Fiscal Policy

Instrument of Fiscal Policy & How it Helps in Stability & Growth?

What is Fiscal Policy?

Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP. It refers to the Revenue and Expenditure policy of the Govt. which is generally used to cure recession and maintain economic stability in the country.

Government in the Economy

Nothing arouses as much controversy as the role of government in the economy. Government can affect the macroeconomy in three ways:

Fiscal policy Monetary policy Discretionary fiscal policy

Government in the Economy

The government can not control certain aspects of the economy related to fiscal policy. For example:

The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits. Government spending depends on government decisions and the state of the economy.

Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income

When government enters the picture, the aggregate income identity gets cut into three pieces:

Yd Y T

Yd C S

Y T C S Y C S T
And aggregate expenditure (AE) equals:

AE C I G

The Budget Deficit

A governments budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:

Budget deficit G T
If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

The Great Depression and World War II

Three developments bolstered the use of fiscal policy

The publication of Keynes General Theory War-time demand on production helped pull the U.S. out of the Great Depression The Full Employment Act of 1946, which gave the federal government responsibility for promoting full employment and price stability

The Economys Influence on the Government Budget

Fiscal drag is the negative

effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

The Federal Budget

The federal budget is the budget of the federal government. The difference between the federal governments receipts and its expenditures is the federal surplus (+)

or deficit (-).

Deficits and Interest Rates

Financing Deficits

Taxes Bonds (borrowing) Printing Money

Ricardian Equivalence

The Federal Deficit Versus the National Debt

The federal deficit is a flow variable measuring the amount by which expenditures exceed revenues in a particular year The national debt is a stock variable measuring the accumulation of past deficits In the U.S., it took 200 years for the national debt to reach $1 trillion

After the debt reached this level, it took only 15 years for the debt to reach the $5 trillion level

Reducing the Deficit

Line-item veto (signed into law in April 1996 struck by the Supreme Court in 1998)

A provision to allow the president to reject particular portions of the budget rather than simply accept or reject the entire budget

Balanced budget amendment

Proposed amendment to the U.S. Constitution requiring a balanced federal budget

The Economys Influence on the Government Budget

Automatic stabilizers are

revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.

The Budget Deficits of the 1980s and 1990s

The tax cuts of the early 1980s together with large increases government spending caused the annual government deficit and the national debt to grow significantly Although both fiscal policy measures stimulated the economy, the resulting tax revenues were not sufficient to manage the large government deficits

Fiscal Policy and the Natural Rate of Unemployment

If there is a natural rate of unemployment, fiscal policy that increases aggregate demand will appear to succeed in the short run because output and employment will both expand But stimulating aggregate demand will, in the long run, result only in a higher price level, while the level of output will fall back to the economys potential

Feedback Effects of Fiscal Policy on Aggregate Supply

Both automatic stabilizers and discretionary fiscal policy may affect individual incentives to work spend, save, and invest, though these effects are usually unintended

Appendix B: The Case In Which Tax Revenues Depend on Y C I G Income

T T0 tY
Yd Y T

T 200 1 3Y

Appendix B: The Case In Which Tax Revenues Depend on Income

Yd Y T
T 200 1 3Y Yd Y (200 1 3Y )
Yd Y 200 1 3Y )
C a bYd
C 100 .75(Y 200 1 3Y )

Y C I G
I 100 G 100

Y 900

A Contractionary Gap Can be Closed by Expansionary Fiscal Policy

Price Level
Potential output

SRAS

AD* AD
contractionary gap Real GDP

An Expansionary Gap Can be Closed by Contractionary Fiscal Policy

Price Level
Potential output

SRAS

AD* AD
expansionary gap Real GDP

The Leakages/Injections Approach

Taxes (T) are a leakage from the flow of income. Saving (S) is also a leakage. In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically,

C S T C I G S T I G

Y C S T

AE C I G

Instruments of Fiscal Policy

1. Reduction of Govt. Expenditure 2. Increase in Taxation 3. Imposition of new Taxes 4. Wage Control 5.Rationing 6. Public Debt 7. Increase in savings 8. Maintaining Surplus Budget

Fiscal Consolidation

Kishors part

Challenges and Issues

How to garner political will for enhanced resource mobilisation? Surge in Commodity Prices Challenge and an opportunity How to build national consensus on propoor spending? How to increase efficiency of expenditure? Fiscal Decentralisation can it be a solution? Evidence is mixed