors like spillover reduces these effects.

Economists continue to study the relationship between fiscal policy and interest rates. It is important to better understand this relationship because it can assist economists and policy makers to develop better fiscal policies, as well as estimate more accurately the consequences of current policies.

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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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