Assignment in Fiscal Policy

1. What is Fiscal Policy? and how does it work?

Fiscal policy is defined as the policy under which the government uses the instrument of taxation,
public spending and public borrowing to achieve various objectives of economic policy. Simply put, it is the
policy of government spending and taxation to achieve sustainable growth. Fiscal policy is often contrasted
with monetary policy which is regulated by the central bank. It is largely inspired by the ideas of British
economist John Maynard Keynes whose theories were developed in the response to the Great Depression
and were hugely influential in the formulation of the New Deal in the U.S. that aimed at huge spending for
public projects and social welfare development.

How does it work : When policymakers want to influence the economy, they mainly have two tools at their
disposal, Monetary policy and Fiscal policy. The monetary policy is regulated by the central banks. Money
supply in the market is adjusted by tweaking the interest rates, bank reserve rates, sale and purchase of
government securities and foreign exchange.

On the other hand, fiscal policy is influenced by the governments by adjusting the nature and extent of the
taxes, government spending and borrowing. A healthy fiscal policy is important to control inflation, increase
employment and maintain the value of money. It has a very important role in managing the economy.

The government has two variables to influence fiscal policy, namely

Taxation- regulating which the government increases or decreases the disposable cash in the hands of the
public.
Government spending- using which the government invests in public infrastructural works and other social
welfare schemes that directly or indirectly influence the state of the economy.

To incentivize spending, the government may announce tax cuts and when the economy faces high inflation,
the government may announce new taxes or raise the levels of existing taxes. During a period of negative
growth, the public and investors may lose faith in the economy which in turn may result in lower production
and lower demand. To counter that the government may increase spending to tide over the falling private
sector investment and to create demand in the market.
This phenomenon was best witnessed during the Second World War when governments invested hugely to
build their armed forces. A huge increase in government spending resulted in a massive growth in
employment and increased demand in the commodity market. The Second World War is often credited with
bringing Europe out of the Great Depression.

2. What is a government budget? and what are the possible sources for it?

A government budget is a financial plan outlining the government's expected revenue and proposed
spending for a specific period, typically a fiscal year. It serves as a roadmap for allocating resources to
various sectors and programs, aiming to achieve economic and social objectives.

Possible Sources for Government Budget

 Tax Revenue: This includes income tax, corporate tax, sales tax, property tax, and other levies imposed
on individuals and businesses.
 Borrowing: Governments may borrow funds through the issuance of treasury bonds, bills, and other
securities to finance budget deficits.
 Grants and Aid: Foreign aid, grants, and assistance from international organizations or other
governments can contribute to the government's budget.
 Fees and Fines: Revenue generated from fees for services, licenses, permits, and fines imposed for
violations.
 State-Owned Enterprises: Profits or dividends from state-owned enterprises can also contribute to the
government's budget.
 Non-Tax Revenue: This includes revenue from sources other than taxes, such as dividends, interest, and
profits from government investments and assets.
 Privatization Proceeds: Revenue generated from the sale of state-owned assets or enterprises.

3. What is a budget deficit, budget surplus and balanced budget?

A balanced budget occurs when a government's revenues (such as taxes and fees) equal its expenditures
(such as spending on public services and infrastructure) for a specific period, typically a year. In this
scenario, there is neither a deficit nor a surplus.

A deficit budget arises when a government's expenditures exceed its revenues during a specific period. This
shortfall is often covered by borrowing, which can lead to an increase in national debt.

A surplus budget occurs when a government's revenues exceed its expenditures for a specific period. This
surplus can be used to pay off debt, invest in infrastructure, or create a reserve fund for future expenses.

4. What are the types of Fiscal Policy and explain thoroughly what happens in each type
Fiscal policy encompasses two primary strategies: expansionary and contractionary. When economic
growth stalls or unemployment rises, governments may deploy expansionary fiscal policy. This involves
injecting capital into the economy through increased government spending on infrastructure, education, or
social programs. Alternatively, tax cuts can bolster disposable income, encouraging consumer spending and
business investment. By boosting aggregate demand, expansionary fiscal policy aims to revitalize economic
activity and job creation. However, if demand surges beyond the economy's capacity, it may fuel inflation.

Conversely, during periods of overheating or inflationary pressures, governments may turn to

contractionary fiscal policy. Here, the emphasis is on curbing spending or increasing taxes to dampen
demand. Reduced government expenditures on projects and services withdraws money from circulation,
while higher taxes reduce disposable income and discourage spending. Though effective in mitigating
inflation, contractionary policies risk dampening economic growth and exacerbating unemployment if
implemented too vigorously. Striking the right balance between expansionary and contractionary measures
is crucial for fostering stable economic conditions and achieving long-term prosperity.

5. Enumerate & explain some criticisms of Fiscal Policies

 Disincentives of Tax Cuts. Increasing taxes to reduce AD may cause disincentives to work, if this
occurs, there will be a fall in productivity and AS could fall.
 However higher taxes do not necessarily reduce incentives to work if the income effect dominates the
substitution effect.

 Side effects on public spending. Reduced government spending (G) to decrease inflationary pressure
could adversely affect public services such as public transport and education causing market failure and
social inefficiency.
 Poor information. Fiscal policy will suffer if the government has poor information. E.g. If the
government believes there is going to be a recession, they will increase AD, however, if this forecast
was wrong and the economy grew too fast, the government action would cause inflation.
 Time lags. If the government plans to increase spending – this can take a long time to filter into the
economy, and it may be too late. Spending plans are only set once a year. There is also a delay in
implementing any changes to spending patterns.
 Budget Deficit. Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the
budget deficit which has many adverse effects. A higher budget deficit will require higher taxes in the
future and may cause crowding out.
 Other components of AD. If the government uses fiscal policy, its effectiveness will also depend upon
the other components of AD, for example, if consumer confidence is very low, reducing taxes may not
lead to an increase in consumer spending.
 Depends on the Multiplier effect. Any change in injections may be increased by the multiplier effect,
therefore the size of the multiplier will be significant. If consumers save any extra income, the
multiplier effect will be low and fiscal policy less effective.
 Crowding Out. Expansionary fiscal policy of increased government spending (G) to increase AD may
cause “Crowding out” Crowding out occurs when increased government spending results in a decrease
in the size of the private sector.
– For example, if the government increase spending it will have to increase taxes or sell bonds and borrow
money, both methods reduce private consumption and investment. If this occurs, AD will not increase or
increase only very slowly.

– Also classical economists argue that the government is more inefficient in spending money than the
private sector, therefore, there will be a decline in economic welfare

– Increased government borrowing can also put upward pressure on interest rates. To borrow more money
the interest rate on bonds may have to rise, causing slower growth in the rest of the economy.

 Monetarist critique. Monetarists argue that in the LRAS is inelastic therefore an increase in AD will
only cause inflation to increase.

Monetarists are generally sceptical of fiscal policy as a tool to boost economic growth. They argue that the
economy

Real business cycle critique

The real business cycle argues that macroeconomic fluctuations are due to changes in technological progress
and supply-side shocks. Therefore, using demand-side policy to influence economic growth fails to address
the issue and just makes the situation worse.