FISCAL POLICY.docx

Fiscal policy deals with the taxation and expenditure decisions of the
government. Some of the major instruments of fiscal policy are as
follows: Budget, Taxation, Public Expenditure, public revenue, Public
Debt, and Fiscal Deficit in the economy.The fiscal policy is concerned with the raising
of government revenue and Government Budget increasing expenditure. To generate revenue
and to increase expenditures, the government finance or policy called Budgeting policy or fiscal
policy. The major fiscal measures are:
1. Public Expenditure – Government spends money on a wide variety of things,
from the military and police to services like education and health care, as well as
transfer payments such as welfare benefits.
2. Taxation – Government imposes new taxes and change the rate of current taxes.
The expenditure of government is funded by the imposition of taxes.
3. Public Borrowing – Government also raises money from the population or from
abroad through bonds, NSC, Kisan Vikas Patra, etc. 4. Other Measure – Other
measures adopted by the government are:
(a) Rationing and price control
(b) Regulation of wages
(c) Increase the production of goods and services.
Difference between fiscal and monetary policy
(Source: economicshelp.org)
Types of fiscal policy

(Source of infographic: freepik)
Objectives of Fiscal policy
 To promote economic growth: Government promotes economic growth by setting
up basic and heavy industries like steel, chemical, fertilizers, machine tools, etc. It
also builds infrastructure like roads, canals, railways, airports, education and health
services, water and electricity supply, telecommunications, etc. that foster economic
growth. Both basic and heavy industries and infrastructure require huge amount of
investment which normally the private sector does not take up. Since these industries
and infrastructure facilities are essential for economic growth in the country, the
burden to set up and develop them falls on the government.
 To reduce income and wealth inequalities: Government reduces inequalities in
income and wealth by taxing the rich more and spending more on the poor. Further, it
provides for the employment opportunities to poor that help them to earn.
 To provide employment opportunities: Employment opportunities are increased by
the government in various ways, One, jobs are created when it sets up public sector
enterprises. Two, it provides subsidies and other incentives like tax holidays, low
rates of taxes etc. to private sector that encourage production and employment. It
also encourages setting up of small scale, cottage and village industries by people
which are employment oriented. This it does by providing them tax concessions,
subsidies, grants, loans at low rates of interest, etc. Finally, it creates jobs for poor
when it undertakes public works programmes like construction of roads, bridges,
canals, buildings, etc.
 To ensure stability in prices: Government ensures stability of prices of essential
goods and services by regulating their supplies. Hence, it incurs expenditure on ration
and fair price shops that keep sufficient stock of food grains. If also subsidizes
cooking gas, electricity, water and essential services like transport and maintains
their prices at low level affordable to the common man.
 To correct balance of payments deficit: The balance of payments account of a
country records its receipts and payment with foreign countries. When payments to

foreigners are more than receipts from foreigners, the balance of payments account is
said to be in deficit. Quite often this deficit is caused when a country imports more
than it exports. Consequently, the payments on imports to foreigners are more than
the receipts from exports. In such a situation, to reduce the deficit in balance of
payment account, the government discourages imports by increasing taxes on them
and encourages exports by increasing subsidies and other export incentives.
However, it should be noted that tax on import is not a popular measure now as it is
treated as an obstacle to free flow of goods and services between countries.
 To provide for effective administration: Government incurs expenditures on police,
defence, legislatures, judiciary, etc. to provide effective administration.
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 HEMANT SINGH
 CREATED ON: FEB 26, 2018 21:06 IST
MODIFIED ON: FEB 25, 2018 21:13 IST
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 Fiscal policy means the use of taxation and public expenditure
by the government for stabilization or growth of the
economy. According to Culbarston, “By fiscal policy we refer to
government actions affecting its receipts and expenditures which
ordinarily as measured by the government’s receipts, its surplus or
deficit.” The government may change undesirable variations in private
consumption and investment by compensatory variations of public
expenditures and taxes.
 Fiscal policy also feeds into economic trends and influences monetary
policy. When the government receives more than it spends, it
has a surplus. If the government spends more than it receives it runs
a deficit. To meet the additional expenditures, it needs to borrow from
domestic or foreign sources, draw upon its foreign exchange reserves
or print an equivalent amount of money. This tends to influence other
economic variables.

On a broad generalization, excessive printing of money leads to
inflation. If the government borrows too much from abroad it leads to a
debt crisis. Excessive domestic borrowing by the government may lead to
higher real interest rates and the domestic private sector being unable to
access funds resulting in the “crowding out” of private investment. So it
can be said that the fiscal deficit can be like a double edge sword, which
need to be tackled very carefully.
Main Objectives of Fiscal Policy in India
Before moving on the discussion on objectives of India’s Fiscal Policies,
firstly know that the general objective of Fiscal Policy.
 General objectives of Fiscal Policy are given below:
 1. To maintain and achieve full employment.
 2. To stabilize the price level.
 3. To stabilize the growth rate of the economy.
 4. To maintain equilibrium in the Balance of Payments.
 5. To promote the economic development of underdeveloped
countries.
Fiscal policy of India always has two objectives, namely improving the
growth performance of the economy and ensuring social justice to the
people.
 The fiscal policy is designed to achieve certain objectives as
follows:-
 1. Development by effective Mobilisation of Resources: The
principal objective of fiscal policy is to ensure rapid economic growth
and development. This objective of economic growth and development
can be achieved by Mobilisation of Financial Resources. The central and
state governments in India have used fiscal policy to mobilise
resources.
 The financial resources can be mobilised by:-
 a. Taxation: Through effective fiscal policies, the government aims to
mobilise resources by way of direct taxes as well as indirect taxes
because most important source of resource mobilisation in India is
taxation.
 b. Public Savings: The resources can be mobilised through public
savings by reducing government expenditure and increasing surpluses
of public sector enterprises.
 c. Private Savings: Through effective fiscal measures such as tax
benefits, the government can raise resources from private sector and
households. Resources can be mobilised through government
borrowings by ways of treasury bills, issuance of government bonds,
etc., loans from domestic and foreign parties and by deficit financing.
 2. Reduction in inequalities of Income and Wealth: Fiscal policy
aims at achieving equity or social justice by reducing income
inequalities among different sections of the society. The direct taxes

such as income tax are charged more on the rich people as compared
to lower income groups. Indirect taxes are also more in the case of
semi-luxury and luxury items which are mostly consumed by the upper
middle class and the upper class. The government invests a significant
proportion of its tax revenue in the implementation of Poverty
Alleviation Programmes to improve the conditions of poor people in
society.
 3. Price Stability and Control of Inflation: One of the main
objectives of fiscal policy is to control inflation and stabilize price.
Therefore, the government always aims to control the inflation by
reducing fiscal deficits, introducing tax savings schemes, productive
use of financial resources, etc.
 4. Employment Generation: The government is making every
possible effort to increase employment in the country through effective
fiscal measures. Investment in infrastructure has resulted in direct and
indirect employment. Lower taxes and duties on small-scale
industrial (SSI) units encourage more investment and consequently
generate more employment. Various rural employment programmes
have been undertaken by the Government of India to solve problems
in rural areas. Similarly, self employment scheme is taken to provide
employment to technically qualified persons in the urban areas.
 5. Balanced Regional Development: there are various projects like
building up dams on rivers, electricity, schools, roads, industrial
projects etc run by the government to mitigate the regional imbalances
in the country. This is done with the help of public expenditure.
 6. Reducing the Deficit in the Balance of Payment: some time
government gives export incentives to the exporters to boost up the
export from the country. In the same way import curbing measures
are also adopted to check import. Hence the combine impact of these
measures is improvement in the balance of payment of the country.
7. Increases National Income: it’s the strength of the fiscal policy
that is brings out the desired results in the economy. When the
government want to increase the income of the country then it
increases the direct and indirect taxes rates in the country. There are
some other measures like: reduction in tax rate so that more peoples
get motivated to deposit actual tax.
8. Development of Infrastructure: when the government of the
concerned country spends money on the projects like railways,
schools, dams, electricity, roads etc to increase the welfare of the
citizens, it improves the infrastructure of the country. A improved
infrastructure is the key to further speed up the economic growth of
the country.
9. Foreign Exchange Earnings: when the central government of the
country gives incentives like, exemption in custom duty, concession in

excise duty while producing things in the domestic markets, it
motivates the foreign investors to increase the investment in the
domestic country.
Fiscal policy means the use of taxation and public expenditure by
the government for stabilisation or growth. According to
Culbarston, “By fiscal policy we refer to government actions
affecting its receipts and expenditures which we ordinarily taken as
measured by the government’s receipts, its surplus or deficit.” The
government may offset undesirable variations in private
consumption and investment by compensatory variations of public
expenditures and taxes.
ADVERTISEMENTS:
Arthur Smithies defines fiscal policy as “a policy under which the
government uses its expenditure and revenue programmes to
produce desirable effects and avoid undesirable effects on the
national income, production and employment.” Though the
ultimate aim of fiscal policy in the long-run stabilisation of the
economy, yet it can be achieved by moderating short-run economic
fluctuations. In this context, Otto Eckstein defines fiscal policy as
“changes in taxes and expenditures which aim at short-run goals of
full employment and price-level stability.”
2. Objectives of Fiscal Policy
The following are the objectives of fiscal policy:
ADVERTISEMENTS:
1. To maintain and achieve full employment.

2. To stabilise the price level.
3. To stabilise the growth rate of the economy.
4. To maintain equilibrium in the balance of payments.
ADVERTISEMENTS:
5. To promote the economic development of underdeveloped
countries.
3. Fiscal Policy for Economic Growth
The role of fiscal policy for economic growth relates to the
stabilisation of the rate of growth of an advanced country. Fiscal
policy through variations in government expenditure and taxation
profoundly affects national income, employment, output and prices.
An increase in public expenditure during depression adds to the
aggregate demand for goods and services and leads to a large
increase in income via the multiplier process; while a reduction in
taxes has the effect of raising disposable income thereby increasing
consumption and investment expenditure of the people.
On the other hand, a reduction of public expenditure during
inflation reduces aggregate demand, national income, employment,
output and prices; while an increase in taxes tends to reduce
disposable income and thereby reduces consumption and
investment expenditures. Thus the government can control
deflationary and inflationary pressures in the economy by a
judicious combination of expenditure and taxation programmes.
For this, the government follows compensatory fiscal policy.

Compensatory Fiscal Policy:
ADVERTISEMENTS:
The compensatory fiscal policy aims at continuously compensating
the economy against chronic tendencies towards inflation and
deflation by manipulating public expenditures and taxes. It,
therefore, necessitates the adoption of fiscal measures over the
long-run rather than once-for-all measures it a point of time.
When there are deflationary tendencies in the economy, the
government should increase its expenditures through deficit
budgeting and reduction in taxes. This is essential to compensate
for the lack in private investment and to raise effective demand,
employment, output and income within the economy.
On the other hand, when there are inflationary tendencies, the
government should reduce its expenditures by having a surplus
budget and raising taxes in order to stabilise the economy at the full
employment level.
The compensatory fiscal policy has two approaches:
ADVERTISEMENTS:
(1) Built-in stabilisers; and
(2) Discretionary fiscal policy.
(1) Built-in Stabilisers:
The technique of built-in flexibility or stabilisers involves the
automatic adjustment of the expenditures and taxes in relation to
cyclical upswings and downswings within the economy without
deliberate action on the part of the government. Under this system,

changes in the budget are automatic and hence this technique is
also known as one of automatic stabilisation.
The various automatic stabilisers are corporate profits tax, income
tax, excise taxes, old age, survivors and unemployment insurance
and unemployment relief payments. As instruments of automatic
stabilisation, taxes and expenditures are related to national income.
Given an unchanged structure of tax rates, tax yields vary directly
with movements in national income, while government
expenditures vary inversely with variations in national income.
ADVERTISEMENTS:
In the downward phase of the business cycle when national income
is declining, taxes which are based on a percentage of national
income automatically decline, thereby reducing the tax yield. At the
same time, government expenditures on unemployment relief and
social security benefits automatically increase. Thus there would be
an automatic budget deficit which would counteract deflationary
tendencies.
On the other hand, in the upward phase of the business cycle when
national income is rising rapidly, the tax yield would automatically
increase with the rise in tax rates. Simultaneously, government
expenditures on unemployment relief and social security benefits
automatically decline. These two forces would automatically create
a budget surplus and thus inflationary tendencies would be
controlled automatically.
It’s Merits:

Built-in stabilisers have certain advantages as a fiscal
device:
1. The built-in stabilisers serve as a cushion for private purchasing
power when it falls and lessen the hardships on the people during
deflationary period.
2. They prevent national income and consumption spending from
falling at a low level.
ADVERTISEMENTS:
3. There are automatic budgetary changes in this device and the
delay in taking administrative decisions is avoided.
4. Automatic stabilisers minimise the errors of wrong forecasting
and timing of fiscal measures.
5. They integrate short-run and long-run fiscal policies.
It’s Limitations:
It has the following limitations:
1. The effectiveness of built-in stabilisers as an automatic
compensatory device depends on the elasticity of tax receipt, the
level of taxes and flexibility of public expenditures. The greater the
elasticity of tax receipts, the greater will be the effectiveness of
automatic stabilisers in controlling inflationary and deflationary
tendencies. But the elasticity of tax receipts is not so high as to act
as an automatic stabiliser even in advanced countries like America.
ADVERTISEMENTS:

2. With low level of taxes even a high elasticity of tax receipts would
not be very significant as an automatic stabiliser doing a
downswing.
3. The built-in stabilisers do not consider the secondary effects of
stabilisers on after-tax business incomes and of consumption
spending on business expectations.
4. This device keeps silent about the stabilising influence of local
bodies, state governments and of the private sector economy.
5. They cannot eliminate the business cycles. At the most, they can
reduce its severity.
6. Their effects during recovery from recession are unfavourable.
Economists, therefore, suggest that built-in stabilisers should be
supplemented by discretionary fiscal policy.
(2) Discretionary Fiscal Policy:
Discretionary fiscal policy requires deliberate change in the budget
by such actions as changing tax rates or government expenditures
or both.
ADVERTISEMENTS:
It may generally take three forms:
(i) Changing taxes with government expenditure constant,
(ii) changing government expenditure with taxes constant, and
(iii) variations in both expenditures and tax simultaneously.

(i) When taxes are reduced, while keeping government expenditure
unchanged, they increase the disposable income of households and
businesses. This increase private spending. But the amount of
increase will depend on whom the taxes are cut, to what extent, and
on whether the taxpayers regard the cut temporary or permanent.
ADVERTISEMENTS:
If the beneficiaries of tax cut are in the higher middle income group,
the aggregate demand will increase much. If they are businessmen
with little incentive to invest, tax reductions are temporary. This
policy will again be less effective. So this is more effective in
controlling inflation by raising taxes because high rates of taxation
will reduce disposable income of individuals and businesses thereby
curtailing aggregate demand.
(ii) The second method is more useful in controlling deflationary
tendencies. When the government increases its expenditure on
goods and services, keeping taxes constant, aggregate demand goes
up by the full amount of the increase in government spending. On
the hand, reducing government expenditure during inflation is not
so effective because of high business expectations in the economy
which are not likely to reduce aggregate demand.
(iii) The third method is more effective and superior to the other
two methods in controlling inflationary and deflationary tendencies.
To control inflation, taxes may be increased and government
expenditure be raised to fight depression.
It’s Limitations:

The discretionary fiscal policy depends upon proper
timing and accurate forecasting:
ADVERTISEMENTS:
1. Accurate forecasting is essential to judge the stage of cycle
through which the economy is passing. It is only then that
appropriate fiscal action can be taken. Wrong forecasting may
accentuate rather than moderate the cyclical swings. Economics is
not an exact science in correct forecasting. As a result, fiscal action
always follows after the turning points in the business cycles.
2. There are delays in proper timing of public spending. In fact,
discretionary fiscal policy is subject to three time lags.
(i) There is the “decision lag,” the time required in studying the
problem and taking the decision. The lag involved in this process
may be too long.
(ii) Once the decision is taken, is an “execution lag.” It involves
expenditure which is to be allocated for the execution of the
programme. In a country like the USA it may take two years and
less than a year in the U.K.
(iii) Certain public work projects are so cumbersome that it is not
possible to accelerate or slow them down for the purpose of raising
or reducing spending on them.
Conclusion:
Despite the higher multiplier effect of government spending as
against changes in tax rates, the latter can be operated more
promptly than the former. Emphasis has thus shifted to taxation as

the best fiscal device for controlling cyclical fluctuations. Thus when
the turning point of a business cycle is already underway,
discretionary fiscal action tends to strengthen the built-in
stabilisers, as has been’ the experience of developed countries like
the USA.
4. Budgetary Policy—Contra-cyclical Fiscal Policy
The budget is the principal instrument of fiscal policy. Budgetary
policy exercises control over size and relationship of government
receipts and expenditures. We discuss below the common
budgetary policies that can be adopted for stabilising the economy.
(1) Budget Deficit—Fiscal Policy during Depression:
Deficit budgeting is an important method of overcoming
depression. When government expenditures exceed receipts, larger
amounts are put into the stream of national income than they are
withdrawn. The deficit represents the net expenditure of the
government which increases national income by the multiplier
times the increase in net expenditure. If the MPC is 2/3, the
multiplier will be 3; and if the net increase in government
expenditure is Rs.-100 crores it will increase national income to Rs.
300 crores (= 100 x 3).
Thus the budget deficit has an expansionary effect on aggregate
demand whether the fiscal process leaves marginal propensities
unchanged or whether a redistribution of disposable receipts
occurs. The E expansionary effect of a budget deficit is shown
diagrammatically in Figure 1. C is the consumption function. C +
I+G represent consumption, investment and government

expenditure (the total spending function) before the budget is
introduced. Suppose government expenditure of ∆G is injected into
the economy.
As a result, the total spending function shifts upward to C +1 + G1.
Income increases OY from OF to OF, when the equilibrium position
moves Income from E1 to E1 .The increase in income YY1 (= EA =
MiE1A) is greater than the increase in government expenditure E1B
(=∆G). BA (E1A – E1B) represents increase in consumption. Thus
the budget deficit is always expansionary, the rise in national
income being (YY1) greater than the actual amount of government
spending (∆G = E1B). In this method of budget deficit, taxes are
kept intact.
Budget deficit may also be secured by reduction in taxes and
without government spending. Reduction in taxes tends to leave
larger disposable income in the hands of the people and thus
stimulates increase in consumption expenditure. This, in turn,
would lead to increase in aggregate demand output, income and
employment. This is illustrated in Figure 2, where С is the original
consumption function. Suppose tax is reduced by ET, it will shift the

consumption function upward to C1.Income will increase from OY to
OY1.
However, reduction in taxes is not so expansionary via increased
consumption expenditure because the tax relief may be saved and
not spent on consumption. Businessmen may not also invest more if
the business expectations are low. Therefore, to safeguard against
such eventualities the government should follow the policy of
reduction in taxes with increased government spending and its
multiplier effect will be much higher in case we also assume that
some consumption and investment expenditures increase due to tax
relief.
(2) Surplus Budget—Fiscal Policy during Boom:
Surplus in the budget occurs when the government revenues exceed
expenditures. The policy of surplus budget is followed to control
inflationary pressures within the economy. It may be through
increase in taxation or reduction in government expenditure or
both. This will tend to reduce income and aggregate demand by the
multiplier times the reduction in government or/and private
consumption expenditure (as a result of increased taxes).
This is explained with the aid of Figure 1, where the economy is at
the initial equilibrium position E1. Suppose the government

expenditure is reduced by ∆G so that the total spending function С
+ I + G shifts downward to С + I + G. Now E is the new equilibrium
position which shows that the income has declined to OY from
OY1 as a result of reduction in government expenditure by E1B. The
fall in income Y1 Y 1(= AE) > E1 B the reduction in expenditure
because consumption has also been reduced by BA.
There may be budget surplus without government spending when
taxes are raised. Enhanced taxes reduce the disposable income with
the people and encourage reduction in consumption expenditure.
The result is fall in aggregate demand, output income and
employment. This is illustrated in Figure 3. С is the consumption
function before the imposition of the tax. Suppose a tax equal to ET
is introduced. The consumption function shifts downward to C1. The
new equilibrium position is E1. As a result, income falls from OY to
OY1.
(3) Balanced Budget:
Another expansionist fiscal policy is the balanced budget. In this
policy the increase in taxes (∆T) and in government expenditure
(∆G) are of an equal amount. This has the impact of increasing net
national income. This is because the reduction in consumption
resulting from the tax is not equal to the government expenditure.

The basis for the expansionary effect of this kind of balanced budget
is that a tax merely tends to reduce the level of disposable income.
Therefore, when only a portion of an economy’s disposable income
is used for consumption purposes, the economy’s consumption
expenditure will not fall by the full amount of the tax. On the other
hand, government expenditure increases by the full amount of the
tax. Thus the government expenditure rises more than the fall in
consumption expenditure due to the tax and there is net increase in
national income.
The balanced budget theorem is based on the combined operation
of the tax multiplier and the government-expenditure multiplier. In
this, the tax multiplier is smaller than the government-expenditure
multiplier. The government-expenditure multiplier is
Or ∆Y = 1/1-c ∆G
∆Y/∆G = 1/1-c
Which indicates that the change in income (∆Y) will equal the
multiplier (1/1- c) times the change in autonomous government
expenditure?
The tax multiplier is
∆Y = –C∆T/1-c
∆Y/∆T = -c/1-c
Which shows that the change in income (∆Y) will equal multiplier
(1/1- c) times the product of the marginal propensity to consume (c)
and the change in taxes (∆T).

A simultaneous change in public expenditure and taxes may be
expressed as a combination of equations (1) and (2). Thus the
balanced budget multiplier
kb = ∆Y/∆G + ∆Y/∆T = 1/1-c + -c/1-c = 1-c/1-c = 1or kb =1
Since ∆G = ∆T, income will change by an amount equal to the
change in government expenditure and taxes.
To understand it, it is explained numerically. Suppose the value of с
– 2/3 and the increase in government expenditure ∆G = Rs 10
crores. Since ∆G = ∆T, therefore the increase in taxes (lumpsum)
∆T = Rs. 10 crores.
We first calculate the government-expenditure multiplier,
kg = ∆Y/∆G =1/1-c =1/1-2/3 =3
The tax multiplier is kT = ∆Y/∆T =-c/1-c = -2/3/1-2/3 = – 2
To arrive at the increase in income as a result of the combined
operation of the government expenditure multiplier and the tax
multiplier, we write the balanced budget multiplier equation as
kb = ∆Y = 1/1-c ∆G + c/1-c ∆T
and fit in the above values of c, ∆G and ∆T so that
kb = ∆Y = 3∆G – 2 ∆T
= 3×10 – 2 ×10 = Rs. 10 crores
Thus the increase in income (∆Y) exactly equals the increase in
government expenditure (∆G) and the lumpsum tax (∆T) i.e., Rs. 10
crores. Hence kb= 1.

This balanced budget multiplier or unit multiplier is explained with
the help of Figure 4. С is the consumption function before the
imposition of the tax with income at OY0 level. Tax of AG amount is
imposed. As a result, the consumption function shifts downward to
C1.Now g government expenditure of GE amount is injected into the
и ш economy which is equal to the tax yield AG.
The new government expenditure line is C1+ G which determines
OY income at point E. The increase in income Y0Y equals the tax
yield A G and the increase in government expenditure GE. This С
proves that income has risen by 1 (one) times the amount of
increase in government expenditure which is a balanced budget
expansion.
Fiscal Policy
Fiscal policy is the use of government spending and tax policy to influence the path
of the economy over time. Automatic stabilizers, which we learned about in the last
section, are a passive type of fiscal policy, since once the system is set up,
Congress need not take any further action. On the other hand, discretionary fiscal
policy is an active fiscal policy that uses expansionary or contractionary measures
to speed the economy up or slow the economy down.
Expansionary fiscal policy occurs when the Congress acts to cut tax rates or
increase government spending, shifting the aggregate demand curve to the
right. Contractionary fiscal policy occurs when Congress raises tax rates or cuts
government spending, shifting aggregate demand to the left.
Figure 1 uses an aggregate demand/aggregate supply diagram to illustrate a
healthy, growing economy. The original equilibrium occurs at E0, the intersection of

aggregate demand curve AD0 and aggregate supply curve AS0, at an output level of
200 and a price level of 90.
One year later, aggregate supply has shifted to the right to AS1 in the process of
long-term economic growth, and aggregate demand has also shifted to the right to
AD1, keeping the economy operating at the new level of potential GDP. The new
equilibrium (E1) is at an output level of 206 and a price level of 92. One more year
later, aggregate supply has again shifted to the right, now to AS2, and aggregate
demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of
212 and a price level of 94. In short, the figure shows an economy that is growing
steadily year to year, producing at its potential GDP each year, with only small
inflationary increases in the price level.
Figure 1. A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply
and aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each
year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if
aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth
with deflation can develop.
In the real world, however, aggregate demand and aggregate supply do not always
move neatly together, especially over short periods of time. Aggregate demand may
fail to grow as fast as aggregate supply, or it may even decline causing a
recession. This could be caused by a number of possible reasons: households
become hesitant about consuming; firms decide against investing as much; or
perhaps the demand from other countries for exports diminishes. For example,
investment by private firms in physical capital in the U.S. economy boomed during
the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling
back to 15.2% by 2002. Conversely, increases in aggregate demand could run
ahead of increases in aggregate supply, causing inflationary increases in the price
level. Business cycles of recession and boom are the consequence of shifts in

aggregate supply and aggregate demand. As these occur, the government may
choose to use fiscal policy to address the difference.
Expansionary Fiscal Policy
Expansionary fiscal policy increases the level of aggregate demand, through either
increases in government spending or reductions in taxes. Expansionary policy can
do this by:
1. increasing consumption by raising disposable income through cuts in personal income
taxes or payroll taxes;
2. increasing investments by raising after-tax profits through cuts in business taxes; and
3. increasing government purchases through increased spending by the federal
government on final goods and services and raising federal grants to state and local
governments to increase their expenditures on final goods and services.
Contractionary fiscal policy does the reverse: it decreases the level of aggregate
demand by decreasing consumption, decreasing investments, and decreasing
government spending, either through cuts in government spending or increases in
taxes. The aggregate demand/aggregate supply model is useful in judging whether
expansionary or contractionary fiscal policy is appropriate.
Consider first the situation in Figure 2, which is similar to the U.S. economy during
the recession in 2008–2009. The intersection of aggregate demand (AD0) and
aggregate supply (AS0) is occurring below the level of potential GDP. At the
equilibrium (E0), a recession occurs and unemployment rises. (The figure uses the
upward-sloping AS curve associated with a Keynesian economic approach, rather
than the vertical AS curve associated with a neoclassical approach, because our
focus is on macroeconomic policy over the short-run business cycle rather than over
the long run.) In this case, expansionary fiscal policy using tax cuts or increases in
government spending can shift aggregate demand to AD1, closer to the full-
employment level of output. In addition, the price level would rise back to the level
P1 associated with potential GDP.

Figure 2. Expansionary Fiscal Policy. The original equilibrium (E0) represents a recession, occurring at a
quantity of output (Yr) below potential GDP. However, a shift of aggregate demand from AD0 to AD1,
enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at
the level of potential GDP. Since the economy was originally producing below potential GDP, any
inflationary increase in the price level from P0 to P1 that results should be relatively small.
Should the government use tax cuts or spending increases, or a mix of the two, to
carry out expansionary fiscal policy? After the Great Recession of 2008–2009, U.S.
government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax
revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009.
This very large budget deficit was produced by a combination of automatic stabilizers
and discretionary fiscal policy. The Great Recession meant less tax-generating
economic activity, which triggered the automatic stabilizers that reduce taxes. Most
economists, even those who are concerned about a possible pattern of persistently
large budget deficits, are much less concerned or even quite supportive of larger
budget deficits in the short run of a few years during and immediately after a severe
recession.
The Politics of Expansionary Fiscal Policy
The choice between whether to use tax or spending tools often has a political tinge.
As a general statement, conservatives and Republicans prefer to see expansionary
fiscal policy carried out by tax cuts, while liberals and Democrats prefer that
expansionary fiscal policy be implemented through spending increases. The Obama
administration and Congress passed an $830 billion expansionary policy in early
2009 involving both tax cuts and increases in government spending, according to the
Congressional Budget Office. However, state and local governments, whose budgets
were also hard hit by the recession, began cutting their spending—a policy that
offset federal expansionary policy.

The conflict over which policy tool to use can be frustrating to those who want to
categorize economics as “liberal” or “conservative,” or who want to use economic
models to argue against their political opponents. But the AD–AS model can be used
both by advocates of smaller government, who seek to reduce taxes and
government spending, and by advocates of bigger government, who seek to raise
taxes and government spending. Economic studies of specific taxing and spending
programs can help to inform decisions about whether taxes or spending should be
changed, and in what ways. Ultimately, decisions about whether to use tax or
spending mechanisms to implement macroeconomic policy is, in part, a political
decision rather than a purely economic one.
TRY IT
WATCH IT
Watch the selected clip from this video to learn more about the ways that government can
implement fiscal policies.
You can view the transcript for “Macro: Unit 3.1 — Types of Fiscal Policy” here (opens
in new window).
Contractionary Fiscal Policy
Fiscal policy can also be used to slow down an overheating economy. Suppose the
macro equilibrium occurs at a level of GDP above potential, as shown in Figure 3.
The intersection of aggregate demand (AD0) and aggregate supply (AS0) occurs at
equilibrium E0. In this situation, contractionary fiscal policy involving federal spending
cuts or tax increases can help to reduce the upward pressure on the price level by
shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to
be at potential GDP.

Figure 3. A Contractionary Fiscal Policy. The economy starts at the equilibrium quantity of output Yr,
which is above potential GDP. The extremely high level of aggregate demand will generate inflationary
increases in the price level. A contractionary fiscal policy can shift aggregate demand down from AD0 to
AD1, leading to a new equilibrium output E1, which occurs at potential GDP.
Again, the AD–AS model does not dictate how this contractionary fiscal policy is to be
carried out. Some may prefer spending cuts; others may prefer tax increases; still others
may say that it depends on the specific situation. The model only argues that, in this
situation, aggregate demand needs to be reduced.
TRY IT
GLOSSARY
automatic stabilizers:
tax and spending rules that have the effect of slowing down the rate of decrease in
aggregate demand when the economy slows down and restraining aggregate
demand when the economy speeds up, without any additional change in legislation
contractionary fiscal policy:
fiscal policy that decreases the level of aggregate demand, either through cuts in
government spending or increases in taxes
discretionary fiscal policy:
the government passes a new law that explicitly changes overall tax rates or
spending levels with the intent of influencing the level or overall economic activity
expansionary fiscal policy:

fiscal policy that increases the level of aggregate demand, either through increases in
government spending or cuts in taxes
Discretionary Fiscal Policy
Fiscal Policy is changing the governments budget to influence aggregate demand. i.e.
changing taxes and spending.Discretionary fiscal policy means the government make
changes to tax rates and or levels of government spending. For example, cutting VAT in
2009 to provide boost to spending.
Expansionary fiscal policy is cutting taxes and/or increasing government spending. Lower
taxes (e.g. lower VAT in the case of the UK) increases disposable income and in theory,
should encourage people to spend.
Discretionary fiscal policy are different to automatic fiscal stabilisers. Automatic stabilisers
occur where in a recession a government automatically spends more because there are
more claiming unemployment benefits. However, the government may feel these automatic
stabilisers are insufficient and so they decide to increase public work spending schemes too.
Fiscal policies include discretionary fiscal policy and automatic
stabilizers. Discretionary fiscal policy occurs when the Federal government
passes a new law to explicitly change tax rates or spending levels. The stimulus
package of 2009 is an example. Changes in tax and spending levels can also occur
automatically through non-discretionary spending, due to automatic stabilizers,
which are programs that are already in place, and thus do not require Congress to
act. Instead, they prevent aggregate demand from falling as much as it otherwise
would in recession, or they hold down aggregate demand in a potentially inflationary
boom. Let’s see how this works.
Counterbalancing Recession and Boom
Automatic stabilizers include unemployment insurance, food stamps, and the
personal and corporate income tax. Suppose aggregate demand were to fall sharply
so that a recession occurred. The lower level of aggregate demand and higher
unemployment will tend to pull down personal incomes and corporate profits, which
would tend to reduce consumer and investment spending, further cutting aggregate
demand and GDP. Consider, though, the effects of automatic stabilizers. As
individuals are laid-off, they qualify for unemployment compensation, food stamps
and other welfare programs. Additionally, since their income has fallen, so have their
tax liabilities. All of these things serve to buoy aggregate demand and prevent it from
falling as far as it otherwise would. Thus, recessions are somewhat milder.
The process works in reverse, too. Consider the situation where aggregate demand
has risen sharply, causing the macro equilibrium to occur at a level of output above
potential GDP. Because taxes are based on personal income and corporate profits,
a rise in aggregate demand automatically increases tax payments, reducing
disposable income and thus spending. On the spending side, stronger aggregate
demand typically means lower unemployment, so there is less need for government
spending on unemployment benefits, welfare, Medicaid, and other programs in the
social safety net. The combination of these automatic stabilizing effects is to prevent
aggregate demand from rising as high as it otherwise would, so that inflationary
pressure is dampened.

A glance back at economic history provides a second illustration of the power of
automatic stabilizers. Remember that the length of economic upswings between
recessions has become longer in the U.S. economy in recent decades. The three
longest economic booms of the twentieth century happened in the 1960s, the 1980s,
and the 1991–2001 time period. One reason why the economy has tipped into
recession less frequently in recent decades is that the size of government spending
and taxes has increased in the second half of the twentieth century. Thus, the
automatic stabilizing effects from spending and taxes are now larger than they were
in the first half of the twentieth century. Around 1900, for example, federal spending
was only about 2% of GDP. In 1929, just before the Great Depression hit,
government spending was still just 4% of GDP. In those earlier times, the smaller
size of government made automatic stabilizers far less powerful than in the last few
decades, when government spending often hovers at 20% of GDP or more.
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WATCH IT
This video briefly explains the difference between automatic stabilizers and discretionary
government spending.
You can view the transcript for “Automatic Stabilizers- Macro Topic 3.9” here (opens in
new window).
The Standardized Employment Deficit or Surplus
From the previous section, it should be clear that the budget deficit or surplus
responds to the state of the economy. That is, the automatic stabilizers cause the
budget to go into deficit (higher spending and lower tax revenues) during recessions
and to go into surplus (lower spending and higher tax revenues) during booms. As a
result, we can’t look at the deficit figures alone to see how aggressive fiscal policy is.
Each year, the nonpartisan Congressional Budget Office (CBO) calculates
the standardized (or full) employment budget—that is, what the budget deficit or
surplus would be if the economy were producing at potential GDP. Since the
automatic stabilizers are “in neutral” at potential GDP, neither boosting nor
dampening aggregate demand, the standardized employment budget calculation
removes the impact of the automatic stabilizers on the budget balance.
Figure 2 compares the actual budget deficits of recent decades with the CBO’s
standardized deficit.

Figure 2. Comparison of Actual Budget Deficits with the Standardized Employment Deficit. When
the economy is in recession, the standardized employment budget deficit is less than the actual budget
deficit because the economy is below potential GDP, and the automatic stabilizers are reducing taxes and
increasing spending. When the economy is performing extremely well, the standardized employment deficit
(or surplus) is higher than the actual budget deficit (or surplus) because the economy is producing about
potential GDP, so the automatic stabilizers are increasing taxes and reducing the need for government
spending. (Sources: Actual and Cyclically Adjusted Budget Surpluses/Deficits,
http://www.cbo.gov/publication/42323; and Economic Report of the President, Table B-1,
http://www.gpo.gov/fdsys/pkg/ERP-2013/content-detail.html).
Notice that in recession years, like the early 1990s, 2001, or 2009, the standardized
employment deficit is smaller than the actual deficit. During recessions, the
automatic stabilizers tend to increase the budget deficit, so if the economy was
instead at full employment, the deficit would be reduced. However, in the late 1990s
the standardized employment budget surplus was lower than the actual budget
surplus. The gap between the standardized budget deficit or surplus and the actual
budget deficit or surplus shows the impact of the automatic stabilizers. More
generally, the standardized budget figures allow you to see what the budget deficit
would look like with the economy held constant—at its potential GDP level of output.
Automatic stabilizers respond to changes in the economy quickly. Lower wages
means that a lower amount of taxes is withheld from paychecks right away. Higher
unemployment or poverty means that government spending in those areas rises as
quickly as people apply for benefits. However, while the automatic stabilizers offset
part of the shifts in aggregate demand, they do not offset all or even most of it.
Historically, automatic stabilizers on the tax and spending side offset about 10% of
any initial movement in the level of output. This offset may not seem enormous, but it
is still useful. Automatic stabilizers, like shock absorbers in a car, can be useful if
they reduce the impact of the worst bumps, even if they do not eliminate the bumps
altogether.
GLOSSARY

automatic stabilizers:
tax and spending rules that have the effect of slowing down the rate of decrease in
aggregate demand when the economy slows down and restraining aggregate
demand when the economy speeds up, without any additional change in legislation
discretionary fiscal policy:
the government passes a new law that explicitly changes overall tax rates or
spending levels with the intent of influencing the level or overall economic activity
standardized (or full) employment budget:
estimate of the budget deficit or surplus excluding the effects of fiscal policy, that is,
as if GDP were at potential
WHAT ARE AUTOMATIC STABILIZERS?
Automatic stabilizers are mechanisms built into government budgets, without any
vote from legislators, that increase spending or decrease taxes when the economy
slows. During a recession, automatic stabilizers can ease households’ financial
stress by decreasing their tax bills or by boosting cash and in-kind benefits, all
without changes in the tax code or any other new legislation. For example, when a
household’s income declines, it generally owes less in taxes, which helps cushion
the blow. Additionally, with a decline in income, a household may become eligible
for unemployment insurance (UI), food stamps (Supplemental Nutrition Assistance
Program, or SNAP), or Medicaid.
Automatic stabilizers don’t just help families facing financial difficulties—they
also help the overall economy by stimulating aggregate demand when times are
bad and when the economy is most in need of a boost. When times are better,
automatic stabilizers generally phase down or turn off. Most automatic stabilizers
are federal; states and localities are generally required to balance their budgets, so
they can’t run big deficits during downturns.
WHAT ARE THE COMPONENTS OF AUTOMATIC
STABILIZERS?
Both taxes and spending can have stabilizing effects on the economy. Most taxes
have a stabilizing effect because they automatically move with economic growth.
For example, personal and corporate income tax collections decline during
recessions along with income and profits, and payroll tax collections decline when
employment and wages fall. Spending on some transfer programs also depends on
the state of the economy. For instance, outlays for unemployment insurance
increase when the unemployment rate rises, and spending on anti-poverty
programs like Medicaid and SNAP increases during recessions because bad
economic times mean that more people are eligible.

As shown in the chart below, the bulk of the value of automatic stabilizers comes
from changes in tax revenues, rather than from spending on programs. According
to the Congressional Budget Office (CBO), revenues have accounted for about
three-quarters, on average, of the effect of automatic stabilizers on the budget over
the past 50 years (CBO 2015).
HOW ARE AUTOMATIC STABILIZERS DIFFERENT FROM
CHANGES IN DISCRETIONARY FISCAL POLICY?
One of the benefits of automatic stabilizers is that they do not require legislative
action and respond quickly to economic downturns. Discretionary fiscal policy
requires action from Congress, so there may be considerable time lags due to
debates on the appropriate response, steps in the rulemaking process, and the
administrative actions for funds to reach the pockets of consumers. During the
Great Recession, Congress responded relatively quickly: the first fiscal action was
the Bush Economic Stimulus Act, which was signed on February 13, 2008, which
turned out to be only two months after the recession was later determined to have
begun (Furman 2018). But the largest stimulus package, the American Recovery
and Reinvestment Act (ARRA) of 2009, was authorized five quarters after the start
of the recession. By this time, spending on automatic stabilizers had already grown
to 2 percent of potential GDP—the maximum sustainable output of the economy
(Schanzenbach 2016). Examining economic stabilization policy from 1980 to
2018, Sheiner and Ng (2019) find that automatic stabilizers provide about half of
the total fiscal stabilization, with the other half provided by discretionary fiscal
policy.

HOW HAVE AUTOMATIC STABILIZERS CHANGED OVER
TIME?
The responsiveness of automatic stabilizers to economic conditions has been fairly
stable over time. According to CBO, automatic stabilizers averaged about 0.4
percent of potential GDP for each percentage point difference between GDP and
potential GDP (“output gap”) from 1965 to 2016. Likewise, Auerbach and
Feenberg (2010) find that the federal tax system’s impact as an automatic stabilizer
has changed relatively little. Sheiner and Ng find that although the degree of
cyclicality of overall fiscal policy has been somewhat stronger in the past 20 years
than the previous 20 before that, the contribution to GDP growth of automatic
stabilizers in response to a percentage point gap between the unemployment rate
and the natural rate has been relatively steady, fluctuating between 0.3 and 0.5
between 1980 and 2008.
HOW DID AUTOMATIC STABILIZERS FUNCTION DURING
THE GREAT RECESSION?
From 2009 to 2012, automatic stabilizers lowered revenues by 1.2 percent of
potential GDP, and increased spending by 0.6 percent — a combined effect of 1.8
percent of potential GDP.[1]
The increase in discretionary spending stemming from
legislative action contributed on average about 1.3 percent of potential GDP over
this period. As shown in the chart below, the stimulus from discretionary spending
was cut off abruptly in 2013, even though the unemployment rate was still high.
Automatic stabilizers provided stimulus for much longer.

HOW DO AUTOMATIC STABILIZERS WORK AT THE STATE
AND LOCAL LEVEL?
State and local governments have balanced budget requirements, meaning that any
reductions in spending or increases in taxes that come from state and local
automatic stabilizers have to be offset in order to balance the budget. Although
states have rainy day funds intended to help balance budgets when tax revenues
fall, most are too poorly financed to stave off the need for spending cuts and tax
increases during recessions. When state and local governments increase taxes or
decrease spending to meet their balanced budget requirements, they counteract
their automatic stabilizers and put a drag on recovery efforts. Sheiner and Ng
estimate that, from 1980 to 2018, discretionary cuts to state and local spending
fully offset the stimulative effects of the state and local automatic stabilizers.
But balanced budget requirements also mean that states are more likely to spend
what they receive, so sending money to states is a particularly effective way for the
federal government to stimulate the economy. For instance, during the Great
Recession, the federal government increased its Medicaid spending share, and this
was an effective relief to states.
WHAT IS THE CASE FOR EXPANDING AUTOMATIC
STABILIZERS IN THE U.S.?
Many analysts are worried that we are ill-prepared for the next recession. On
average, the Federal Reserve typically cuts interest rates by five percentage points
to combat recessions (Summers 2018). But with interest rates still well below 5
percent, monetary policy is likely to be constrained by the zero lower bound,
increasing the importance of fiscal policy as a stabilizing tool. Further, with the
debt-to-GDP ratio already very high by historical standards, it is unclear whether
we can rely on Congress to enact measures to boost the economy during the next
recession. But the benefits of using fiscal policy to fight recessions are likely to far
exceed their costs. With interest rates so low, debt isn’t very costly (Elmendorf
and Sheiner 2016; Blanchard 2019). Furthermore, to the extent that prolonged
joblessness leads to lower labor force participation for an extended amount of time,
using fiscal policy to fight recessions may even pay for itself in the long run
(DeLong and Summers 2012)
WHAT ARE SOME OPTIONS FOR STRENGTHENING
AUTOMATIC STABILIZERS?
For automatic stabilizers to be effective, they should be timely and bolster
aggregate demand. That is, people who are on the receiving end of a stimulus must
get the money quickly, and then actually spend it. However, not all tax cuts or
spending programs are created equal: cutting certain taxes or increased spending
on certain programs have more “bang per buck.” For instance, lower income
households are more likely to spend additional income than are higher income

households, who are more likely to have the resources to maintain spending levels
during hard times.
Thus, a good way to enhance automatic stabilizers is by strengthening the safety
net. One option is to automatically increase the amount of food stamps one can
receive during a downturn. This action could be administered quickly by raising
the value of electronic benefit cards, and is well-targeted to the most vulnerable
families (Bernstein and Spielberg 2016). Another option would be to extend or
increase the value of UI benefits (currently, UI benefits are limited to 26 weeks).
Indeed, research indicates that policies like SNAP and UI have high “bang per
buck” as economic stimulus (Blinder 2016).
But these policies alone may not involve enough stimulus. One alternative could be
to provide a temporary, refundable tax credit for working households (Sahm 2019).
Refundable tax credits help lower-income households because they receive money
even if it exceeds the amount of taxes they owe. On the other hand, a policy that
reduces tax rates, which would give disproportionate benefits to higher-income
households, may be less effective.
Other policies, such as increasing infrastructure spending or grants to states, may
also be helpful by increasing spending substantially, but may not be optimal due to
time lags. To get around the timing issue, Haughwout (2019) proposes an
infrastructure investment plan that delivers federal funds to state and local
infrastructure projects that would be automatically triggered during a recession.
Fiedler et al. (2019) propose to tie the share of federal support for state Medicaid
and CHIP (Children’s Health Insurance Program) programs to state unemployment
rates.
HOW DO AUTOMATIC STABILIZERS IN THE U.S. COMPARE
WITH THOSE IN OTHER RICH COUNTRIES?
Automatic stabilizers are linked to the size of the government, and tend to be larger
in advanced economies (Horton and El-Ganainy 2018). Among the advanced
economies, the U.S. has relatively weaker automatic stabilizers. The chart below
shows the size of automatic stabilizers—the automatic change in the fiscal balance
due to a one percentage point change in the output gap—for each country
calculated by Girouard and Andre (2005). Their finding that the U.S. has weaker
automatic stabilizers than most of Europe is consistent with other studies (Dolls et
al. 2010; Fatas and Mihov 2016). Instead, the U.S. has tended to use relatively
more aggressive discretionary fiscal policy to compensate for weaker automatic

stabilizers (Fatas and Mihov 2016).
Discretionary Fiscal Policy:
The central government exercises discretionary fiscal policy when it
identifies an unemployment or inflation problem, establishes a
policy objective concerning that problem, and then deliberately
adjusts taxes and/or spending accordingly.
Depending on the situation, the central government could, for
example, institute a tax cut or raise the tax rate, change personal
income tax exemptions or deductions, grant tax rebates or credits,
levy surcharges, initiate or postpone transfer programmes, and
either initiate or eliminate direct spending projects.
Automatic Fiscal Policy:
:
Another type of fiscal action — automatic stabilisation — takes place
when changing economic conditions cause government expen-
ditures and taxes to change automatically, which, in its turn, helps
to combat unemployment or demand-pull inflation.
These adjustments in government expenditures and taxes occur
without any deliberate legislative action, and stimulate aggregate
spending in a recession and reduce aggregate spending during

economic expansion. Two automatic fiscal policy stabilisers are of
primary importance transfer payments, especially unemployment
compensation, and the personal income tax.
To understand how automatic stabilisers work, consider a
recession. During a downswing, when people lose their jobs and
earned incomes are reduced, some important changes in
government expenditures and taxes occur automatically.
Firstly, some unemployed individuals become eligible for a number
of transfer payments, particularly unemployment benefit. Second,
because the personal income tax is normally progressive tax with
several rates, some of the unemployed experience a decline in the
percentage of their income that is taxed, thus resulting in lower tax
payments or a tax refund.
These responses to a downswing are automatic and provide
additional money, through increased transfer payments and
decreased taxes, to households for spending. Without these built-in
stabilisers, or automatic responses, household spending would fall
more sharply, and the economy would most likely fall into a deeper
recession.
When the economy expands, unemployment falls, and incomes rise,
the built-in stabilisers automatically remove spending from the
economy to reduce demand-pull inflationary pressures. As more
people are employed, the government provides less in transfer pay-
ments, and higher incomes push some individuals into higher tax
brackets. Without this automatic removal of spending power as the
economy heats up —particularly toward full employment —
inflation could be worse.
Automatic stabilisers soften the impact of cyclical expansions and
contractions. Without the help of any deliberate action they pump
money into the economy during a downswing and decrease
aggregate spending during an upswing. However, in the face of a
sever; recession or inflation, automatic stabilisers alone would not
be sufficient to correct the problem.
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In macroeconomics, discretionary policy is an economic policy based on the ad hoc judgment
of policymakers as opposed to policy set by predetermined rules. For instance, a central
banker could make decisions on interest rates on a case-by-case basis instead of allowing a set
rule, such as Friedman's k-percent rule, an inflation target following the Taylor rule, or a nominal
income target to determine interest rates or the money supply. In practice, most policy actions
are discretionary in nature.
"Discretionary policy" can refer to decision making in both monetary policy and fiscal policy. The
opposite is a commitment policy.
Arguments against[edit]
Monetarist economists in particular have been opponents of the use of discretionary policy.
According to Milton Friedman, the dynamics of change associated with the passage of time
presents a timing problem for public policy. The reason this poses a problem is because a long
and variable time lag exists between:
1. the need for action and the recognition of that need;
2. the recognition of a problem and the design and implementation of a policy response;
and
3. the implementation of the policy and the effect of the policy.[1]:145
It is because of these lags that Friedman argues that discretionary public policy will often be
destabilizing. For this reason, he argued the case for general rules rather than discretionary
policy.
Friedman formalized his argument in the context of monetary policy as follows.[2]
The quantity
equation says that
where M is the money supply, V is the velocity of money, and Y is nominal GDP. Expressing
this in growth rates gives
where m, v, and y are the growth rates of the money supply, velocity and nominal GDP
respectively. Suppose that the policymaker wishes for the variance of nominal GDP to
be as low as possible—that is, it defines a stabilizing approach to monetary policy as
one which decreases nominal GDP variance. From the last equation we have
where refers to the standard deviation (square root of the variance) of the
subscripted variable and refers to the correlation coefficient between the
subscripted variables. With no use of discretionary policy or any rule giving

fluctuations of the money supply, will equal zero and the target variance
will simply be the exogenous variance of velocity, With the use of
discretionary policy, on the other hand, all standard deviations in the above equation
will be positive, and discretionary policy will have been stabilizing if and only if
—that is, if and only if
Thus the monetary authority would have to be sufficiently astute in its policy
timing, in trying to counteract anticipated fluctuations in velocity, that the
correlation of its money supply changes with velocity changes is not merely
negative, but sufficiently negative to overcome the inherently GDP-variance-
magnifying effects of money supply variation. Friedman believed that this
condition for discretionary policy to be stabilizing is unlikely to be fulfilled in
practice, because of the timing problems discussed above.
A related issue is the probable existence of multiplier uncertainty—imperfect
knowledge of the overall ultimate effect of a policy action of a given size.
Generally multiplier uncertainty calls for more caution and the use of
quantitatively smaller policy actions.[3]
Arguments for[edit]
Proponents of the use of discretionary policy, including in particular Keynesians,
argue that our understanding of the workings of the economy is sufficiently
astute, and the accessibility of detailed real-time economic data to policymakers
is sufficiently great, that in practice discretionary policy has been stabilizing. For
example, it is widely believed[citation needed]
that the extreme expansion of the
monetary base by the U.S. Federal Reserve and other central banks prevented
the Great Recession of the 2000s decade from becoming a full-
blown depression.
References[edit]
1. ^ Friedman, Milton. Essays in Positive Economics, University of Chicago Press,
1953.
2. ^ Friedman, Milton. "The effects of a full-employment policy on economic
stability: A formal analysis", 1953, pp. 117–132 in Friedman, Milton. Essays in
Positive Economics, University of Chicago Press, 1953.
3. ^ Brainard, William. "Uncertainty and the effectiveness of policy, 'American
Economic Review 57 (2), 1967, 411–425. JSTOR=1821642
10 Importance and Objectives of
Fiscal Policy (Economy)
Updated on: March 31, 2021 Leave a Comment
The economic conditions and priorities of developed and developing countries differ
from each other. Therefore, the importance and objectives of the fiscal policy
adopted by such countries differ vastly.

importance and objectives of fiscal policy
The significance of the fiscal policy has increased since the worldwide depression of
the thirties (1930).
Importance and Objectives of Fiscal Policy
In the developing country, the importance and objectives of fiscal policy are the
following:
1. Revenue Earning
The most effective objective of fiscal policy is to earn public revenue. The government needs
adequate revenue to fulfill responsibilities.
The state cannot fulfill its duties in case of a shortage of money but excessive taxes cannot
be imposed for increasing revenue.
The tax should be based on the taxable capacity of the citizens of the country.
From the social point of view, the burden of tax should be equal on all citizens.
Moreover, it should not adversely affect savings and investment in the country.
The main objective of fiscal policy is to increase government revenue through the
appropriate taxation system.
2. Rapid Economic Development
The government plays a significant role in rapid economic development.

The government spends its revenue on those activates which will facilitate the rapid
economic development of the country.
By spending on infrastructure (Both physical and social), maintaining law and order,
protecting national boundaries and providing services for social welfare the
government promotes rapid economic development.
Related: 14 Elements of Good and Effective Planning (How they work).
3. Proper Allocation of Resources
It is also one of the effective objectives of fiscal policy.
Generally, all natural and human resources are in limited supply as compared to
their requirement. Hence these should not be misused.
When making use of these resources priority should be given to those areas or
activities which are more essential.
The optimum allocation of resources should be done in such a way that it increases
employment opportunities and facilitates judicious distribution and checks misuse of
national wealth.
The resources can be transferred from luxurious activities to essential activities or areas
through fiscal policy.
4. Capital Formation
The objectives of fiscal policy are also to encourage capital formation in the country.
Saving and investments are low in most of the developing countries like Bangladesh
because their national income low, Therefore, fiscal policy can be used to increase
the level of savings, investment, and capital formation.
Consumption can be reduced and savings can be increased through appropriate
fiscal and taxation policy. It will increase capital formation in the country.
Related: 15 Essential Features of Venture Capital (in Simple Words).
5. Control on Inflation
Deficit financing is resorted to when public expenditure exceeds public revenue. It
creates a situation of inflation in the country. Inflation affects adversely the economy
of the country.
Therefore. It should be checked urgently and essentially.
The fiscal policy may aim at controlling inflation.
The purchasing power of the public can be reduced by increasing taxes. It will help
to check inflation and price rise.
Related: 37 Essential Qualities of Successful Entrepreneur (Must Know).

6. Price Stability
Various classes of society such as consumers, laborers and employees,
agriculturists, producers, traders, etc. Are affecting by in-fluctuation in prices.
The general public is adversely affected by increasing prices. Of course, it increases
opportunities for earning undue profits.
In the country, employment, and output are badly affected by a decrease in prices.
The fiscal policy endeavors to bring stability in prices by removing demerits of
increase/decrease in prices.
The impact of the price increase can be reduced by providing subsidy or decreasing
taxes.
Likewise, in the case of the decrease in prices, the government can purchase
commodities at minimum support price or it can provide the subsidy to buyers.
7. Balanced Economic Development
Imbalanced economic development creates several problems in the
country. Balanced economic development can be done through fiscal policy.
The government takes initiatives to invest their money example: irrigation, transport,
power and water supply facilities in India.
By setting up various projects in underdeveloped areas the government
facilitates balanced development in the country.
Related: 8 Role of Entrepreneurs in Balanced Regional Development of Industries.
8. Economic Stability
One of the objectives of fiscal policy is to provide economic stability in the country by
reducing the adverse impact of international cyclical fluctuations.

importance and objectives of fiscal policy
The fiscal policy provides economic stability by controlling external and internal
forces.
Tariffs and customs duties can be imposed in the situation of the boom period while
public construction works can be encouraged during the period of depression.
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9. Increase In the Rate of Investment
The fiscal policy also aims at increasing the rate of investment in the private
and public sector.
The rate of capital formation in developing countries is very low due to
unemployment and low per capita income.
The vicious circle of poverty is main the problem of these countries.
Therefore, fiscal policy is adopted in such a way that it reduces consumption and
encourages savings.
Taxation policy is used to reduce undesirable consumption in developed
countries.
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10. Creation of More Employment
Last but not the least objectives of fiscal policy is to increase employment
opportunities and to reduce unemployment and underemployment, For achieving this
objective the government should develop socio-economic and physical
infrastructure.
The community development programmes should be launched in rural areas.
Importance of Fiscal Policy for Economic Stabilisation!
The economy does not always work smoothly. There often occur
fluctuations in the level of economic activity. At times the economy
finds itself in the grip of recession when levels of national income,
output and employment are far below their full potential levels.
During recession, there is a lot of idle or un-utilised productive
capacity, that is, available machines and factories are not working to
their full capacity. As a result, unemployment of labour increases
along with the existence of excess capital stock.
ADVERTISEMENTS:
On the other hand, at times the economy is ‘overheated which
means inflation {i.e. rising prices) occurs in the economy. Thus, in a
free market economy there is a lot of economic instability. The
classical economists believed that an automatic mechanism works
to restore stability in the economy; recession would cure itself and
inflation will be automatically controlled.
However, the empirical evidence during the 1930s when severe
depression took place in the Western capitalist economies and also
the evidence of post Second World II period amply shows that no

such automatic mechanism works to bring about stability in the
economy.
That is why Keynes argued for intervention by the Government to
cure depression and inflation by adopting appropriate tools of
macroeconomic policy. The two important tools of macroeconomic
policy are fiscal policy and monetary policy.
According to Keynes, monetary policy was ineffective to lift the
economy out of depression. He emphasized the role of fiscal policy
as an effective tool of stabilising the economy. However, in view of
the modem economists both fiscal and monetary policies play a
useful role in stabilising the economy.
ADVERTISEMENTS:
Goals of Macroeconomic Policy:
Stabilising the economy at a higher level of employment and
national output is not the only goal of macro-economic policy.
Ensuring price stability is it’s another goal. Both inflation, (that is,
rising prices) and deflation (that is, falling prices) have bad
economic consequences.
It is therefore desirable to achieve price stability. Similarly, every
nation wants to raise the level of living of its people which can be
attained through bringing about economic growth which in turn
depends on raising the rates of saving and investment and
accumulating capital. Macro- economic policies can play a useful
role in raising the rate of saving and investment and therefore
ensure rapid economic growth.

Thus, three important goals or objectives of
macroeconomic policy (both fiscal and monetary) are
follows:
ADVERTISEMENTS:
1. Economic stability at a high level of output and employment.
2. Price stability.
3. Economic growth.
We shall confine ourselves to the discussion of the role of fiscal
policy in achieving economic stability at full employment level and
in controlling inflation and deflation and thus attaining price
stability.
ADVERTISEMENTS:
Discretionary Fiscal Policy for Stabilisation:
Fiscal policy is an important instrument to stabilise the economy,
that is, to overcome recession and control inflation in the economy.
Fiscal policy is of two kinds:
Discretionary fiscal policy and Non-discretionary fiscal policy of
automatic stabilisers. By discretionary policy we mean deliberate
change in the Government expenditure and taxes to influence the
level of national output and prices.
ADVERTISEMENTS:
Fiscal policy generally aims at managing aggregate demand for
goods and services. On the other hand, non-discretionary fiscal

policy of automatic stabilisers is a built-in tax or expenditure
mechanism that automatically increases aggregate demand when
recession occurs and reduces aggregate demand when there is
inflation in the economy without any special deliberate actions on
the part of the Government. In this section we shall confine
ourselves to the discussion of discretionary fiscal policy.
At the time of recession the Government increases its expenditure
or cuts down taxes or adopts a combination of both. On the other
hand, to control inflation the Government cuts down its
expenditure or raises taxes. In other words, to cure recession
expansionary fiscal policy and to control inflation contractionary
fiscal policy is adopted.
It is worth mentioning that fiscal policy aims at changing aggregate
demand by suitable changes in Government spending and taxes.
Thus, fiscal policy is mainly a policy of demand management. It
should be further noted that when the Government adopts
expansionary fiscal policy to cure recession, it raises its expenditure
without raising taxes or cuts down taxes without changing
expenditure or increases expenditure and cuts down taxes as well.
With the adoption of any of these types of expansionary fiscal policy
Government’s budget will have a deficit. Thus expansionary fiscal
policy to cure recession and unemployment is a deficit budget
policy. If, on the other hand, to control inflation.
ADVERTISEMENTS:
Government reduces its expenditure or increases taxes or adopts a
combination of the two, it will be planning for a budget surplus.

Thus policy of budget surplus, or at least reducing budget deficit is
adopted to remedy inflation. In what follows we will discuss fiscal
policy first to cure recession and then to control inflation.
Fiscal Policy to Cure Recession:
As we know, the recession in an economy occurs when aggregate
demand decreases due to a fall in private investment. Private
investment may fall when businessmen become highly pessimistic
about making profits in future, resulting in decline in marginal
efficiency of investment.
As a result of fall in private investment expenditure, aggregate
demand curve shifts down creating a deflationary or recessionary
gap. It is the task of fiscal policy to close this gap by increasing
Government expenditure, or reducing taxes.
ADVERTISEMENTS:
Thus there are two fiscal methods to, get the economy out
of recession:
(a) Increase in Government Expenditure
(b) Reduction of Taxes.
We discuss below both these methods.
(a) Increase in Government Expenditure to Cure
Recession:
For a discretionary fiscal policy to cure depression, the increase in
Government expenditure is an important tool. Government may
increase expenditure by starting public works, such as building

roads, dams, ports, telecommunication links, irrigation works,
electrification of new areas etc.
ADVERTISEMENTS:
For undertaking all these public works, Government buys various
types of goods and materials and employs workers. The effect of this
increase in expenditure is both direct and indirect. The direct effect
is the increase in incomes of those who sell materials and supply
labour for these projects.
The output of these public works also goes up together with the
increase in incomes. Not only that, Keynes showed that increase in
Government expenditure also has an indirect effect in the form of
the working of a multiplier. Those who get more incomes spend
them further on consumer goods depending on their marginal
propensity to consume.
As during the period of recession there exists excess capacity in the
consumer goods industries, the increase in demand for them brings
about expansion in their output which further generates
employment and incomes for the unemployed workers and so the
new incomes are spent and re-spent further and the process of
multiplier goes on working till it exhausts itself.
How large should be the increase in expenditure so that equilibrium
is established at full employment or potential level of output. This
depends on the magnitude of GNP gap caused by deflationary gap
on the one hand and the size of multiplier on the other. It may be
recalled that the size of the multiplier depends on the marginal
propensity to consume.

The impact of increase in Government expenditure in a recessionary
condition is illustrated in Fig. 28.1. Suppose to begin with the
economy is operating at full-employment or potential level of
output YF with aggregate demand curve C + I2 + G2 intersecting 45°
line at point E2. Now, due to some adverse happening (say due to
the crash in the stock market), investor’s expectations of making
profits from investment projects become dim causing a decline in
investment.
With the decline in investment, say equal to E2B, aggregate demand
curve will shift down to the new position C + I2 + G2 which will bring
the economy to the new equilibrium position at point Ex and thereby
determine Y2 level of output or income.
ADVERTISEMENTS:
The fall in output will create involuntary unemployment of labour
and also excess capacity (i.e. idle capital stock) will come to exist in
the economy. Thus emergence of deflationary gap equal to E2B and
the reverse working of the multiplier have brought about conditions
of recession in the economy.
It will be observed from Fig. 28.1 that, to overcome recession if the
Government increases its expenditure by E1H, the aggregate
demand curve will shift upward to original position C + I2 + G2 and
as a result the equilibrium level of income will increase to the full-
employment or potential level of output YF and in this way the
economy would be lifted out of depression. Note that the increase
(∆Y) in national income or output by Y1YF is not only equal to the
increase in Government expenditure by AG or E1H but a multiple of
it depending on the marginal propensity to consume. Thus, increase
in national income is equal to ∆G x 1/ 1 – MPC where 1/ 1 – MPC is

the valUE ofmultiplier.
It may also be further noted that increase in Government
expenditure without raising taxes (and therefore the policy of deficit
budgeting) will fully succeed in curing recession if rate of interest
remains unchanged. With the increase in Government expenditure
and resultant increase in output and employment demand for
money for transactions purposes is likely to increase as is shown in
Fig. 28.2 where demand for money curve shifts to right from M1
d to
M2
d as a result of increase in transactions demand for money.
Money supply remaining constant, with increase in demand for
money rate of interest is likely to rise which will adversely affect the
private investment.
The decline in private investment will tend to offset the
expansionary effect of rise in Government expenditure. Therefore, if

fiscal policy of increase in Government expenditure (or of deficit
budgeting) is to succeed in overcoming recession, the Central Bank
of the country should also pursue expansionary monetary policy
and take steps to increase the money supply so that increase in
Government expenditure does not lead to the rise in rate of interest.
It will be noticed from Fig. 28.2 that if money supply is
increased from M1
S to M2
S, the rate of interest does not rise despite
the increase in demand for money. With rate of interest remaining
unchanged, private investment will not be adversely affected and
increase in Government expenditure will have full effect on raising
national income and employment.
Financing Increase in Government Expenditures and
Budget Deficit:
An important question is how to finance the increase in
Government expenditure which is undertaken to cure recession.
This increase in Government expenditure must not be financed by
raising taxes because rise in taxes would reduce disposable incomes
and consumers’ demand for goods. As a matter of fact, rise in taxes
would offset the expansionary effect of rise in Government
spending. Therefore, proper discretionary fiscal policy at times of
recession is to have the budget deficit if expansionary effect is to be
listed.
Borrowing:
ADVERTISEMENTS:
A way to finance budget deficit is to borrow from the public by
selling interest-bearing bonds to them. However, there is a problem
in adopting borrowing as a method of financing budget deficit.

When the Government borrows from the public in the money
market, it will be competing with businessmen who also borrow for
private investment.
The Government borrowing will raise the demand for loanable
funds which in a free market economy, if rate of interest is not
administered by the Central Bank, will drive up the rate of interest.
We know the rise in rate of interest will reduce or crowd out some
private investment expenditure and interest-sensitive consumer
spending for durable goods.
Creation of New Money:
The more effective way of financing budget deficit is the creation of
new money. By creating new money to finance the deficit, the
crowding out of private investment can be avoided and full
expansionary effect of rise in Government expenditure can be
realised. Thus, creation of new money for financing budget deficit
or what is called monetisation of budget deficit has a greater
expansionary effect than that of borrowing by the Government.
(b) Reduction in Taxes to Overcome Recession:
Alternative fiscal policy measure to overcome recession and to
achieve expansion in output and employment is reduction of taxes.
The reduction in taxes increases the disposable income of the
society and causes the increase in consumption spending by the
people.
ADVERTISEMENTS:
If tax reduction of Rs. 200 crores is made by the Finance Minister, it
will lead to Rs. 150 crores in consumption, assuming marginal

propensity to consume is 0.75 or 3/4. Thus reduction in taxes will
cause an upward shift in the consumption function. If along with
the reduction in taxes, the Government expenditure is kept
unchanged, aggregate demand curve C + I + G will shift upward due
to rise in consumption function curve.
This will have an expansionary effect and the economy will be lifted
out of recession, and national income and employment will increase
and as a result unemployment will be reduced. Note that reduction
in taxes, with Government expenditure remaining constant, will
also result in budget deficit which will have to be financed either by
borrowing or creation of new money.
It is worth noting that reduction in taxes has only an indirect effect
on expansion and output through causing a rise in consumption
function. But, like the increase in government expenditure, the
increase in consumption achieved through reduction in taxes will
have a multiplier effect on increasing income, output and
employment. The value of tax multiplier, as it is called, is given by
∆T x MPC/1 – MPC or ∆C x MPC/1 – MPC
The effect of reduction in taxes in curing recession and in causing
expansion in income and output can be graphically shown by figure
such as Fig. 28.1. In case of reduction in taxes, instead of increase in
Government expenditure G, it is increase in consumption C which
will cause upward shift in the aggregate demand curve (C + I + G)
and will result in, through the working of multiplier, a higher level
of equilibrium national income.

There are some instances in the history of the capitalist world,
especially U.S.A. when taxes were reduced to stimulate the
economy. In 1964, the President Kennedy reduced personal and
business taxes by about $12 billion to give a boost to the American
economy when there was high unemployment and lower capacity
utilisation in the American economy.
ADVERTISEMENTS:
This tax cut was quite successful in reducing unemployment
substantially and expanding national income through full utilisation
of excess capacity. Again, over the period 1981-84, President
Reagan made a very large tax reduction to get out of recession and
to achieve expansion in national income to reduce unemployment.
There is some debate whether President Reagan’s tax cut alone had
positive effect on national income as some economists attribute the
recovery in that period to the monetary expansion that took place.
However, tax reduction by President Reagan did play a significant
role for bringing about the recovery.
Fiscal Policy Option: Increase in Government Expenditure
or Reduction in Taxes:
Is it better to use Government expenditure or changes in taxes to
stabilise the economy at full employment and potential-level of
output. The answer depends to a great extent upon one’s view
regarding the role of public sector.
Those who think that public sector should play a significant role in
the economy to meet various failures of a free market system will
recommend the increase in Government expenditure during

recession on public works to achieve expansion in output and
employment. On the other hand, those economists who think that
public sector is inefficient and involves waste of scarce resources
would advocate for reduction in taxes to stimulate the economy.
The choice between tax reduction and increase in Government
expenditure depends on the basis of another factor, namely, the
magnitude of the effect of expenditure multiplier and tax multiplier.
The value of tax multiplier is less than the Government expenditure
multiplier.
Ignoring the signs of the multipliers, it should be noted that
whereas expenditure multiplier is equal to 1/1 – MPC the tax
multiplier equals MPC/1 – MPC or MPC x 1/1 – MPC which is less
than 1/1 – MPC. Suppose marginal propensity to consume is 0.75 or
3/4 so that value of expenditure multiplier is 4. Increase in
Government expenditure by Rs. 100 crores will raise national
output by Rs. 400 crores. On the other hand, reduction in taxes by
Rs. 100 crores will increase income and output by 100 x MPC/1 –
MPC = 100 x ¾ /1 – ¾ = Rs. 300 crores.
Thus, the effect of reduction in taxes by an equal amount as the
increase in Government expenditure has a smaller impact on
national income than that of increase in Government expenditure.
This difference in the effects of the two methods of expanding
output has implications for the size of the Government deficit.
If we want to achieve expansion in income by the same amount, we
need to cut taxes by more than we would need to increase
Government expenditure because the size of the tax multiplier is

less than that of expenditure multiplier. In other words, in case we
adopt the policy of tax reduction, to achieve expansion by a given
amount the budget deficit planned will to have to be much greater.
However, the size of expenditure multiplier relative to the size of the
tax multiplier is not the sole deciding factor for the choice of a
policy option. For example, reductions in taxes are greatly
welcomed by the people as it directly increases their disposable
incomes. Further, it is individual or households who themselves
decide how to spend their extra disposable income made possible by
a tax cut, while in case of increase in expenditure the Government
decides how to spend it.
Fiscal Policy to Control Inflation:
When due to large increases in consumption demand by the
households or investment expenditure by the entrepreneurs, or
bigger budget deficit caused by too large an increase in Government
expenditure, aggregate demand increases beyond what the economy
can potentially produce by fully employing it’s given resources, it
gives rise to the situation of excess demand which results in
inflationary pressures in the economy.
This inflationary situation can also arise if too large an increase in
money supply in the economy occurs. In these circumstances infla-
tionary gap occurs which tend to bring about rise in prices. If
successful steps to check the emergence of exceed demand or close
the inflationary gap are not taken, the economy will experience a
period of inflation or rising prices.

For the last some decades, problem of demand- pull inflation has
been faced by both the developed and developing countries of the
world. An alternative way of looking at inflation is to view it from
the angle of business cycles. After recovery from recession, when
during upswing an economy finds itself in conditions of boom and
become overheated prices start rising rapidly.
Under such circumstances ant cyclical fiscal policy calls for
reduction in aggregate demand. Thus, fiscal policy measures to
control inflation are (1) reducing Government expenditure and (2)
increasing taxes. If in the beginning the Government is having
balanced budget, then increasing taxes while keeping Government
expenditure constant will yield budget surplus.
The creation of budget surplus will cause downward shift in the
aggregate demand curve and will therefore help in easing pressure
on prices. If there is a balanced budget to begin with and the
Government reduces its expenditure, say on defence, subsidies,
transfer payments, while keeping taxes constant, this will also
create budget surplus and result in removing excess demand in the
economy.
It is important to mention that in the developing countries like
India, the main factor responsible for inflationary pressures is
heavy budget deficit of the Government for the last several years
resulting in excess demand conditions. Rate of inflation can be
reduced not necessarily by planning for budget surplus which is in
fact impracticable but by trying to take steps to reduce budget
deficits. It has been estimated that the aim should be to reduce

fiscal deficit to 3 per cent of GNP to achieve price stability in the
Indian economy.
How the reduction in Government expenditure will help in checking
inflation is shown in Fig. 28.3. It will be seen from this figure that
an aggregate demand curve C + I + G1 intersects 45° line at point E
and determines equilibrium national income at full-employment
level of income YF. However, if due to excessive Government
expenditure and a large budget deficit, the aggregate demand curve
shifts upward to C + I + G2, this will determine Y2 level of income
which is greater than full employment or potential output level YF.
Since output cannot increase beyond YF, income will rise only in
money terms through rise in prices, real income or output
remaining unchanged. To put in other words, while the economy
does not have labour, capital and other resources sufficient to
produce Y2 level of income or output, the households, businessmen
and Government are demanding Y2 level of output.
This excess demand pushes up the price level so that level of only
nominal income increases real income or output remaining
constant. It is thus clear that with the increase in aggregate demand

beyond the full-employment level of output to C + I + G2 causes
excess demand equal to EA to emerge in the economy. It is this
excess demand EA relative to full-employment output YF which
causes the price level to rise and thus creates inflationary situation
in the economy.
This excess demand EA at full- employment level has therefore been
called inflationary gap. The task of fiscal policy is to close this
inflationary gap by reducing Government expenditure or raising
taxes. With equilibrium at point H and nominal income equal to Y2,
if Government expenditure equal to HB (which is equal to
inflationary gap AE) is reduced, aggregate demand curve will shift
downward to C + I + G1 which will restore the equilibrium at the
full-employment level YF.
The reduction in Government expenditure equal to HB through the
operation of multiplier will result in a multiple decline in the level of
national income or output. It will be seen from Fig. 28.3 that the
decrease in Government expenditure by HB has led to a much
bigger decline in output by Y2YF.
Ideally Government expenditure should cut down its expenditure
on non-development or unproductive heads such as defence,
unnecessary subsidies. It may however be noted that in India to
control inflation the Government has been reducing capital
expenditure which is mainly of development nature and has
therefore been validly criticised.
Raising Taxes to Control Inflation:
As an alternative to reduction in Government expenditure, the taxes
can be increased to reduce aggregate demand. For this purpose
especially personal direct taxes such as income tax, wealth tax, and

corporate tax can be raised. The hike in taxes reduces the disposable
incomes of the people and thereby forces them to reduce their
consumption demand.
Note that in Fig. 28.3 as a result of hike in personal taxes it is the
decrease in consumption-demand (C) component which will cause
the aggregate demand curve C + I + G2 to shift downward. Since, as
shown above, the magnitude of tax multiplier is smaller than the
expenditure multiplier, the tax revenue will be raised by a greater
amount to achieve contraction in national income by Y2YF.
Disposing of Budget Surplus:
We have seen above to control demand-pull inflation the
Government either reduces its expenditure or raises taxes to lower
aggregate demand for goods and services. Reduction in expenditure
or hike in taxes results in decrease in budget deficits (if occurring
before such steps) or in the emergence of budget surplus if the
Government was having balanced budget prior to the adoption of
anti-inflationary fiscal policy measures. Let us assume that anti-
inflationary fiscal policy results in budget surplus. Anti-inflationary
impact of budget surplus depends to a good extent on how the
Government disposes of this budget surplus.
There are two ways in which budget surplus can be
disposed of:
(1) Reducing or retiring public debt and
(2) Impounding public debt.
We examine below the anti-inflationary effects of these
two ways of disposing of the budget surplus:

1. Retiring Public Debt:
The budget surplus created by anti-inflationary policy can be used
by the Government to pay back the outstanding debt. However,
using budget surplus for retiring public debt will weaken its anti-
inflationary effect. In paying off the debt held by the public, the
Government will be returning the money to the public which it has
collected through taxes. Further, this will also add to the money
supply with the public.
The general public will spend a part of the money so received which
will raise consumption demand. Besides, retiring of public debt will
result in the expansion of money supply in the money market which
will tend to lower the rate of interest. The lower rate of interest will
stimulate consumption and investment demand while anti-
inflationary policy requires that they should be reduced.
2. Impounding of Public Debt:
To realise a large anti-inflationary effect of budget surplus it is
desirable to impound the surplus fund. The impounding surplus
funds means that they should be kept idle. Thus by impounding the
budget surplus, the Government shall be withdrawing some income
or purchasing power from the income-expenditure stream and thus
will not create any inflationary pressures to offset the deflationary
impact of the budget surplus. To conclude, the impounding of
budget surplus is a better method of disposing of budget surplus
than of paying off public debt.
Non-Discretionary Fiscal Policy: Automatic Stabilizers:
There is an alternative to the use of discretionary fiscal policy which
generally involves problems of lags in recognising the problem of

recession or inflation and lag of taking appropriate action to tackle
the problem. In this non-discretionary fiscal policy, the tax
structure and expenditure pattern are so designed that taxes and
Government spending vary automatically in appropriate direction
with the changes in national income.
That is, these taxes and expenditure pattern without any special
deliberate action by the Government and Parliament automatically
raise aggregate demand in times of recession and reduce aggregate
demand in times of boom and inflation and thereby help in
ensuring economic stability. These fiscal measures are therefore
called automatic stabilizers or built-in stabilizers.
Since these automatic stabilizers do not require any fresh deliberate
policy action or legislation by the government, they represent non-
discretionary fiscal policy. Built-in-stability of tax revenue and
Government expenditure of transfer payments and subsidies is
created because they vary with national income.
These taxes and expenditure automatically bring about appropriate
changes in aggregate demand and reduce the impact of recession
and inflation that might occur in an economy at some times. This
means that because of the existence of these automatic or built-in
stabilizers recession and inflation will be shorter and less intense
than otherwise be the case.
Important automatic fiscal stabilisers are personal income taxes,
corporate income taxes, transfer payments such as unemployment
compensation, welfare benefits, and corporate dividends. We

discuss below these taxes, revenue from which varies directly with
the change in national income.
Personal Income Taxes:
The tax rate structure is so designed that revenue from these taxes
directly varies with income. Moreover, personal income taxes have
progressive rates; the higher rates are charged from the upper
income brackets. As a result, when national income increases
during expansion and inflation, increasing percentage of the
people’s income are paid to the Government.
Thus, through causing a decline in their disposable income these
taxes automatically reduce people’s consumption and therefore
aggregate demand. This decline in aggregate demand because of
imposition of progressive personal income taxes tends to check
inflation from becoming more severe. On the other hand, when
national income declines at times of recession, the tax revenue
declines as well which prevents aggregate demand from falling by
the same proportion as the decline in income?
Corporate Income Taxes:
Companies, or corporations as they are called now, also pay a
percentage of their profits as tax to the Government. Like personal
income taxes, corporate income tax rate is also generally higher at
higher levels of corporate profits.
As recession and inflation affect corporate taxes greatly, they have a
powerful stabilising effect on aggregate demand; the revenue from
them rises greatly during inflation and boom which tends to reduce

aggregate demand, and revenue from them falls greatly during
recession which tends to offset the decline in aggregate demand.
Transfer Payments:
Unemployment Compensation and Welfare Benefits. When there is
recession and as a result unemployment increases, the Government
has to spend more on compensation for unemployment and other
welfare programmes such as food stamps, rent-subsidies, subsidies
to farmers.
This hike in Government expenditure tends to make recession
short-lived and less intense. On the other hand, when at times of
boom and inflation national income increases and therefore
unemployment falls, the Government curtails its programme of
social benefits which result in lowering Government expenditure.
The smaller spending by the Government helps to control inflation.
Corporate Dividend Policy:
With economic fluctuations, corporate profits also rise and fall.
However, corporations do not so quickly increase or reduce
dividends in tune with fluctuations in profits and follow a fairly
stable dividend policy. This permits the individuals to spend more
during recession and spend less than would have the case if
dividends were lowered in time of recession and raised in
conditions of boom and inflation. Thus, fairly stable dividends tend
to cushion a recession and curb inflation by stabilising consumption
expenditure.
Conclusion:

It follows from above that automatic stabilisers reduce the intensity
of business fluctuations, that is. both recession and inflation.
However, the automatic or built-in stabilizers cannot alone correct
the recession and inflation significantly. According to an estimate
made for the U.S.A., automatic stabilizers have been able to reduce
fluctuations in national income only by one-third. Therefore, the
role of discretionary fiscal policy, namely, deliberate and explicit
changes in tax rates and amount of Government expenditure are
required to cure recession and curb inflation.
Crowding Out and Effectiveness of Fiscal Policy:
The critics of Keynesian theory has pointed out that expansionary
effect of fiscal policy is not as much large as Keynesian economists
suggest. In the Keynesian theory it is asserted that when
Government increases its expenditure without raising taxes or when
it reduces taxes without changing expenditure, it will have a large
expansionary effect on national income.
In other words, deficit budget would lead to the large increase in
aggregate demand and thereby help to expand national output and
income. However, it has been pointed that the above analysis of
effect of expansionary fiscal policy of budget deficit ignores the
effect of increase in Government expenditure or budget deficit on
private investment.
It has been argued that increase in Government expenditure or
creation of budget deficit adversely affects private investment which
offsets to a good extent the expansionary effect of budget deficit.
This adverse effect comes about as increase in Government

expenditure or reduction in taxes causes rate of interest to go up.
There are two ways in which rise in rate of interest is explained.
First, within the framework of Keynesian theory increase in
Government expenditure leads to the rise in national output which
raises the transactions demand for money. Given the supply of
money in the economy, the increase in transactions demand for
money will cause the rate of interest to go up. Secondly, in order to
finance its budget deficit the Government will borrow funds from
the market. This will raise the demand for loanable funds which will
bring about rise in the rate of interest.
Whatever the mechanism the budget deficit or increase in
Government expenditure to achieve expansion in national income
and output will cause the rate of interest to go up. The rise in the
rate of interest will discourage private investment. As we know from
the theory of investment, at a higher rate of interest, private
investment declines.
Thus, increase in Government expenditure or fiscal policy of budget
deficit crowds out private investment. This fall in private
investment as a result of rise in rate of interest will offset or cancel
out a part of the expansionary effect of increase in Government
expenditure. The magnitude of this crowding-out effect depends on
the elasticity of the investment demand.
If investment demand is more elastic, the decrease in private
investment consequent to the rise in rate of interest will be quite
substantial and will greatly offset the expansionary effect of the
increase in Government expenditure. On the contrary, if investment

demand is relatively inelastic, the rise in rate of interest will lead to
only a small decline in private investment and therefore crowding
out-effect will be relatively small.
It, therefore, follows that the magnitude of crowding out
weakens the effectiveness of fiscal policy. The crowding out effect of
expansionary fiscal policy and its effect on national output and
employment is graphically shown in Fig. 28.4 and 28.5.

To begin with the economy is in equilibrium at Y1 level of income
where aggregate demand curve C + I + G1 intersects the 45° line and
determines Y1 level of income.
Let us assume that this is much below the potential or full-
employment level of output. Suppose in order to raise the level of
national income and output, the Government raises its expenditure
from G1 to G2 so that the aggregate demand curve shifts upward to
the new position C + I + G2 which intersects the 45° line at point E3.
With the increase in Government expenditure national income will
rise by ∆G x multiplier, that is, by ∆ G x (1/ 1 – MPC). In the
absence of crowding-out effect, national income will rise to Y3. This
change in national income, ∆Y or by Y1Y3 is equal to the increase in
Government expenditure (G) times the value of multiplier 1/ 1 –
MPC.
However, as explained above, the increase in Government
expenditure or the creation of budget deficit causes the rate of
interest to rise, say from r1 to r2. With the rise in interest from r1 to
r2 private investment decreases from I1to I2.

Now, with the decline in private investment expenditure, the new
lower position C +1 + G2 (dotted) and as a result new equilibrium is
reached at Y2 level of income. Thus, net result of increase in
Government expenditure (DG) and crowding out of private
investment equal to 2 or ∆I is the expansion in national income
equal to only Y1Y2 which is relatively very small as compared to the
rise in income by Y1 Y3 in the absence of crowding-out effect. Thus,
the crowding-out effect has weakened the expansionary effect of
fiscal policy.
However, in view of this author crowding out effect has been blown
out of all proportions by the critics of Keynes. As a matter of fact,
when Government raises its expenditure, it leads to a large increase
in aggregate demand for several goods and services through the
working of multiplier. This rising aggregate demand improves
investment climate by raising expectations of making profits by the
private sector.
That at each rate of interest, more private investment will be
forthcoming. Thus, while negative crowding out effect takes place as
a result of moving upward along the given investment demand
curve, there is positive effect of increase in aggregate demand on
private investment which occurs as a result of rightward shift in the
investment demand curve. Thus, we see that crowding out effect is a
highly controversial issue of macro-economics.

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