How Fiscal Policy Impacts Loan Interest Rates

Last Updated: 11 Oct 2024

Fiscal policy is concerned with the revenues and expenditures of the government. It is therefore also concerned with taxation. This is different from monetary policy. Monetary policy is conducted by central banks. It is concerned with demand and supply of money.

When a government wants to give a boost to the economy it opts for a more expansionary fiscal policy. It increases its expenditures. The GDP of a country is made of 4 components. These are Private Consumption, Government Expenditure, Private Investment, and Net Exports. So any change in government expenditure also affects the GDP and its growth. A higher government expenditure can increase GDP growth, keeping other things equal. A lower government expenditure can lower GDP growth. But things are, in reality, not that simple.

When government increases its expenditures, it also tries to raise more revenues for itself. This it does by raising taxes or by borrowing more. When government borrows more from the market, interest rate goes up for private borrowers. For example, an NBFC that borrows from the market through commercial papers, to give loans to its customers, may have to pay a higher interest rate because of more government borrowing. This happens because with more government borrowing, demand for credit increases. So interest rate goes up both for the government and private borrowers. Now the NBFC which gives its customers gold loans or business loans may have to increase the interest rate on the loans that it gives because it too is now paying higher interest rate on its borrowings.

The opposite happens when the government follows a contractionary fiscal policy. It reduces its expenditures in a contractionary fiscal policy. Governments follow contractionary fiscal policy in order to cut down their fiscal deficit. Fiscal deficit happens when the expenditures of the government are more than its revenues. Now when the government cuts down its expenditures and fiscal deficit, it also needs to borrow less from the market. This in turn has the effect of bringing down interest rates.

So the interest that you pay on your gold loan, business loan, personal loan etc. all get impacted by the fiscal policy too. It is not just the monetary policy that affects interest rates. The impact of monetary policy on interest rates is more direct, while that of the fiscal policy can be more indirect.