Welcome to Fiscal & Monetary Policy!

Hey everyone! Welcome to one of the most important topics in macroeconomics. Ever wonder who's "steering" the economy? Why the government sometimes gives out money (like consumption vouchers) or why interest rates go up and down? This chapter answers those questions!

Think of the economy as a car. Sometimes it goes too slow (a recession), and sometimes it goes too fast (high inflation). Fiscal Policy and Monetary Policy are like the car's accelerator and brake pedals. They are the two main toolkits that governments and central banks use to keep the economy running smoothly.

Don't worry if this sounds complicated at first. We'll break it down with simple examples and analogies. Let's get started!



Part 1: Fiscal Policy (The Government's Toolkit)

What is Fiscal Policy?

Fiscal Policy is the use of government spending and taxation to influence the economy.

It's like managing a giant household budget. The government decides how much money to collect from people (taxes) and how much to spend on public services (spending). These decisions can speed up or slow down the whole economy.

Who's in charge? In Hong Kong, it's the HKSAR Government, led by the Financial Secretary who announces the budget each year.

The Government's Budget: A Balancing Act

The government's yearly plan for spending and taxing is called the budget. There are three possible outcomes:

  • Balanced Budget: Government Revenue (Taxes) = Government Spending. (Spending exactly what you earn.)
  • Budget Deficit: Government Revenue (Taxes) < Government Spending. (Spending more than you earn. The government has to borrow money to cover the difference.)
  • Budget Surplus: Government Revenue (Taxes) > Government Spending. (Earning more than you spend. The government has extra money.)
Quick Review Box

Fiscal Policy: Using government spending (G) and taxes (T) to manage the economy.
Deficit: G > T
Surplus: G < T
Balanced: G = T

Fiscal Policy Tool #1: Public Expenditure (Government Spending)

This is the "spending" part of fiscal policy. It's all the money the government spends to provide goods and services and support the community.

Classification by Function (What is the money spent on?):

  • Education: Building schools, paying teachers.
  • Social Welfare: Providing support for the elderly and those in need.
  • Health: Running public hospitals and clinics.
  • Infrastructure: Building roads, bridges, and MTR lines.

Did you know? A common way to measure the size of the government's role in the economy is to look at public expenditure as a percentage of GDP. This tells us how much of the total economic activity is driven by the government.

Fiscal Policy Tool #2: Taxation

This is how the government collects money. There are different ways to classify taxes.

Classification 1: Direct vs. Indirect Taxes
  • Direct Taxes: Taxes paid directly by the person or company they are imposed on. The tax burden cannot be easily shifted to someone else.
    Examples in HK: Profits Tax (on companies), Salaries Tax (on your income).
  • Indirect Taxes: Taxes imposed on goods and services. The seller pays the tax to the government but can shift the burden to the buyer by charging a higher price.
    Examples in HK: Stamp Duty (on property and stock transactions), Tobacco Duty (on cigarettes).
Classification 2: Tax Rates (How tax relates to income)
  • Progressive Tax: The percentage of income paid as tax increases as income increases. People with higher incomes pay a larger proportion of their income in tax. This is often seen as a way to reduce income inequality.
    Example: Hong Kong's Salaries Tax under progressive rates.
  • Proportional Tax: The percentage of income paid as tax stays the same regardless of income level.
    Example: If everyone paid a flat 15% tax rate, regardless of how much they earn.
  • Regressive Tax: The percentage of income paid as tax decreases as income increases. People with lower incomes pay a larger proportion of their income in tax.
    Example: A fixed $100 tax per person. For someone earning $1,000, that's 10% of their income. For someone earning $10,000, it's only 1%. This can worsen income inequality.
Principles of a "Good" Tax System

The famous economist Adam Smith suggested four principles for a good tax system. A good way to remember them is CCEE!

  1. Certainty: The taxpayer should know exactly how much tax to pay and when to pay it. No surprises!
  2. Convenience: Paying the tax should be easy and straightforward for the taxpayer.
  3. Economy: The cost of collecting the tax should be low compared to the amount of revenue it generates.
  4. Equity: The tax should be fair. (This can mean different things, like taxing people based on their ability to pay).

Taxation Principle in Hong Kong: Hong Kong uses the territorial source principle. This means you only pay tax on income that is "arising in or derived from" Hong Kong. If you earn money from a job overseas, you generally don't pay HK tax on it.

Using Fiscal Policy: Expansionary vs. Contractionary

This is where the government uses its tools to steer the economy. The goal is to close inflationary gaps (when the economy is overheating) or deflationary (output) gaps (when the economy is in a recession).

Expansionary Fiscal Policy (Stepping on the Gas ⛽)

Goal: To boost the economy during a recession (when output is low and unemployment is high).

How it's done:

  • Increase Government Spending (G ↑) OR
  • Decrease Taxes (T ↓)

This often results in a deficit budget.

The Process (using the AD-AS model):

  1. The government increases spending (e.g., building a new bridge) or cuts taxes (giving people more disposable income).
  2. This leads to an increase in Aggregate Demand (AD), as G is a component of AD (Y = C+I+G+NX) or lower T increases C.
  3. The AD curve shifts to the right.
  4. Result: The output level increases and the price level increases. (More jobs, but a risk of some inflation).

Real-world example: The government's Consumption Voucher Scheme in HK was a form of expansionary fiscal policy to boost consumer spending.

Contractionary Fiscal Policy (Hitting the Brakes ブレーキ)

Goal: To cool down the economy when it's overheating and suffering from high inflation.

How it's done:

  • Decrease Government Spending (G ↓) OR
  • Increase Taxes (T ↑)

This often results in a surplus budget.

The Process (using the AD-AS model):

  1. The government cuts spending or raises taxes.
  2. This leads to a decrease in Aggregate Demand (AD).
  3. The AD curve shifts to the left.
  4. Result: The output level decreases and the price level decreases. (Helps control inflation, but risks slowing down the economy).
A Special Case: Same Increase in Spending and Tax

What if the government increases spending AND increases taxes by the exact same amount (a balanced budget change)? You might think the effects cancel out, but they don't!

An equal increase in G and T is still expansionary. This is because every dollar of government spending (G) goes directly into AD. However, when people's taxes go up by a dollar, they don't cut their consumption (C) by a full dollar (they also save less). So, the increase in G has a bigger impact on AD than the decrease in C from higher taxes. The net effect is a small boost to the economy.

Key Takeaways: Fiscal Policy
  • Fiscal policy uses government spending and taxes.
  • Expansionary policy (G↑ or T↓) fights recessions by shifting AD right.
  • Contractionary policy (G↓ or T↑) fights inflation by shifting AD left.
  • Taxes can be direct/indirect and progressive/proportional/regressive.
  • HK uses a territorial source principle for taxation.


Part 2: Monetary Policy (The Central Bank's Toolkit)

What is Monetary Policy?

Monetary Policy is the management of the money supply and interest rates to influence the economy.

Think of it as controlling the amount of water (money) available in the economy's plumbing. More water flowing at low pressure (low interest rate) encourages growth. Less water at high pressure (high interest rate) slows things down.

Who's in charge? Usually, it's the country's Central Bank. In Hong Kong, the Hong Kong Monetary Authority (HKMA) performs many central banking functions.

Using Monetary Policy: Expansionary vs. Contractionary

Just like fiscal policy, monetary policy can be used to speed up or slow down the economy.

Expansionary Monetary Policy (Easy Money 💸)

Goal: To boost the economy during a recession.

How it's done: The central bank acts to increase the money supply, which causes the interest rate to fall.

The Process (using the AD-AS model):

  1. The central bank increases the money supply.
  2. A lower interest rate makes it cheaper for firms to borrow for investment (I) and for consumers to borrow for big purchases (C).
  3. Higher consumption (C) and investment (I) lead to an increase in Aggregate Demand (AD).
  4. The AD curve shifts to the right.
  5. Result: The output level increases and the price level increases.
Contractionary Monetary Policy (Tight Money 🏦)

Goal: To cool down an overheating, inflationary economy.

How it's done: The central bank acts to decrease the money supply, which causes the interest rate to rise.

The Process (using the AD-AS model):

  1. The central bank decreases the money supply.
  2. A higher interest rate makes it more expensive to borrow. Firms cut back on investment (I) and consumers cut back on spending (C).
  3. Lower consumption (C) and investment (I) lead to a decrease in Aggregate Demand (AD).
  4. The AD curve shifts to the left.
  5. Result: The output level decreases and the price level decreases.
Common Mistake Alert!

A very common mistake is confusing fiscal and monetary policy. Remember:

Fiscal = Government (Spending/Taxes)
Monetary = Central Bank (Money Supply/Interest Rates)

Monetary Policy in Hong Kong: A Very Special Case!

This is extremely important for HKDSE students! Hong Kong's monetary policy is unique because of the Linked Exchange Rate System (LERS).

Under the LERS, the Hong Kong dollar is pegged to the US dollar at a fixed rate (around 7.8 HKD = 1 USD). The main goal of the HKMA is not to manage the economy's booms and busts, but to maintain this fixed exchange rate.

What does this mean for HK's monetary policy?

It means Hong Kong cannot have an independent monetary policy. To keep the exchange rate stable, Hong Kong's interest rates must closely follow the interest rates set by the central bank in the United States (the Federal Reserve).

  • If the US raises its interest rates, HK must raise its interest rates too.
  • If the US lowers its interest rates, HK must lower its interest rates too.

So, if Hong Kong is in a recession but the US is worried about inflation and raises interest rates, Hong Kong must also raise interest rates, which could make its own recession worse! This is the trade-off for having a stable exchange rate.

Key Takeaways: Monetary Policy
  • Monetary policy uses money supply and interest rates.
  • Expansionary policy (Money Supply↑ → Interest Rate↓) fights recessions by shifting AD right.
  • Contractionary policy (Money Supply↓ → Interest Rate↑) fights inflation by shifting AD left.
  • CRUCIAL: Due to the Linked Exchange Rate System, Hong Kong gives up its independent monetary policy to maintain a stable exchange rate with the USD. Its interest rates must follow the US.


Final Summary: Fiscal vs. Monetary Policy

| Feature | Fiscal Policy | Monetary Policy | | ------------------- | ------------------------------------------------------------ | --------------------------------------------------------- | | Who controls it? | The Government (e.g., Financial Secretary) | The Central Bank (e.g., HKMA) | | What are the tools? | Government Spending (G) and Taxes (T) | Money Supply and Interest Rates | | Expansionary Action | Increase G, Decrease T | Increase Money Supply → Decrease Interest Rate | | Contractionary Action| Decrease G, Increase T | Decrease Money Supply → Increase Interest Rate | | Effect on AD-AS | Directly affects AD (through G, C, and I) | Affects AD indirectly (through C and I) | | Situation in HK | Government can actively use it (e.g., spending, tax rebates) | Cannot be used independently; must follow US interest rates |

You've made it! This chapter is all about understanding the big levers that control our economy. By knowing the difference between fiscal and monetary policy, you can better understand the economic news and how government decisions affect our daily lives. Keep reviewing the key terms and the AD-AS diagrams, and you'll master this topic!