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Home Fiscal Policy What is Fiscal Policy?

What is Fiscal Policy?

 

Definition and Explanation:

 

The classical economists were of the view that the economy automatically moves towards full employment in the long run. They ruled out the possibility of over production and hence unemployment in the long period. The role of the government in the economy, according to the classical economists, should be the minimal.

 

The J. M. Keynes in his famous book, "General Theory of Employment, Interest and Money", disagreed with the views of the classical economists that the economy has the tendency to move towards full employment in the long run.

 

He was of the strong view that the government must interfere in economic matters to achieve full employment, to prevent inflation and to promote rapid economic growth. In order to achieve the macro economic goals, he stressed that the government must step in and use government expenditure and taxes for changing the size of national income and the tempo of aggregate economic activity in the country. The use of deliberate changes in government expenditure and or taxes to achieve certain national economic goals is called Fiscal Policy.

 

Fiscal policy thus is the deliberate change in government spending and taxes to stimulate or slow down the economy. In the words of F.R. Glahe:

 

"By fiscal policy is meant the regulation of the level of government expenditure and taxation to achieve full employment without inflation in the economy".

 

J. M. Keynes describes fiscal policy as the steering wheel for the aggregate economy.

 

Objectives/Goals of Fiscal Policy:

 

The objectives of fiscal policy differ with the state of development in the country. In advanced countries of the world, the goal of fiscal policy may be the maintenance of full employment without inflation. In developing countries, the objectives of fiscal policy may be to achieve maximum level of employment and reduction in economic inequalities. However, the main goals of fiscal policy are in brief as under:

 

(i) Removing Deflationary Gap:

 

J. M. Keynes is of the view that fiscal policy can play a major role in lifting the economy out of depression and closing the deflationary gap. When the economy is in depression, it is faced with rising unemployment, falling income, severe declining investment and shrinking of economic activities. The government, by undertaking public works programme, increases its expenditure which helps in raising the level of aggregate demand out employment in the economy.

 

The government can also induce changes in aggregate investment by reduction of taxes, tax relieves, abolition of sales tax, reducing excise duties etc. The tax relief measures are also an effective methods to raise the level of aggregate demand and removing deflationary gap from the economy.

 

(ii) Fiscal Policy in Inflation:

 

If the economy of a country is faced with inflationary gap, then anti cyclical fiscal policies should be adopted to bring down the prices and for closing the inflationary gaps. The main fiscal measures to bring down the excess demand in the economy are: (a) reduction in government expenditure, (b) increase in taxes and (c) creating a budget surplus.

 

By adopting contractionary fiscal policy, the aggregate demand curve shifts downward and the economy begins to operate at the desired potential level of income.

 

(iii) Counter Cyclical Fiscal Policy:

 

Another important objective of fiscal policy is to minimize the fluctuations in aggregate demand so that the economy is always at its target and potential level of income. The fluctuations in the economy which are associated with the business cycles can be smoothed in a number of ways.

 

For example, when the aggregate demand rises rapidly in the expansionary phase of the business cycle, it can be tuned by reducing government expenditure or raising taxes. This will help in dampening down the expansionary phase. In the recessionary phase, the problem of unemployment and low growth can be covered and remedied by cutting taxes and raising government expenditure. If timely counter cyclical fiscal measures are adopted the problems of excess or deficiency of demand will never be severe and the economy operates at the potential level of income which is called fine tuning.

 

Diagram:

 

Keynesian Fiscal Policy in the Short Run

 

 

 

In figure 27.1 (A), it is shown how an increase in government spending increases the level of national income in the short run. The increase in government spending from G0 to G, shifts the C + I + G0 line upward and increases the level of income from Oy0 to Oy1.

 

In figure 27.1 (B), it is shown how an increase in taxes and reduction in government expenditure leads to a decrease in national income in the short run. It is clear from the diagram that as the level of tax increases and government expenditure falls down, the aggregate demand curve C + I + G1 shifts downward. The equilibrium income falls from Oy0 to Oy1.

 

(iv) Equilibrium in Balance of Payments:

 

The level of national income is also affected by the balance of payments position of the country. If the country has a favorable balance of payments, it will lead to increase in income. The rise in aggregate demand will shift the demand line upward and will increase the level of national income. The fall in the balance of payments has the opposite effect. The government uses fiscal policy in such a way that the balance of payments remains in equilibrium in the short run.

 

(v) Economic Growth:

 

The elements of Keynes fiscal policy were developed in 1930's. Since then, the Keynesian fiscal policy is in action. The economists believe even now that if the economy is operating below its potential level, the increase in government expenditure and cut in taxes is the perfect medicine to bring the economy back to its full employment level. The economists stress that government should encourage investment to increase the rate of capital formation by using timely proper fiscal measures. The government borrowing for financing schemes of development, the increase in ratio of savings to national income, cut in taxes to increase investment spending can accelerate the rate of capital for nation in the country and lead to economic growth.

Relevant Articles:

What is Fiscal Policy
Principles/Tools of Fiscal Policy
Fiscal Policy With Reference to Underdeveloped Countries
 

Principles and Theories of Micro Economics
Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
Price and Output Determination Under Monopoly
Price and Output Determination Under Monopolistic/Imperfect Competition
Theory of Factor Pricing OR Theory of Distribution
Rent
Wages
Interest
Profits
Principles and Theories of Macro Economics
National Income and Its Measurement
Principles of Public Finance
Public Revenue and Taxation
National Debt and Income Determination
Fiscal Policy
Determinants of the Level of National Income and Employment
Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
Development and Planning Economics
Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance
History of Money

 

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