How Fiscal and Monetary Policy Shape Forex and Stock's Market
Think of a country as a large corporation, with its fiscal policies acting as its budget and monetary policy determined by the company’s financial strategy of controlling interest rates and the money supply. Therefore, both will have direct effects on the company's stock price, i.e. the entire financial market.
Governmental spending fuels growth in GDP. Interest rates set by a central bank determine the cost of borrowing money. Fiscal and monetary policies create the basis of how investors value currencies and equities. Both government and central bank policies drive a shift in capital flows when either the government increases its spending or when the central bank lowers interest rates. This has an immediate effect on the prices of assets, movement in markets and in both financial and commodity markets.
What Is Fiscal Policy and How Does It Move Markets?
Governments utilize fiscal policy in the economy by the means of spending and taxing to control and influence economic activity. When a government decreases taxes and/or increases its spending, this is considered an expansionary fiscal policy. Conversely, contractionary fiscal policy occurs when a government reduces its spending and/or increases taxes.
For example, if your parents suddenly increased your allowance and allowed you to spend more money, you would likely do so. This is an example of expansion; conversely, if your parents reduced your allowance, you would likely begin economizing with your allowance. This is an example of contraction. To a larger extent, the same type of thinking applies to an entire economy.
What is the function of monetary policy
Monetary policy refers to the methods used by central banks to regulate the money supply and influence economic activity. The three main methods that central banks use are interest rates, quantitative easing (QE), and open market operations.
Interest rates represent the cost of borrowing money; when interest rates are low, borrowing can be less costly; this can encourage businesses to borrow capital to invest in their business, and consumers to borrow money to make purchases. Therefore, when interest rates are low, it is similar to when a school sells lunch for less. Conversely, when interest rates are high, this can slow the rate of borrowing and increase the rate of inflation.
How Fiscal and Monetary Policy Drive Inflation
The bridge between policy and the price of assets is Inflation. Both Fiscal Authorities and Monetary Authorities target Inflation because of its effect on Purchasing Power, Interest Rates, and Economic Stability. When governments spend money without increasing taxes, more money is placed into circulation. If the money being spent does not allow for larger quantities of goods and services to be produced, then prices will rise. As an example, consider how a cafeteria may raise its prices each day so that you have to pay more to feed yourself than you would today.
Practical Trading Strategies Based on Policy Trends
Trading has been driven by rising inflation expectations. Traders could short a currency if inflation is rising but the central bank is slow to respond to that inflation. Conversely, if inflation is falling and market participants are anticipating rate cuts from the central bank, shorting the currency is appropriate to capitalize on anticipated currency movement but traders should always be vigilant for signs of potential reversals from these directional moves.
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