Fiscal policy serves as an important tool to influence the aggregate demand. The instruments of fiscal policy are government spending and taxation. Depending upon existing situation of the economy, government can employ either expansionary or contractionary fiscal policy. Expansionary fiscal policy increases the aggregate demand whereas contractionary or deflationary fiscal policy reduces the aggregate demand. Changes in the level, timing and composition of government spending and taxation have an important effect on the economy. The objective of this article is to introduce the readers with objectives, nature and techniques of fiscal policy. For analysis, the aggregate demand and aggregate supply (AD-AS) model have employed.
Key words: Aggregate demand, Aggregate supply, Expansionary fiscal policy, Contractionary fiscal policy, Classical version, Keynesian version, Budget deficit, Budget Surplus, AD-AS model
Fiscal policy is the policy of government related to its own expenditure and taxes in order to influence the aggregate demand (AD).It is one of the very important demand –side policies. Demand –side policies focus on changing the AD or shifting the AD curve in the aggregate demand and aggregate supply (AD-AS) model in order to achieve the goals of price stability, full employment, and economic growth(Tragakes,2009:249). There are four components of AD: consumer spending(C), investment spending (I), government spending (G), and net exports(X-M), where X=exports and M=imports. Fiscal policy influences all of these four components of AD. Government can influence ‘C’ by means of taxes levied on consumers, i.e., personal income taxes. It can influence ‘I’ by means of taxes levied on business profits. Similarly, government can easily change its own spending. It influences ‘X-M’ by means of subsidies provided to the domestic producers, import tax, and so on.
The major objectives of fiscal policy are as follows:
a. Full employment
It is very important objective of fiscal policy. Unemployment reduces the level of production, and hence the level of economic growth. It also creates many problems to the unemployed people in their day to day life. So, countries try to remove unemployment and attain full employment. Full employment refers to that situation, where there is no involuntary unemployment in the economy. To attain this objective, government should:
- increase its spending
- lower the personal income taxes
- lower the business taxes, or
- employ a combination of increasing government spending and decreasing taxes
b. Price stability
Both sharp rise and sharp fall in general price level are not desirable. It is because sharp rise in prices makes many goods and services unaffordable to the consumers whereas sharp fall in prices discourages the producers to produce goods and services. So, price stability is desirable. However, it should be noted that the principle that general price level should be reasonably stable is generally accepted, the determination of exact trends which are most satisfactory from the stand point of welfare of society is difficult. There are following three alternative points of view regarding the price stability (Due, 1970:513-518):
- It is sometimes argued that a slightly downward trend best serves the interest of the community as a whole, because the gains from increased productivity and lower cost would be shared among all persons in society instead of going chiefly to the workers in the industries affected. On the other hand, a downward trend would increase the difficulty of maintaining full employment because of its adverse effects upon investment and business optimism. Furthermore, such a trend appears to be impossible of attainment in the light of present day union strength and policies.
- A gradually increasing general price level has likewise been advocated, primarily because it would encourage investment and lessen labour strife, since annual money wage increases would be possible. However, this alternative would produce a gradual worsening of the economic position of the fixed income receivers.
- The third alternative point of view, a compromise between the other two, regards a perfectly stable general price level as the optimum. The gains from greater productivity would go primarily to the workers in the industries, but the injury to the economic well-being of the fixed income groups would be avoided, as well as dampening effects of declining prices.
c. Economic growth
It is also an important objective of fiscal policy. By means of higher rate of economic growth the problem of unemployment can also be solved. However, it may create some problems in the maintenance of price stability. The developed countries, like USA, UK, Japan, etc. give attention to the relationship of actual growth rate to the potential growth rate permitted by the consumption – saving ratio, technological considerations and other factors. The less developed countries, like Nepal, give emphasis to the increase in the potential growth rate as well as the relationship of the actual and potential growth rate. The concept of actual and potential growth of output can be explained with the help of following diagram:
In figure (a), AB is the original production possibility curve (PPC) of the economy. The movement from X to Y on the PPC shows the actual growth of output. This increases the level of gross domestic product (GDP) of the country. Such type of movement is possible by means of better utilization of existing resources and increasing the aggregate demand by means of fiscal policy. On the other hand, the rightward shift in PPC of the country from AB to CD shows the potential growth of output. It is possible due to the increase in quantity and quality of the resources, and improvement in technology. For this, fiscal policy can be employed.
d. Resource allocation
Resource allocation refers to assigning the available resources of the economy to the specific uses chosen among many possible and competing alternatives. It gives answer to what to produce and how to produce questions of the economy. Fiscal policy should ensure the optimum allocation of the resources. It should divert the resources from unproductive sectors to the productive sectors of the economy. It is the long-run objective of the government. The emphasis of the government upon the above major goals should not overshadow the resource allocation goal.
NATURE AND TECHNIQUES
The nature of fiscal policy may be either expansionary or contractionary.
Expansionary fiscal policy
The fiscal policy, which is undertaken to eliminate the recessionary gap, is known as expansionary fiscal policy. Expansionary fiscal policy expands the AD and the level of economic activities in the country. A recessionary gap is defined as a situation, where the equilibrium real GDP is less than the potential real GDP. Recessionary gap arises due to the insufficient AD in the economy. It represents the short-run equilibrium position of the economy. In this situation, unemployment is greater than natural rate of unemployment. It can be explained with the help of following diagram:
In figure (b), the short-run aggregate supply (SRAS) curve and AD curve are intersecting to each other at point E1 so that the equilibrium price level is OP1 and equilibrium real GDP is OQ1. Here, OQ2 is the potential real GDP. It should be noted that potential real GDP refers to the economy’s full employment level of real GDP. As here the economy’s equilibrium real GDP is less than the potential real GDP, economy is experiencing the recessionary gap. The recessionary gap is also known as the deflationary gap. The recessionary gap arises because with the aggregate demand represented by AD, there is not enough total demand in the economy to make it worthwhile for the firms to produce potential GDP. Thus, with the aggregate demand AD, firms produce smaller quantity of real GDP than the potential real GDP. When the equilibrium real GDP is lower than the potential real GDP, the quantity of labour demanded is lower. Hence, in such situation, the unemployment is greater than natural rate of unemployment. The above analysis is based upon the classical version of AD-AS model.
The concept of recessionary gap can also be explained with the help of Keynesian version of AD-AS model as follows:
In figure(c), the equilibrium is established at point E1 so that equilibrium price level is OP1 and equilibrium real GDP is OQ1.But,here the potential real GDP is OQ2 .As here the equilibrium real GDP is less than the potential real GDP, economy is experiencing recessionary gap.
The fiscal policy can be used to eliminate the recessionary gap caused by the insufficient AD. For this purpose, there are following techniques or instruments of fiscal policy:
- increasing government spending
- decreasing personal income taxes
- decreasing business taxes, or
- a combination of increasing government spending and decreasing taxes.
With the increase in government spending, the level of aggregate demand increases directly. As we know that:
Thus, the increase in ‘ G ‘ increases the AD and thus shifts the aggregate demand curve from AD1 to AD2 as in the figures (d) and (e) given below. The reduction in personal income taxes increases the personal disposable income, and hence increases the consumer spending(C), which leads to increase in AD ultimately. This also brings rightward shift in AD curve from AD1 to AD2. In the similar manner, reduction in business taxes increases the after-tax business profit, which leads to increase in investment spending(I) ,and hence the AD. This also shifts AD curve from AD1 to AD2.
Government can also increase its spending and reduce the taxes simultaneously. In such situation, government can finance the excess of spending over tax revenues by borrowing. If initially government has a balanced budget, then by increasing ‘ G ‘ while lowering taxes, it will create a budget deficit. If it already has a budget deficit at the outset, then deficit will become larger. If, on the other hand, it has a budget surplus at the outset, then the surplus will either become smaller, or it will shrink until it eventually turns into a deficit (Tragakes, 2009:251).
In each of the above four cases, with the shift in aggregate demand curve from AD1 to AD2, economy can achieve the potential output as given below:
Contractionary fiscal policy
The fiscal policy, which is undertaken to eliminate the inflationary gap, is known as contractionary fiscal policy. It contracts the AD and the level of economic activities in the country. An inflationary gap is defined as a situation, where the equilibrium real GDP is greater than potential real GDP. Inflationary gap arises due to the too much AD in the economy. It represents the short-run equilibrium position of the economy. In this situation, firms produce more output so that the demand for labour increases, and hence the level of unemployment is lower than the natural rate of unemployment. The concept of inflationary gap can be explained with the help of figure (f):
Figure (f) shows the classical version of AD-AS model. Here, equilibrium is established at point E1 ,where there is the intersection between the SRAS curve and AD curve so that equilibrium price level is OP1 and equilibrium real GDP is OQ1.As here equilibrium real GDP is greater than potential real GDP, which is equal to OQ , there is inflationary gap.
The fiscal policy can be used to eliminate the inflationary gap. For this, the following techniques or instruments of fiscal policy can be employed:
- decreasing government spending
- increasing personal income taxes
- increasing business taxes, or
- a combination of decreasing government spending and increasing taxes.
Since AD=C+I+G+(X-M),the decrease in government spending (G) directly reduces AD so that the AD curve shifts from AD1 to AD2 as in figure(g):
Similarly, increase in the personal income taxes reduces the disposable income of the people. As a result, consumer spending (C) decreases, which reduces the AD so that in this case also, the AD curve shifts from AD1 to AD2.
The increase in business taxes leads to fall in the after –tax business profits so that it reduces the investment spending (I).Thus, in this case also, the AD falls so that AD curve shifts leftward from AD1 to AD2.
In each of the above three cases, with the leftward shift in AD curve from AD1 to AD2,the economy produces the potential real GDP, i.e., OQ2.As a result, the inflationary gap is eliminated. With the elimination of the inflationary gap, there is the decline in the general price level of the economy from OP1 to OP2.
The reduction of the government spending and increase in the taxes simultaneously reduce the AD and shift the AD curve to the left from AD1 to AD2 as in the figure (g).Depending on the initial conditions that prevail in the governments’ budget, such a combination of policies would lead to the creation of budget surplus, or shrinkage of a budget deficit, or turning a budget deficit into a budget surplus (Tragakes, 2009:252).
Government can influence the level of production, inflation and unemployment by using the fiscal policy. Thus, fiscal policy is an important tool in the hands of the government to achieve its macroeconomic goals. Depending upon the existing situation of the economy and priority of the government, it can use the different instruments of fiscal policy as mentioned above.
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By Kumar Bhattarai
Mr.Bhattarai is Assistant Lecturer of Economics at Patan Multiple Campus, Tribhuvan University, Nepal.