FISCAL POLICY

TYPES OF FISCAL POLICY

• According to the classical economists, fiscal policy may be unnecessary because market mechanisms eventually cure instability without government intervention. These market forces, they argue, are dynamic and help to keep the economy always at or near the natural level of real GDP.
•  For example they believed that prices and wages are flexible and that they would guarantee that markets adjust to equilibrium and eliminate shortages and surpluses. 
• Fiscal policy measures to correct different problems created by business-cycle instability are of two basic types namely, expansionary and contractionary. Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction.
•  This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in all types of government spending and / or a decrease in taxes. 
• Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely to induce inflation. 
• This is carried out by decreasing the aggregate expenditures and aggregate demand through a decrease in all types of government spending and/ or an increase in taxes. Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a larger budget surplus. In other words, if the state of the economy is such that its growth rate is extraordinarily high causing inflation and asset bubbles, contractionary fiscal policy can be used to confine it into sustainable levels. 

We have understood in general that governments influence the economy through their policies in respect of taxation, expenditure and borrowing. The essence of what we learn in the rest of the unit is that:

• during inflation or when there is excessive levels of utilization of resources, fiscal policy aims at controlling excessive aggregate spending, and 
• during deflation or during a period of sluggish economic activity when the rate of utilization of resources is less, fiscal policy aims to compensate the deficiency in effective demand by boosting aggregate spending. 

We shall now describe the application of each of the fiscal policy tools.

Expansionary Fiscal Policy

• A recession is said to occur when overall economic activity declines, or in other words, when the economy ‘contracts’. A recession sets in with a period of declining real income, as measured by real GDP simultaneously with a situation of rising unemployment.
• If an economy experiences a fall in aggregate demand during a recession, it is said to be in a demand-deficient recession. Due to decline in real GDP, the aggregate demand falls and therefore, lesser quantity of goods and services will be produced. To combat such a slump in overall economic activity, the government can resort to expansionary fiscal policies. 
• An expansionary fiscal policy is used to address recession and the problem of general unemployment on account of business cycles. We may technically refer to this as a policy measure to close a ‘recessionary gap’. A recessionary gap, also known as a contractionary gap, is said to exist if the existing levels of aggregate production is less than what would be produced with full employment of resources. 
• It is a measure of output that is lost when actual national income falls short of potential income, and represents the difference between the actual aggregate demand and the aggregate demand which is required to establish the equilibrium at full employment level of income .This gap occurs during the contractionary phase of business-cycle and results in higher rates of unemployment. In other words, recessionary gap occurs when the aggregate demand is not sufficient to create conditions of full employment. Now the question is how do changes in government expenditure (G), and taxes (T) eliminate a recessionary gap? 

We shall now look into the Keynesian arguments for combating recession using expansionary fiscal policy. When the aggregate demand (i.e. economy’s appetite for buying goods and services) falls short of aggregate supply (the economy’s capacity to produce goods and services), it results in unemployment of resources, especially labour. In that case, the government intervenes through an expansionary fiscal policy. The following figure illustrates the operation of expansionary fiscal policy.

Expansionary Fiscal policy for Combating Recession 

Real GDP at Y1 level lies below the natural level, Y 2. This represents a situation where the economy is initially in a recession. There is less than full employment of the resources in the economy. The classical economists held the view that in such a condition flexibility of wages would cause wages to fall resulting in reduction in costs. Consequently, suppliers would increase supply and the short run aggregate supply curve SAS1 will shift to the right say SAS 2 and bring the economy back to the level of full employment at Y2. However, according to Keynes, wages are not as flexible as what the classical economists believed and are ‘sticky downward,’ meaning wages will not adjust rapidly to accommodate the unemployed. Therefore, recession, once set in, would persist for a long time. How does the government intervene? The government responds by increasing government expenditures in adequate quantities as to cause a shift in the aggregate demand curve to the right from AD 1 to AD 2. In doing so, the government may have to incur a budget deficit by spending more than its current receipts. As a response to the shift in AD, output increases as the total demand in the economy increases. Firms respond to growing demand by producing more output. In order to increase their output in the short- run, firms must hire more workers. This has the effect of reducing unemployment in the economy.

A relevant question here is how much should be the increase in government expenditure? Should it be exactly the same amount as the required level of increase in output? (Y 2 - Y 1 )? The answer is that it depends upon the GNP gap created due to recession and also on the size of multiplier which depends upon marginal propensity to consume. The increase in government expenditures need not be equal to the difference between Y 2 and Y 1, it can be much less. The concept of ‘fiscal multiplier,’ i.e. the response of gross domestic product to an exogenous change in government expenditures is of use to determine the required level of government expenditure. Any increase in autonomous aggregate expenditures (including government expenditures) has a multiplier effect on aggregate demand. As such, the government needs to incur only a lesser amount of expenditure to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP.

• A pertinent question here is; from where will the government find resources to increase its expenditure? We know that if government resorts to increase in taxes, it is self- defeating as increased taxes will reduce the disposable incomes and therefore aggregate demand.
•  The government should in such cases go for a deficit budget which may be financed either through borrowing or through monetization (creation of additional money to finance expenditure). The former runs the risk of crowding out private spending. 
• It may however be noted that expansionary fiscal policy will be successful only if there is accommodative monetary policy. If interest rates rise as a result of increased demand for money but money supply does not rise concurrently, then private investment will be adversely affected. If interest rates remain unchanged, private investment will not be affected badly and a rise in government expenditure will have full effect on national income and employment.