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Fiscal Policy: Objectives, Nature and Effectiveness

Wed, Jun 15, 2011

Articles, Economics

Kumar Bhattarai

Abstract

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 effectiveness of fiscal policy. For analysis, the classical version of AD-AS model has employed.

Key words: Aggregate demand, Aggregate supply, Expansionary fiscal policy, Contractionary fiscal policy, Effectiveness of fiscal policy, Multiplier, Accelerator, AD-AS model

INTRODUCTION

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 imposing taxes on consumers, i.e., personal income taxes. It can influence ‘I’ by imposing taxes 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.

OBJECTIVES

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

However, in practice, it is difficult to achieve full employment. As the factor markets are not perfect, factor units may lose their jobs and may not get the new jobs immediately.

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 give emphasis to the increase in the potential growth rate as well as the relationship of the actual and potential growth rate (Due, 1970:517). The concept of actual and potential growth of output can be explained with the help of figure (a):

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 (Tragakes, 2009:17). 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 full employment, price stability and economic growth should not overshadow the resource allocation goal.

ALTERNATIVE FISCAL POLICIES

a. Fiscal policy during the contraction

  • increase in government spending
  • reduction in personal income taxes
  • reduction in business taxes
  • increase in transfer payments
  • practicing deficit budget

b. Fiscal policy during the expansion

  • decrease in government spending
  • increase in personal income taxes
  • increase in business taxes
  • reduction in transfer payments
  • practicing surplus budget

NATURE AND TECHNIQUES

The nature of fiscal policy may be either expansionary or contractionary.

Expansionary fiscal policy
Expansionary fiscal policy increases the AD of the economy. It increases the level of production, and hence the level of employment. It eliminates the recessionary gap existing in the economy. It should be noted that recessionary gap occurs when the equilibrium real GDP is less than the potential real GDP of the country. 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 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, there is recessionary gap. Recessionary gap is also known as deflationary gap. Fiscal policy can be used to eliminate the recessionary gap. For this, AD should be increased. To increase AD:

  • government spending should be increased
  • personal income taxes and business taxes should be reduced

Each of the above actions shift the AD curve from AD1 to AD2 so that economy achieves the potential real GDP as follows:

Contractionary fiscal policy
Contractionary fiscal policy reduces the AD of the economy. It reduces the level of production, and hence the level of employment. It eliminates the inflationary gap existing in the economy. It should be noted that inflationary gap occurs when the equilibrium real GDP is greater than potential real GDP. In this situation, unemployment is lower than the natural rate of unemployment. It can be explained with the help of following diagram:

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:

  • government spending should be reduced
  • personal income taxes and business taxes should be increased

Each of the above actions shift the AD curve from AD1 to AD2 so that the economy produces the potential real GDP as follows:

EFFECTIVENESS

Fiscal policy becomes effective when it produces the intended result. There are different objectives of fiscal policy, like achievement of full employment, price stability, economic growth, and so on. If the government is able to achieve these objectives by employing the fiscal policy, then such fiscal policy becomes effective, otherwise it becomes ineffective.

Government employs the fiscal policy in order to influence the AD and through the AD, it wants to influence other macroeconomic problems, like inflation, unemployment, and so on. So, by means of fiscal policy, government makes intervention in the market. It is a very important tool in the hands of government to correct the market failure. Fiscal policy becomes effective, when it increases the economic efficiency.

The effectiveness of fiscal policy depends upon the following factors:

  • The availability and accuracy of  information
    To bring the intended result, government should have sufficient information on the related problem. It should get these information on the appropriate time .Before employing the fiscal policy, government requires the information about the economy. In such situation, government can employ the appropriate fiscal instruments to correct the problems. Similarly, during the period of implementation of different fiscal tools, it requires information to know whether fiscal tools are working properly or not. If the employed fiscal tools are not working properly, government should make changes in the use of fiscal tools. The information collected by the government must be accurate; otherwise the use of the fiscal policy can not solve the economic problems. Sometimes, it may be difficult to get the information on a problem. For example, it is difficult to get information on true value of negative externality. Due to which it is difficult to determine a correct rate of taxation, which reduces the actual production to the socially efficient level.
  • Size of the multiplier effect
    If the size of multiplier is large, the effect of fiscal policy on AD is also large so that fiscal policy becomes effective to achieve the desired objectives, and vice versa.
  • Timing of the effects of fiscal policy
    This significantly influences the effectiveness of fiscal policy. If the techniques of fiscal policy take very long period of time to create the effects on AD, fiscal policy will be less effective, and vice versa.
  • Effects of change in AD
    The different techniques of fiscal policy influence the AD. The effectiveness of fiscal policy also depends upon the effects of change in AD on the level of output, employment, inflation, and so on. Larger such effects, stronger will be the impact of fiscal policy and vice versa.
  • Effects on incentives
    The use of fiscal policy has some effects on the incentives. These effects may be positive as well as negative. Such effects on the incentives influence the effectiveness of fiscal policy. For example, reduction in government spending and increase in the taxation may have some undesirable side-effects. This influences the effectiveness of fiscal policy. If these undesirable side-effects are strong, fiscal policy creates inefficiencies in the economy.
  • Size of accelerator effect
    If the accelerator effect is strong, fiscal policy becomes more effective.

CONCLUSION

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.

BIBLIOGRAPHY

Bhattarai, K. (2010). Research Methodology in Economics. Lalitpur: Prativa Prakashan.

Chelliah, R. J. (1976). Fiscal Policy in Underdeveloped Countries. London: George Allen and Unwin Ltd.

Due, J. F. (1970). Government Finance. Baltimore, Maryland: The Johns Hopkins Press.

Due, J.F., & Friedlaender, A.F. (2002).Government Finance: Economics of the Public Sector. Delhi: AITBS Publishers and Distributors (Regd.).

Misra, B. (1997). Economics of Public Finance. New Delhi: Macmillan India Ltd.

Tragakes, E. (2009). Economics. The Edinburgh Building, Cambridge, UK: Cambridge University Press.

By Kumar Bhattarai
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Mr.Bhattarai is Assistant Lecturer of Economics at Patan Multiple Campus, Tribhuvan University, Nepal.
Email:bhattarai1000@gmail.com

One Response to “Fiscal Policy: Objectives, Nature and Effectiveness”

  1. sudhira shrestha says:

    Thank you Kumar Sir. This is a useful note and we expect the same kind of online resources in Publice Finance.

    Sudhira
    MA Economics (2nd Yr)
    Patan College

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