Question

Two policies that can correct the situation are- Fiscal policy and Monetary Policy. (Fill the following table showing at-leasttwo difference between the two. You can tell more than two differences also.)

Difference	Fiscal Policy	Monetary Policy
1
2

Fiscal Policy: There are two types of Fiscal policies: Expansionary fiscal policy and contractionary fiscal policy.

Key-Questions:

1. Explain each of the key terms in not more than one or two sentences (give formula or examples whichever is applicable):

(a) Expenditure multiplier (b) transfer-payments (c) tax multiplier

2. Discuss about the impact of each policy on aggregate demand and inflation with suitable explanation and example.

3. Give a graphical explanation of the working of the policy.

Answer 1

Difference fiscal policy/ monetary policy

• Fiscal policy changes government spending and tax rates whereas monetary policy changes interest rates/money supply.
• Fiscal policy is set by the government whereas monetary policy is set by the central bank.

key questions

• Expenditure multiplier:‐ A simple expenditure multiplier is the inverse of one minus marginal propensity to consumer ( mpc). Expenditure multiplier =1/(1—mpc) =1/maps
• Transfer payments:— Transfer payments are like negative taxes. It is tranfered to individuals for social security, vetrans etc. It is not included in the GDP of the country because it is not given for rendering active productive services.
• Tax multiplier:— A tax has negative effect on consumption expenditures. So it reduces aggregate demand by reducing consumption. A tax multiplier is the negative ratio between mpc and mps . Tax multiplier = — mpc/mps

​​​​​​​2 In case of inflation a contractionary fiscal policy is set. In the period of inflation we know that aggregate demand for goods and services exceeds aggregate supply of output at the full employment. So to curve the inflation in the economy aggregate demand is to be reduced. For this government spending and transfer payments should be decreased ,and the tax rate should be increased. A increase in tax rates and decrease in the transfer payments indirectly reduce the aggregate expenditure via reduction in the consumption expenditures where as a decrease in the government spending directly reduces the aggregate expenditures.

In the above diagram aggregate demand exceeds aggregate supply of output corresponding to full employment of resources, so excess aggregate demand causes inflation in the economy. Aggregate demand is to be reduced through reduction in either of its components. So that aggregate demand curve shifts inward eliminating excess aggregate demand .