FISCAL POLICY

DEFINITION

Fiscal policy can be defined as the policy of the

government regarding changes in taxes, government

spending and government borrowing to affect aggregate

demand in the economy.

A policy under which government uses its expenditure

and revenue program to produce desirable effects and

avoid undesirable effects in the national income,

production and employment.

-Arthur Smith

DIFFERENCE

FISCAL POLICY MONETARY

POLICY• Deals with taxation and

government spendings.

• Deals with money supply.

• Is administered by the

government through

various laws and policies.

• Is controlled by the central

bank (RBI) through

interest rates and lending

rates.

• Measures take time to get

implemented.

• Measures can be

implemented very quickly.

OBJECTIVES

• The main objective of fiscal policy is to control inflation or

deflation in the market i.e. maintaining economic stability.

• It helps in diverting resources from undesirable channels to

desirable channels.

• Helps in achieving welfare objectives i.e. basically to reduce

inequalities between rich and poor and increase welfare.

STANCES OF FISCAL POLICY

• Neutral: This is the equilibrium phase for the economy. In

this case the government spending is entirely funded by tax

revenue and there is no need of borrowing.

• Expansionary: This is the phase where the government

spending exceeds tax revenue. This happens during the

time of recessions.

• Contractionary: This is the phase where the government

spending is lower than tax revenue. This is undertaken to

pay down government debt.

METHODS OF FUNDINGFROM WHERE DOES THE MONEY COME FROM?

• Recovery of loans: The central government grants loans to various

states inside and outside the country. When government recovers

these loans the government gets more money that it can now

utilize for the welfare.

• Disinvestment: Government holds equity or shares of the public

sector enterprises. It can raise funds by selling its holding in the

market. It leads to reduction in assets held by the government.

• Borrowings: It basically means that the government is

borrowing money from various institutions be it inside or

outside the country.

The government may choose to borrow funds from public

by issuing bonds or treasury bills. The government can also

borrow funds from financial institutions like world bank or

any other country.

• Taxes: The most effective way for the government is to

increase tax rates or impose new taxes.

INSTRUMENTS OF FISCAL POLICY

•Budgetary surplus and deficit

•Government expenditure

•Public debt

•Taxation

PUBLIC DEBT

• Public debt refers to borrowing by a government from within

the country or from abroad, from private individuals or

association of individuals or from banking and NBFIs.

It can be classified in three ways:

i. Internal and external

ii. Productive and unproductive

iii.Short term and long term

• Internal public debt: When the government borrows from

within the country be it from the citizens or financial institutions

or the central bank.

• This is called internal borrowing.

•External public debt: When the government borrows funds

from international market be it any financial institutions or any

nation in particular.

• Acquiring loan from outside is comparatively difficult as the other

party first studies the financial position of the country and then

only grants a loan.

•Productive debt: The debt that is expected to create

assets which will yield income sufficient to pay the principal

amount and the interest on it, is known as ‘productive debt’.

• In other words, they are expected pay their way, they are self-

liquidating.

•Unproductive Debt: On the other hand, unproductive

debt is the debt that is raised for financing unproductive

assets or heavy unproductive expenditures.

• Such a debt is a deadweight debt.

•Short Term Loan: The loans which are to be repaid

within a period of one year.

The loan provided usually is for a limited amount.

It is used to fulfil short term needs of the government.

•Long Term Loan : The loans which are to be repaid after

a period of one year.

The loan provided here can be for a huge amount.

It is very helpful for long term projects.

TAXATION

• Tax is a legal compulsory payment paid to the government

by the people.

• It is the most common and effective way for the

government to influence the aggregate demand in the

economy.

• There are two types of taxes

i. Direct Tax

ii. Indirect Tax

•Direct Tax: It is the tax where the liability to pay

and the incidence lie on the same person.

example: income tax, corporate tax, property tax etc.

•Indirect Tax: When the liability to pay and the

incidence of the tax lie on a different person.

example: sales tax, VAT, service tax etc.

• During the time of inflation (when aggregate

demand is more than aggregate supply) the

government increases the tax rates and may also

impose new tax rates.

• This would result in reduction in the money

supply in the economy and will control the

inflationary gap.

•During the time of deflation (when aggregate

demand is less than aggregate supply) the

government reduces the tax rates and may also

cut of some taxes temporarily.

•This would result in an increase in the money

supply in the economy and will control the

deflationary gap.

BUDGETARY SURPLUS

• It is a situation where the revenue earned by government

is more than the expenditure.

• The surplus amount is used for repayment of loans or can

be kept as a reserve for the future.

• It can also be used to make desired purchases that were

delayed and for the development of the economy.

• It is a sign that the government is running the economy

efficiently.

BUDGETARY DEFICIT

• It is a situation where the revenue earned by the

government is less than its expenditure.

• At this time the government reduces its expenditure on

public welfare, increases tax rates and may also opt for

borrowings.

• The surplus from previous years can be used.

• It is a sign that the government is not running

efficiently.

GOVERNMENT EXPENDITURE

• During the time of inflation the government decides

to reduce its expenditure on public welfare like

police, military, courts, education etc.

• This results in the fall of aggregate demand.

• Which leads to reduction in the inflationary gap.

• At the time of deflation (when aggregate demand is

less than aggregate supply) the government decides

to increase its expenditure for the welfare of the

people.

• This injects money in the economy and helps remove

unemployment and increases the aggregate demand.

• It leads to reduction in deflationary gap.

FISCAL STRAITJACKET

• The concept of a fiscal straitjacket is a general

economic principle that suggests strict constraints on

government spending and public sector borrowing, to

limit or regulate the budget deficit over a time period.

• This term originated from the definition of straitjacket

(anything that severely confines, constricts, or hinders).

• Various states in the United States have various forms

of self-imposed fiscal straitjackets.

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