THEORIES OF DEMAND FOR MONEY

 THEORIES OF DEMAND FOR MONEY 

 Classical Approach:

 The Quantity Theory of Money (QTM) The quantity theory of money, one of the oldest theories in Economics, was first propounded by Irving Fisher of Yale University in his book ‘The Purchasing Power of Money’ published in 1911 and later by the neoclassical economists. Both versions of the QTM demonstrate that there is strong relationship between money and price level and the quantity of money is the main determinant of the price level or the value of money. In other words, changes in the general level of commodity prices or changes in the value or purchasing power of money are determined first and foremost by changes in the quantity of money in circulation.

Fisher’s version, also termed as ‘equation of exchange’ or ‘transaction approach’ is formally stated as follows:

                        MV = PT

Where,

 M= the total amount of money in circulation (on an average) in an economy

V = transactions velocity of circulation i.e. the average number of times across all transactions a unit of money(say Rupee) is spent in purchasing goods and services

P = average price level (P= MV/T)

T = the total number of transactions.

  Later, Fisher extended the equation of exchange to include demand (bank) deposits (M’) and their velocity (V’) in the total supply of money. Thus, the expanded form of the equation of exchange becomes:

                  MV + M'V' = PT

Where

 M' = the total quantity of credit money

V' = velocity of circulation of credit money

The total supply of money in the community consists of the quantity of actual money (M) and its velocity of circulation (V). Velocity of money in circulation (V) and the velocity of credit money (V') remain constant. T is a function of national income. Since full employment prevails, the volume of transactions T is fixed in the short run. Briefly put, the total volume of transactions (T) multiplied by the price level (P) represents the demand for money. The demand for money (PT) is equal to the supply of money (MV + M'V)'. In any given period, the total value of transactions made is equal to PT and the value of money flow is equal to MV+ M'V'.

We shall now look into the classical idea of the demand for money. Fisher did not specifically mention anything about the demand for money; but the same is embedded in his theory as dependent on the total value of transactions undertaken in the economy. Thus, there is an aggregate demand for money for transactions purpose and more the number of transactions people want, greater will be the demand for money. The total volume of transactions multiplied by the price level (PT) represents the demand for money.

The Neo classical Approach: The Cambridge approach

In the early 1900s, Cambridge Economists Alfred Marshall, A.C. Pigou, D.H. Robertson and John Maynard Keynes (then associated with Cambridge) put forward a fundamentally different approach to quantity theory, known as neoclassical theory or cash balance approach. The Cambridge version holds that money increases utility in the following two ways:

1. enabling the possibility of split-up of sale and purchase to two different points of time rather than being simultaneous ,and

2. being a hedge against uncertainty.

While the first above represents transaction motive, just as Fisher envisaged, the second points to money’s role as a temporary store of wealth. Since sale andpurchase of commodities by individuals do not take place simultaneously, they need a ‘temporary abode’ of purchasing power as a hedge against uncertainty. As such, demand for money also involves a precautionary motive in Cambridge approach. Since money gives utility in its store of wealth and precautionary modes, one can say that money is demanded for itself.
              Now, the question is how much money will be demanded? The answer is: it depends partly on income and partly on other factors of which important ones are wealth and interest rates. The former determinant of demand i.e. income, points to transactions demand such that higher the income, the greater the quantity of purchases and as a consequence greater will be the need for money as a temporary abode of value to overcome transactions costs. The Cambridge equation is stated as:

                                                                Md = k PY
Where

Md  = is the demand for money

 Y = real national income
P = average price level of currently produced goods and services

 PY = nominal income
k = proportion of nominal income (PY) that people want to hold as cash balances

The term ‘k’ in the above equation is called ‘Cambridge k’. The equation above explains that the demand for money (M) equals k proportion of the total money income.

Thus we see that the neoclassical theory changed the focus of the quantity theory of money to money demand and hypothesized that demand for money is a function of only money income. Both these versions are chiefly concerned with money as a means of transactions or exchange, and therefore, they present models of the transaction demand for money. 

 The Keynesian Theory of Demand for Money

Keynes’ theory of demand for money is known as ‘Liquidity Preference Theory’. ‘Liquidity preference’, a term that was coined by John Maynard Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’(1936), denotes people’s desire to hold money rather than securities or long-term interest-bearing investments.

According to Keynes, people hold money (M) in cash for three motives:

(i) Transactions motive ,

(ii) Precautionary motive, and

(iii) Speculative motive. 

(a) The Transactions Motive

The transactions motive for holding cash relates to ‘the need for cash for current transactions for personal and business exchange.’ The need for holding money arises because there is lack of synchronization between receipts and expenditures. The transaction motive is further classified into income motive and business (trade) motive, both of which stressed on the requirement of individuals and businesses respectively to bridge the time gap between receipt of income and planned expenditures.

Keynes did not consider the transaction balances as being affected by interest rates. The transaction demand for money is directly related to the level of income. The transactions demand for money is a direct proportional and positive function of the level of income and is stated as follows: 

                              L_r = kY
Where

Lr, is the transactions demand for money,

k is the ratio of earnings which is kept for transactions purposes 

 Y is the earnings.

Keynes considered the aggregate demand for money for transaction purposes as the sum of individual demand and therefore, the aggregate transaction demand for money is a function of national income. 

(b) The Precautionary Motive

Many unforeseen and unpredictable contingencies involving money payments occur in our day to day life. Individuals as well as businesses keep a portion of their income to finance such unanticipated expenditures. The amount of money demanded under the precautionary motive depends on the size of income,prevailing economic as well as political conditions and personal characteristics of the individual such as optimism/ pessimism, farsightedness etc. Keynes regarded the precautionary balances just as balances under transactions motive as income elastic and by itself not very sensitive to rate of interest.

(c) The Speculative Demand for Money

The speculative motive reflects people’s desire to hold cash in order to be equipped to exploit any attractive investment opportunity requiring cash expenditure. According to Keynes, people demand to hold money balances to take advantage of the future changes in the rate of interest, which is the same as future changes in bond prices. It is implicit in Keynes theory, that the ‘rate of interest’, i, is really the return on bonds. Keynes assumed that that the expected return on money is zero, while the expected returns on bonds are of two types, namely:

(i) the interest payment

(ii) the expected rate of capital gain.

The market value of bonds and the market rate of interest are inversely related. A rise in the market rate of interest leads to a decrease in the market value of the bond, and vice versa. Investors have a relatively fixed conception of the ’normal’ or ‘critical’ interest rate and compare the current rate of interest with such ‘normal’ or ‘critical’ rate of interest.
               If wealth-holders consider that the current rate of interest is high compared to the ‘normal or critical rate of interest’, they expect a fall in the interest rate (rise in bond prices). At the high current rate of interest, they will convert their cash balances into bonds because:

(i) they can earn high rate of return on bonds

(ii) they expect capital gains resulting from a rise in bond prices consequent upon an expected fall in the market rate of interest in future.
               Conversely, if the wealth-holders consider the current interest rate as low, compared to the ‘normal or critical rate of interest’, i.e., if they expect the rate of interest to rise in future (fall in bond prices), they would have an incentive to hold their wealth in the form of liquid cash rather than bonds because:

(i) the loss suffered by way of interest income forgone is small,

(ii) they can avoid the capital losses that would result from the anticipated increase in interest rates, and

(iii) the return on money balances will be greater than the return on alternative assets

(iv) If the interest rate does increase in future, the bond prices will fall and the idle cash balances held can be used to buy bonds at lower price and can thereby make a capital-gain.

Summing up, so long as the current rate of interest is higher than the critical rate of interest, a typical wealth-holder would hold in his asset portfolio only government bonds while if the current rate of interest is lower than the critical rate of interest, his asset portfolio would consist wholly of cash. When the current rate of interest is equal to the critical rate of interest, a wealth-holder is indifferent to holding either cash or bonds. The inference from the above is that the speculative demand for money and interest are inversely related.

The speculative demand for money of individuals can be diagrammatically presented as follows:
Individual’s Speculative Demand for



The discontinuous portfolio decision of a typical individual investor is shown in the figure above. When the current rate of interest rn is higher than the critical rate of interest rc, the entire wealth is held by the individual wealth-holder in the form of government bonds. If the rate of interest falls below the critical rate of interest rc, the individual will hold his entire wealth in the form of speculative cash balances.

When we go from the individual speculative demand for money to the aggregate speculative demand for money, the discontinuity of the individual wealth-holder's demand curve for the speculative cash balances disappears and we obtain a continuous downward sloping demand function showing the inverse relationship between the current rate of interest and the speculative demand for money as shown in figure below:

Aggregate Speculative Demand for Money



According to Keynes, higher the rate of interest, lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. The sum of the transaction and precautionary demand, and the speculative demand, is the total demand for money.

To sum up, an increase in income increases the transaction and precautionary demand for money and a rise in the rate of interest decreases the demand for speculative demand money.

DEMAND FOR MONEY

 THE DEMAND FOR MONEY

• Having understood the role of money in an economy, we shall now examine the concept of demand for money. If people desire to hold money, we say there is demand for money. As we are aware, the demand for money is in the nature of derived demand; it is demanded for its purchasing power. Basically, people demand money because they wish to have command over real goods and services with the use of money. 
• Demand for money is actually demand for liquidity and demand to store value. The demand for money is a decision about how much of one’s given stock of wealth should be held in the form of money rather than as other assets such as bonds. Although it gives little or no return, individuals, households as well as firms hold money because it is liquid and offers the most convenient way to accomplish their day to day transactions.
• One might think why is it important to study about demand for money? Demand for money has an important role in the determination of interest, prices and income in an economy. The role of money in the macro economy is usually examined in a supply/demand framework.Before we go into the theories of demand for money, we shall have a quick look at some important variables on which demand for money depends on. 
• The quantity of nominal money or how much money people would like to hold in liquid form depends on many factors, such as income, general level of prices, rate of interest, real GDP, and the degree of financial innovation etc. Higher the income of individuals, higher the expenditure and richer people hold more money to finance their expenditure.
•  The quantity is directly proportional to the prevailing price level; higher the prices, higher should be the holding of money. As mentioned above, one may hold his wealth in any form other than money, say as an interest yielding asset. It follows that the opportunity cost of holding money is the interest rate a person could earn on other assets. 
• Therefore, higher the interest rate, higher would be opportunity cost of holding cash and lower the demand for money. Innovations such as internet banking, application based transfers and automatic teller machines reduce the need for holding liquid money. Just as households do, firms also hold money essentially for the same basic reasons.

MONEY MARKET

INTRODUCTION

• Money is at the centre of every economic transaction and plays a significant role in all economies. In simple terms money refers to assets which are commonly used and accepted as a means of payment or as a medium of exchange or of transferring purchasing power. 
• For policy purposes, money may be defined as the set of liquid financial assets, the variation in the stock of which will have impact on aggregate economic activity.
• Money has generalized purchasing power and is generally acceptable in settlement of all transactions and in discharge of other kinds of business obligations including future payments. Anything that would act as a medium of exchange is not necessarily money. 
• For example, a bill of exchange may also be a medium of exchange, but it is not money since it is not generally accepted as a means of payment. Money is a totally liquid asset as it can be used directly, instantly, conveniently and without any costs or restrictions to make payments. 
• At the fundamental level, money provides us with a convenient means to access goods and services. Money represents a certain value, but currency which represents money does not necessarily have intrinsic value. 
• As you know, fiat money has no intrinsic value, but is used as a medium of exchange because the government has, by law, made them “legal tender,” which means that they serve by law as means of payment. In modern days, money is not necessarily a physical item; it may also constitute electronic records. 
• Money is, in fact, only one among many kinds of financial assets which households, firms, governments and other economic units hold in their asset portfolios. Unlike other financial assets, money is an essential element in conducting most of the economic transactions in an economy.

There is no unique definition of ‘money’, either as a concept in economic theory or as measured in practice. Money can be defined for policy purposes as the set of liquid financial assets, the variation in the stock of which could impact on aggregate economic activity. As a statistical concept, money could include certain liquid liabilities of a particular set of financial intermediaries or other issuers’. (Reserve Bank of India Manual on Financial and Banking Statistics, 2007)

 FUNCTIONS OF MONEY

Money performs many important functions in an economy.

(i) Money is a convenient medium of exchange or it is an instrument that facilitates easy exchange of goods and services. Money, though not having any inherent power to directly satisfy human wants, by acting as a medium of exchange, it commands purchasing power and its possession enables us to purchase goods and services to satisfy our wants. By acting as an intermediary, money increases the ease of trade and reduces the inefficiency and transaction costs involved in a barter exchange. By decomposing the single barter transaction into two separate transactions of sale and purchase, money eliminates the need for double coincidence of wants. Money also facilitates separation of transactions both in time and place and this in turn enables us to economize on time and efforts involved in transactions. 

(ii) Money is an explicitly defined unit of value or unit of account. Put differently, money is a ‘common measure of value’ or ‘common denominator of value’ or money functions as a numeraire. We know, Rupee is the unit of account in India in which the entire money is denominated. The monetary unit is the unit of measurement in terms of which the value of all goods and services is measured and expressed. The value of each good or service is expressed as price, which is nothing but the number of monetary units for which the good or service can be exchanged. It is convenient to trade all commodities in exchange for a single commodity. So also, it is convenient to measure the prices of all commodities in terms of a single unit, rather than record the relative price of every good in terms of every other good. An obvious advantage of having a single unit of account is that it greatly reduces the number of exchange ratios between goods and services. Use of money as a unit of account can encourage trade by making it easier for individuals to know how much one good is worth in terms of another.
                   A common unit of account facilitates a system of orderly pricing which is crucial for rational economic choices. Goods and services which are otherwise not comparable are made comparable through expressing the worth of each in terms of money. Money is a useful measuring rod of value only if the value of money remains constant. The value of money is linked to its purchasing power. Purchasing power is the inverse of the average or general level of prices as measured by the consumer price index.

(iii) Money serves as a unit or standard of deferred payment i.e money facilitates recording of deferred promises to pay. Money is the unit in terms of which future payments are contracted or stated. However, variations in the purchasing power of money due to inflation or deflation, reduce the efficacy of money in this function.
             Like nearly all other assets, money is a store of value. People prefer to hold it as an asset, that is, as part of their stock of wealth. The splitting of purchases and sale into two transactions involves a separation in both time and space. This separation is possible because money can be used as a store of value or store of means of payment during the intervening time. Again, rather than spending one’s money at present, one can store it for use at some future time. Thus, money functions as a temporary abode of purchasing power in order to efficiently perform its medium of exchange function.

Money also functions as a permanent store of value. There are many other assets such as government bonds, deposits and other securities, land, houses etc. which also store value. Despite having the advantages of potential income yield and appreciation in value over time, these other assets are subject to limitations such as storage costs, lack of liquidity and possibility of depreciation in value. Money is the only asset which has perfect liquidity. Additionally, money also commands reversibility as its value in payment equals its value in receipt. All assets other than money lack perfect reversibility in the sense that their value in payment is not equal to their value in receipt. Even financial assets like the riskless government bonds do not command perfect reversibility as their purchase and sale are subject to certain brokerage costs although this may be quite small.The effectiveness of an asset as a store of value depends on the degree and certainty with which the asset maintains its value over time. Hence, in order to serve as a permanent store of value in the economy, the purchasing power or the value of money should either remain stable or should monotonically rise over time.

There are some general characteristics that money should possess in order to make it serve its functions as money. Money should be:

•  generally acceptable 
•  durable or long-lasting 
•  effortlessly recognizable.
•  difficult to counterfeit i.e. not easily reproducible by people
•   relatively scarce, but has elasticity of supply 
•  portable or easily transported 
•  possessing uniformity; and 
• divisible into smaller parts in usable quantities or fractions without losing value

CROWDING OUT

Crowding Out

• Some economists are of the opinion that government spending would sometimes substitute private spending and when this happens the impact of government spending on aggregate demand would be smaller than what it should be and therefore fiscal policy may become ineffective.
•  An increase in the size of government spending during recessions will ‘crowd-out’ private spending in an economy and lead to reduction in an economy’s ability to self-correct from the recession, and possibly also reduce the economy’s prospects of long-run economic growth .
• Crowding out effect is the negative effect fiscal policy may generate when money from the private sector is ‘crowded out’ to the public sector. In other words, when spending by government in an economy replaces private spending, the latter is said to be crowded out. 
• For example, if government provides free computers to students, the demand from students for computers may not be forthcoming. When government increases it’s spending by borrowing from the loanable funds from market, the demand for loans increases and this pushes the interest rates up. 
•  Private investments are sensitive to interest rates and therefore some private investment spending is discouraged. Similarly, when government increases the budget deficit by selling bonds or treasury bills, the amount of money with the private sector decreases and consequently interest rates will be pushed up. 
• As a result, private investments, especially the ones which are interest –sensitive, will be reduced. Fiscal policy becomes ineffective as the decline in private spending partially or completely offset the expansion in demand resulting from an increase in government expenditure. 
•  Nevertheless, during deep recessions, crowding-out is less likely to happen as private sector investment is already minimal and therefore there is only insignificant private spending to crowd out. Moreover, during a recession phase the government would be able to borrow from the market without increasing interest rates. 

 CONCLUSION

Well designed and timely fiscal responses are necessary for an economy which is either going through stages of recession or inflation or on a drive to achieve economic growth and/ or equitable distribution of income. During periods of recession when there are idle productive capacity and unemployed workers, an increase in aggregate demand will generally bring about an increase in total output without changing the level of prices. On the contrary, if an economy is functioning at full employment, an expansionary fiscal policy will exert pressure on prices to go up and will have no impact on total output. Fiscal policy is also a potent instrument for bringing in economic growth and equality in distribution of income.

FISCAL POLICY

 FISCAL POLICY FOR REDUCTION IN INEQUALITIES OF INCOME AND WEALTH

• Many developed and developing economies are facing the challenge of rising inequality in incomes and opportunities. Fiscal policy is a chief instrument available for governments to influence income distribution and plays a significant role in reducing inequality and achieving equity and social justice. 
• The distribution of income in the society is influenced by fiscal policy both directly and indirectly. While current disposable incomes of individuals and corporates are dependent on direct taxes, the potential for future earnings is indirectly influenced by the nation’s fiscal policy choices.
• Government revenues and expenditure have traditionally been regarded as important instruments for carrying out desired redistribution of income. 

 We shall see a few such measures as to how each of these can be manipulated to achieve desired distributional effects.

•  A progressive direct tax system ensures that those who have greater ability to pay contribute more towards defraying the expenses of government and that the tax burden is distributed fairly among the population.
• Indirect taxes can be differential: for example, the commodities which are primarily consumed by the richer income group, such as luxuries, are taxed heavily and the commodities the expenditure on which form a larger proportion of the income of the lower income group, such as necessities, are taxed light.
• A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer sections of the society. This is done through spending programmes targeted on welfare measures for the disadvantaged , such as

1.    poverty alleviation programmes
2. free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of living of poor
3.  infrastructure provision on a selective basis
4. various social security schemes under which people are entitled to old-age pensions, unemployment relief, sickness allowance etc.
5.  subsidized production of products of mass consumption
6. public production and/ or grant of subsidies to ensure sufficient supply of essential goods, and
7.  strengthening of human capital for enhancing employability etc.

Choice of a progressive tax system with high marginal taxes may act as a strong deterrent to work save and invest. Therefore, the tax structure has to be carefully framed to mitigate possible adverse impacts on production and efficiency. Additionally, the redistributive fiscal policy and the extent of spending on redistribution should be consistent with the macroeconomic policy objectives of the nation.

 LIMITATIONS OF FISCAL POLICY
We have seen above that discretionary fiscal policy is the conscious manipulation of government spending and taxes to influence the economy. However, there are some significant limitations in respect of choice and implementation of fiscal policy.

1. One of the biggest problems with using discretionary fiscal policy to counteract fluctuations is the different types of lags involved in fiscal-policy action. There are significant lags are:

•  Recognition lag: The economy is a complex phenomenon and the state of the macro economic variables is usually not easily comprehensible. Just as in the case of any other policy, the government must first recognize the need for a policy change.
•  Decision lag: Once the need for intervention is recognized, the government has to evaluate the possible alternative policies. Delays are likely to occur to decide on the most appropriate policy.
•  Implementation lag: even when appropriate policy measures are decided on, there are possible delays in bringing in legislation and implementing them.
• Impact lag: impact lag occurs when the outcomes of a policy are not visible for some time.

2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an expansionary policy is initiated when the economy is already on a path of recovery and vice versa.

3. There are difficulties in instantaneously changing governments’ spending and taxation policies.

4. It is practically difficult to reduce government spending on various items such as defence and social security as well as on huge capital projects which are already midway.

5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.

6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and also promptly determining the accurate policy to be undertaken.

7. There are possible conflicts between different objectives of fiscal policy such that a policy designed to achieve one goal may adversely affect another. For example, an expansionary fiscal policy may worsen inflation in an economy

8. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example, increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security benefits may adversely affect incentives to work and save.

9. Deficit financing increases the purchasing power of people. The production of goods and services, especially in under developed countries may not catch up simultaneously to meet the increased demand. This will result in prices spiraling beyond control.

10. Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid. If the economy lags behind in productive utilization of borrowed money, sufficient surpluses will not be generated for servicing debts. External debt burden has been a constant problem for India and many developing countries.

11. If governments compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may not be realized. This phenomenon is described below.

FISCAL POLICY

Contractionary Fiscal Policy

• When aggregate demand rises beyond what the economy can potentially produce by fully employing it’s given resources, it gives rise to inflationary pressures in the economy. The aggregate demand may rise due to large increase in consumption demand by households or investment expenditure by entrepreneurs, or government expenditure.
•  In these circumstances inflationary gap occurs which tends to bring about rise in prices. Under such circumstances, a contractionary fiscal policy will have to be used.
• Contractionary fiscal policy refers to the deliberate policy of government applied to curtail aggregate demand and consequently the level of economic activity.

 In other words, it is fiscal policy aimed at eliminating an inflationary gap. This is achieved by adopting policy measures that would result in the aggregate demand curve (AD) shift the to the left so the equilibrium may be established at the full employment level of real GDP. This can be achieved either by:

1. Decrease in government spending: With decrease in government spending, the total amount of money available in the economy is reduced which in turn trim down the aggregate demand.

2. Increase in personal income taxes and/or business taxes: An increase in personal income taxes reduces disposable incomes leading to fall in consumption spending and aggregate demand. An increase in taxes on business profits reduces the surpluses available to businesses, and as a result, firms’ investments shrink causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants who will respond by holding back fresh investments.

3. A combination of decrease in government spending and increase in personal income taxes and/or business taxes

We shall analyze the overall impact of these abovementioned measures with the help of the following figure.

Contractionary Fiscal policy for Combating Inflation

As real GDP rises above its natural level, (Y in the above figure), prices also rise, prompting an increase in wages and other resource prices. This causes the SAS curve to shift from SAS 1 to SAS 2. As a result, the price level goes up from P 1 to P 3. Nevertheless, the real GDP remains the same at Y. The government now needs to intervene to control inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand so that the aggregate demand curve (AD1) does not shift to AD2 . The government needs to reduce expenditures or raise taxes only by a small amount because of the multiplier effects that such actions may have. Even as expenditures are reduced, the government may attempt to enhance public revenues in order to generate a budget surplus. In any economy, on account of political, social and defence considerations government spending cannot be reduced beyond a particular limit. However, the government can change its expenditure in response to inflationary pressures. 

FISCAL POLICY FOR LONG-RUN ECONOMIC GROWTH 

• We have been discussing so far about how fiscal policy acts as an effective tool for managing aggregate demand in the short-run to help maintain price stability and employment levels. However, demand-side policies unaccompanied by policies to stimulate aggregate supply cannot produce long-run economic growth.
•  Fiscal policies such as those involving infrastructure spending generally have positive supply-side effects. When government supports building a modern infrastructure, the private sector is provided with the requisite overheads it needs. Government provision of public goods such as education, research and development etc. provide momentum for long-run economic growth.
•  A well designed tax policy that rewards innovation and entrepreneurship, without discouraging incentives will promote private businesses who wish to invest and thereby help the economy grow.

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.