Question

Present a thorough analysis of fiscal policy. Detail the effects of discretionary fiscal policies, the various policy levers, the impact of crowding out, time lags, and automatic stabilizer. Please cite sources!

Answer 1

Solution:-

Fiscal policy is the policy used by government of any country to increase aggregate output during recession and to reduce output during boom.

Discretionary fiscal policy is is the policy used by government to acheive some macroeconomic goals such as economic growth, price stability etc through changes in government expenditure and tax rates. Where as, automatic stabilizers are those that reduces fluctuations in output and prices automatically. But discretionary policy is difficult because there are lags during the occuring of event and its actual impact on the economy. This is because fiscal policy requires legislative changes, which take a whole lot of time to implement. An expansionary fiscal policy is used when economy is in recession through increase in government spending and reduction in tax rates. This policy has advantage over the monetary policy because once implemented it will lead to immediate inrease in output. However, the effect of a cut in tax may be more moderate and have bigger time lags. This is because individuals may not spend the inrease their disposable income immediately resulting from tax cut.

Following are the Various components of fiscal policy of the government:

1. Taxes- Tax is a compulsory payment made to the government by the households and the producing sector. By increasing the tax rate on the households and the producers, the government reduces purchasing power in the economy and takes a step towards the correction of the excess demand or inflationary gap. On the other hand, to correct deficient demand or deflationary gap, the government lowers the tax burden and increases the purchasing power in the economy.

2. Public borrowing/public debt/borrowing from the public through issue of treasury bills to the public- By borrowings from the public, the government creates public debt in a situation of deficient demand, government reduces it's borrowings from the public so that the public are left with greater liquidity or cash balances and accordingly, the problem of deficient demand will be combated. On the other hand, in a situation of excess demand, government increases its public borrowings by offering the public an attractive rate of interest. This reduces liquidity with the people and accordingly, the problem of inflationary gap is combated.

3. Government expenditures- The government of a country incurres various kinds of expenditures, namely:

(a) Expenditure on education and public welfare programmes.

(b) Expenditure on defence of the company and maintainance of law and order.

(c) Expenditure on public works programmes such as construction of roads, bridges, dams, etc.

(d) Expenditure on providing subsidies to the producers with a view to encourage production.

When there is excess demand, government expenditure is reduced and when there is deficient demand, government expenditure is increased.

4. Deficient financing i.e. printing of new notes by RBI/borrowings from RBI/central bank by the government- This instrument of fiscal policy is used only under Deflationary gap when circulation of money is to be increased in the economy and for that purpose government borrows from RBI by way of printing of new notes. This instrument is never used under inflationary gap because under inflationary gap, the circulation of money is already higher in the economy and printing new notes would further worsen the situation of inflationary gap. Whenever RBI prints new notes, it is always given to the government as a loan which the government would repay to the central bank after a specified period of time.