UNIT 2

TOPIC 1: FISCAL POLICY

Concept:
• Fiscal Policy refers to the government’s actions affecting its receipts and expenditures.
When we talk about government’s earnings and spending – we are talking about the
fiscal policy.
• It primarily concerns with the flow of funds. Incoming of funds – public receipts and
outgoing of funds – public expenditure.
• This fiscal policy of the government (that is inflow and outflow of funds in the form of
public revenue and public expenditure) directly affects the variables in the economy,
i.e., volume of output, income, and employment in the economy.
• This policy is adopted to stabilise things in the economy. To keep the economy under
control. So that depression can be wiped out or inflation can be reduced.

Broad Objectives of Fiscal Policy

The broad objectives of fiscal policy in any type of economy are
1. Economic Growth: By increasing national income etc.
2. Full Employment: Full employment is not an ordinary situation but any economy aims at
full employment.
3. Prize Stability: Prices of goods and services fluctuate a lot in the market because of which
the other variables in the economy (like output, income, employment) may change and to
control that FP can be adopted.
4. Social Justice: SJ means that each and every section of the society get adequate income,
have adequate sources of livelihood, their standard of living increases and their quality of life
also increases so that we have economic development in real sense.
Economic growth occurs only when the income of the country increases but that doesn’t
ensure increased standard of living for all individuals in the economy. Economic development
relates to the overall growth of income of all the individuals in the economy. Not just income
growth but also the quality of life, i.e., people get adequate housing, adequate food, adequate
hygiene facilities, sanitation and also their quality of life is enhanced, that is called inclusive
growth. So, social justice brings in inclusive growth in the economy. Primarily these are the
basic or broad objectives of fiscal policy that are there in any type of economy. But the fiscal
policy also has certain specific objectives related to underdeveloped or developing
economies.

Fiscal policy that is followed by the government also has certain objectives in such types of
economies.
OBJECTIVES IN UDE (Under Developed Economies):
1. Maximising the level of aggregate savings:
The fiscal policy aims to increase the level of savings in the economy, but increasing
the level of savings does not mean decreasing for reducing the demand in the
economy. Maximising the level of aggregate savings means that fiscal policy curbs
conspicuous consumption (means the unnecessary consumption which is happening
in some commodities - which can be avoided and it can be directed towards some
other commodities so fiscal policy aims to reduce that type of consumption).
So if suppose there is unnecessary purchasing speculation activity in the economy,
unnecessary buying of luxurious goods or jewelleries etc. - so according to the
demands of the economy, the fiscal policy aims at reducing such type of conspicuous
consumption and increasing the level of aggregate savings. This increasing the level of
aggregate savings is important because we know that if savings increase there will be
increase in the money with the banks and financial institutions and this money with
the banks and financial institutions forms the base of loans or funds that are going to
the producers for investment purposes. So if the savings increase - the investment
also increases. And we all know investment in goods and services always leads to the
economic growth and development of the economy.

2. Maximising the rate of capital formation:

This point is the related to the first point - when aggregate savings increase the
investment increases and when the investment increases - the rate of capital
formation increases because investment is related to capital stock in the economy.
We know that investment is related to the increase in capital stock of the economy.
Investment is a flow concept (that is, it is over a period of time) and capital is when
investment is done to produce the capital goods - whatever amount of machinery
plant and equipment are produced they are the capital stock of the economy. This
capital stock of the economy increases the production of consumer goods in the
economy which caters to the demand of the public. So this capital formation is
important, and fiscal policy aims to increase this capital formation in the economy so
as to break the economic stagnation. If capital formation becomes standstill, the
economy will also become standstill because there will be no further production - if
there will be no further production - there will be no employment, no income, no
demand etc., therefore capital permission is important.

3. Diversion of resources from less productive to more productive uses:

Since resources are scarce in the economy they have to be allocated properly in an
efficient manner for production of the commodity which is needed in the economy.
But sometimes it happens that these resources, especially the financial capital, are
diverted to less productive uses. There may be certain things in the economy which
are not that much productive but the resources are diverted for production of those
commodities ignoring the production of the more productive commodities.
So in this situation, fiscal policy is adopted to divert the resources from less productive
to more desirable uses of the resources.
 4. Curbs the inflationary pressures in the economy:
We all know that when inflation increases or when there is hyperinflation, galloping
inflation etc., it is detrimental to the economy. Hence, to curb the inflationary
pressures - fiscal policy is adopted.

5. Eliminate sectoral imbalances:

So, in any under developed economy we see that there may be in-balances in the
economy, that is, the dis-balance growth of the regions in the economy.
So, in such economies it is seen that some regions are very much developed and some
regions remain underdeveloped. But for overall growth of the economy, balanced
regional development is very important. So government adopts fiscal policy to
increase the development in particular regions which remain underdeveloped and to
reduce the amount of expenditure in already developed regions. So, to create balance
in the economy, fiscal policy is adopted for the balanced regional development.
6. Encouraging high employment potential industries:
Full employment is not a normal phenomenon. Normally we have underemployment
situation. So to reduce the unemployment in the economy (that is to increase the
employment in the economy) we need industries which have high employment
potential. We need those industries which absorb more and more labor. So there are
certain specific industries which have high employment potential, meaning to say that
the production pattern in such industries is such that they absorb more and more
labor. So it is always advised to increase the growth rate of such type of high
employment potential industries. So through the fiscal policy of the government, the
government encourages such type of industries so that the growth in such type of
industries increases and it employees more and more labor.
7. Eliminate glaring inequalities of income:
The imbalances in various regions is because there are glaring inequalities of income
distribution. Certain category of people remain below poverty line or their income
levels are very low. So even if economic growth is taking place, even if the growth rate
of GDP is very high, but still certain sections of the society still remain in the destitute
of poverty.
This is glaring inequality of income - that is certain sections of the society are getting
high income whereas the other sections of the society are not even getting the bare
minimum necessities of food clothing and shelter. So fiscal policy is adopted to remove
these inequalities of income and the tools of the fiscal policy in the form of public
expenditure and public revenue is adopted to eliminate these clearing inequalities of
income distribution.

TOOLS OF FISCAL POLICY:

These tools are adopted to curb the inflationary and the depression situation in the
economy.
1. GOVERNMENT/PUBLIC REVENUES:
2. GOVERNMENT/PUBLIC EXPENDITURE:
3. PUBLIC BORROWINGS:
FISCAL POLICY DURING DEPRESSION:

1. INCREASE GOVERNMENT EXPENDITURE:

Suppose this is a depression time, so the tool of government expenditure is used to
remove this depression situation in the economy.

What is depression situation? Depression is a time when:

The demand is less - demand is less because income is less – income is less because
employment is less – employment is less because investment is less - investment is
less because the chances of profit in the economy are less - chances of profit in the
economy are less because demand is less.

We know that these variables are related to each other - so that if one variable falls
all other variables start falling and that is where depression sets in.
So depression is a time when there is a lull in the economy. So the government needs
to increase the economic activity.

We know that when there is a gap between consumption and income – the gap has
to be removed through investment but the time of depression is such that since there
are lesser chances, less demand and less opportunities of getting profits - the private
investment is not forthcoming during the time of depression because the private
investors wish to see chances of profit in in the market which is absent.
So at such time the government has to increase its expenditure. The government can
increase its expenditure on the public welfare programmes - by building roads, dams,
rural electrification, artificial irrigation for the rural areas, for the agriculture etc.
So when government increases its expenditure to public welfare programme – it
employs all the factors of production - so that the employment increases - it increases
the income - it increases demand - when demand for consumption goods increases -
it brings in induced investment by the private sector and hence the private sector also
starts investing - when it starts investing then it hires the factors of production so that
employment increases - income increases - profits increase and so on. The economy
starts moving in the upward direction, that is from depression now it starts moving to
the path of recovery. That is why increasing government expenditure is important.
Also the government buys various types of goods and services from private producers
or farmers etc. so that they also get some income. So this is how the government
increases its expenditure.

2. REDUCE TAXES
Second tool which the government adopts during depression is reducing the amount
of taxes. Why reducing the amount of taxes? Because the government wants to
increase the demand in the economy. The crux is the demand during depression. So
then how demand can be increased? When the people have more purchasing power
in their hands and this can be done by reducing the taxes. If taxes are on a higher side,
people will have less purchasing power with them - their income will be reduced so
when the income is reduced obviously the demand will get reduced. So the
 government has to somehow increase their demand - the government can do this by
reducing the amount of taxes - income tax, corporate tax etc. can be reduced. So what
happens is that the purchasing power with the public increases and hence there is
increased demand.

3. Reduce public borrowing:

Public borrowing means - when the government borrows money from the public.
The government borrows money for going on with its government expenditure
programmes because at time public revenue is not sufficient to cater to all the
expenditure demands of the government and hence the government also borrows
from the public. But this borrowing from the public has the effect of reducing the
purchasing power from the public. Because suppose people have savings - they will
invest these savings or they will give the savings to the government - obviously they
will get a rate of exchange but still for some time they will have reduced money in
their hands from which they can create the demand. Since the government wants to
increase demand, it reduces the amount of money which it is borrowing from the
public or it may also repay the past public debt. So, if in the past, the government has
borrowed money from the public - it can repay those past debt. So by repaying those
past debts, people have money in their hands and that is what government wants to
do, it wants to increase the purchasing power with the public so that it increases
demand.

So this is how the three tools of fiscal policies are adopted to fight depression.

FISCAL POLICY DURNG INFLATION:

1. REDUCING GOVERNMENT EXPENDITURE:

During inflation, there is boom period. In boom period there is increased demand -
since there is increased demand there is increased opportunities of profit which leads
to increased investment, increased employment, increased income, increased profits
and hence, increased prices.

So when the prices start increasing - it is inflationary time. Although in such time the
demand and profits are high - but somehow since the prices are increasing manifold
as compared to the increase in income and that is when demand starts reducing
because rising income is not able to match the rising prices.

So at such time, demand starts falling and when demand starts falling - all the other
economic variable also fall. So such type of galloping inflation has to be removed for
which fiscal policy is adopted but in a reverse manner, counter to what it followed
during the time of depression. So, in inflation the government reduces its expenditure
program.
But for government it is not very easy to reduce the expenditure because government
expenditure is done on important items like public welfare programs which cannot be
reduced just because government wants to reduce expenditure. But government can
reduce its expenditure by controlling its expenditure on unproductive heads
 (subsidies, transfer payments etc). But still transfer payments in the form of pension,
unemployment allowances or any other types of allowances are important. Subsidies
are also given for increasing investment etc., but during galloping inflation these
things may be reduced or they may be suspended for that period of time. They cannot
be suspended altogether, but for that much period of time these can be suspended
and the unproductive head other unproductive adds can be reduced.

2. INCREASING TAXES:

During inflation, the purchasing power with the public has to be reduced because the
demand is on a higher side and the prices are increasing. So, somehow this demand
has to be reduced and this can be reduced by reducing the purchasing power with the
public. This can be done by increasing the amount of taxes in the economy - so tax
rates are increased on income tax, corporate tax or the number of indirect taxes on
commodities, on production, on other types of customs duties, the indirect taxes GST
etc are increased, their rates are increased so that people have lesser purchasing
power - so they create lesser demand.

3. INCREASING PUBLIC BORROWINGS

So government would start taking money from the public by floating its various saving
schemes etc. So, the government will start its borrowing programs and the purchasing
power will move from public to the government so that again there is reduce
purchasing power with the public.

So, this is how the three tools of fiscal policy are adopted to control inflation. They are
in the reverse direction as compared to the fiscal policy during depression.

TYPES OF FISCAL POLICY

1. Pump priming fiscal policy (to stimulate private spending):
The pump priming fiscal policy relates to the initial public expenditure which is done
to initiate and revive the economic activity. During the time of depression, the
economic activity is on a lull. To revive this economic activity, some amount of initial
public expenditure is required to stimulate the private spending because at such time
the private producers are also not investing because they are not seeing opportunities
of profit. So to induce them to invest - some amount of initial public expenditure or
initial level of expenditure program has to be there. So the government increases the
expenditure so as to induce the private investment in the economy and hence overall
system in the economy moves to the recovery path. So the objective of pump priming
fiscal policy is to stimulate the private spending in the economy.

2. Compensatory fiscal policy:

It refers to that government expenditure program that is undertaken with a set idea
of making a compensation for the decline in public works.
 So at times the government aims to have a certain set level of public expenditure, i.e.
when the government comes up with the budget every year - the government aims to
do this much amount of expenditure. So it aims to spend such and such amount of
money on various heads but at times it happens that it is lagging behind with its
targeted public expenditure program.
So to compensate for that, the government introduces this compensatory fiscal policy.
The thing which the government does is the same i.e., it will increase the public
expenditure through increasing the public welfare program in both the pump priming
and in compensatory. Only the names are different just to show the intention with
which the government is going up with the expenditure program. When it is done to
stimulate private spending it is called pump priming fiscal policy and when it is done
to compensate the decline in public works it is known as compensatory fiscal policy.
No other difference is there. The thing that the government will do with the public
expenditure programs is the same that is spending on public works, social security
measures etc., so that is the same only the names are different according to the
intention with which the government is starting with the program.

GOVERNMENT BUDGET