Assignment 4

FISCAL POLICY AND THE CASE OF EXPANSIONARY

FISCAL CONTRACTION IN IRELAND IN THE 1980S
Name: Shubham Tapadiya
Roll No: BD21096

Case Background
The case discusses about Keynesianism. By explaining his conviction that issues of widespread
unemployment and idle capital were not always best left to market forces, John Maynard
Keynes questioned orthodox economic thought. Instead, Keynes advocated for direct
government involvement to boost aggregate demand and, as a result, re-establish full
employment and economic development. States all around the world considered huge changes
in production and income growth as unavoidable prior to the Great Depression of the 1930s.
Fluctuations in economic activity were considered as natural and self-correcting. Governments
were not interested in stabilizing the economy using policy measures. With time the popularity
of Keynes theory grew and countries all around the world started adopting it as means to
stabilize the highly fluctuating economy. But by 2000, policy makers realized that Keynes
theory was not always effective in combating recession or depression.
Then case discusses about two type of policy measures that can be taken to stabilize the
economy. One is the monetary policy. It was based on Milton Friedman’s prescription, a
"Chicago-school" free-market economist who advocated focusing on reducing inflation by
controlling the money supply while empowering markets and avoiding government
intervention. Monetarists opposed fiscal action to offset recessions because they felt it resulted
in the private sector being crowded out. The second measure is fiscal policy. Fiscal policy is
concerned with the government's taxes and spending decisions. Expansionary fiscal policy,
according to Keynes, might be employed to boost aggregate demand. Contraction fiscal policy,
on the other hand, might be employed to cool down an overheated economy by lowering
aggregate demand and total wealth.
Usually, Contraction Fiscal Policy is used to cool down an overheated economy. According to
conventional economic theory, contractionary fiscal policy slows growth by reducing
government expenditure and higher taxes. However in some countries with high fiscal deficit
and high debt, contraction policy actually helped in economic growth. The case then discusses
about similar case that happened in Ireland during 1980s. During late 1980s, after
implementing fiscal contraction the economic growth of Ireland picked up. Then cases then
discusses various factors that led to high growth even after implementing contractionary policy.
 Issues and Challenges
Limitations of Keynesianism:
John Maynard Keynes suggested that direct government involvement through increased
spending which will increase aggregate demand and consequently result in generating
employment and economic growth. This increased spending can be supported through
borrowing and deficit spending. Theory’s popularity grew till 1970s, however policy makers
soon realized it limitations after its failure to fight worldwide recession which came after the
abolishment of Bretton Woods System in 1971 as well as oil crisis in 1973. Deficit financing
suggested by Keynes led to crowding out of private borrowing and therefore slowed down
private investment. The governments began to adopt monetary policy measures in which they
restricted money supply in the economy to counter the cyclicity and recession and inflation.
High Inflation:
Ireland was beset by continuous inflation, high costs of declining industry, and long-term
unemployment in the mid-1980s. Government kept on spending with the help of borrowed
money which resulted in depreciation of their currency and high inflation. The continuous
inflation also aided in the high inflation. As people were expecting high inflation, they used to
raise their price expecting high inflation rate in the future. Similarly, when everyone in the
economy raised prices, the inflation raised and this cycle continued.
High Budget Deficit:
A decade of high budget deficits, funded mostly via foreign borrowing, along with a lack of
realistic suggestions for future surpluses casted doubt on the Ireland’s government to
adequately handle the country's worsening economic crisis. In order to build trust in the
economy and private player government had to control its spending and bring down borrowing
and budget deficit. Targets for public finances were to be aligned with sound economic
management. Borrowing and government debt servicing were to be drastically curtailed. A
special emphasis was to be focused on constructive economic activity and job creation.

Case Analysis
The case discusses different policy measures that can be used during the time of recession to
enable economy of a country to come out of recession as quickly as possible. Generally, in a
recessionary economy, expansionary fiscal policy, such as raising government purchases,
increasing transfer payments, or lowering taxes, might be employed to boost aggregate demand
and stimulate GDP growth. Similarly, contractionary fiscal policy, which involves reducing
government purchases, reducing transfer payments, or raising taxes, may also be employed to
cool an overheated economy by lowering aggregate demand and national income. Generally,
contractionary fiscal policy is used to slow down the economy. However, in some cases like
Ireland it can result in opposite results and boost the economic growth of a country.
Before Great Depression of the 1930s, governments all around the world believed that
fluctuation in economic output of country depends on market forces and government should
not interfere. However, John Maynard Keynes questioned this orthodox thinking by suggesting
that government should stabilize the economy by directly interfering in the market. The
Keynes’s theory became popular, and governments used fiscal deficit to finance the
expansionary fiscal policy during the economic recessions. However, after its failure during
recession after termination of Bretton Wood system and during oil crisis of 1973, the
government realised that Keynes theory is not effective every time. Instead of Keynesianism
the governments adopted Milton Friedman’s suggested monetary policy.
Fiscal Policy
The monetarist approach prioritised monetary policy, whereas the Keynesian approach
prioritised fiscal policy toward the mutual aim of economic stabilisation. The goal of monetary
policy is to keep the money supply under control, usually via altering interest rates. The goal
of fiscal policy is to increase demand through government spending. If you increase
government spending it is called as expansionary fiscal policy and if you decrease the
government spending it is called as contractionary fiscal policy. Expansionary Policy is used
to boost the economic growth whereas Contractionary Policy is used to slow down the
overheated economy. However, in some cases when country has high fiscal deficit, high
inflation and high government debt, contractionary fiscal policy can boost the economy. There
are some limitations to the Keynes Fiscal theory, it lacks flexibility and can be used by
manipulated by politicians for their benefit. Also there it might be ineffective if there is lag
between proposal of tax and implementation of tax. It can also crowd out the private
investment.
Expansionary policy is based on the concept of multiplier effect which means that when
government spends 1 unit of money it will create multiplier effect and will increase the nations
income and GDP by more than 1 unit. Developed economy have low multiplier effect like USA
has multiplier effect of around 1.5, Developing economies can have higher multiplier effect
like India has multiplier effect of around 2.5. To calculate the multiplier effect, we can use the
following formula:
Income Multiplier = 1 / (1-MPC)
Where MPC = Marginal Propensity to Consume.
Expansionary Fiscal Contraction in Ireland
Generally fiscal contraction, which means increased taxes, lower government spending and
lower budget deficit, leads to slowdown in economic growth. However, in many cases fiscal
contraction in reality led to growth in economy. On such example is of Ireland.
Ireland observed significant growth during the period of 1987 to 1990, even after fiscal
contraction. This is called as Expansionary Fiscal Contraction (EFC). This can happen when a
government with high debt and high deficit try to reduce the debt and deficit through fiscal
contraction which increases the consumer confidence and consequently leads to higher growth.
The long-term interest rates of the government bonds go down which leads to increased
consumption and investments. Furthermore, the present tax hike to combat the budget deficit
lead to the anticipation that future tax liabilities will be smaller. As a result the private sector
spending exceed the contraction in government spending. Consequently, consumption,
employment and GDP increases.
Ireland was experiencing consistent inflation, high cost of capital and high unemployment
during the mid-1980s. After the new government was formed it decided to turn around the
Ireland’s economy. Fianna Fail party along with the support of independents formed the
government and presented the 1987 budget. The new government tried to handle the Ireland’s
public expenditure and debt problems. In 1987, the targeted borrowing was at 1.85 billion IEP
or 10.7% of GNP down from 2.15 billion in 1986. The budget deficit was cut from 8.5% to
6.9% of GDP. The government also focused on reducing government spending on wages. The
growth in weekly earnings in the manufacturing sector declined from 4.9 percent to 4.3 percent.
This lowered wages and favourable exchange rate led to cost advantage of 3% against the
United Kingdom. With the help of fiscal tightening the continuously high inflation was brought
down. CPI dropped to 3.2% which was the lowest rate since 1960s.
This increased confidence among consumer and private sector. With low interest rate people
began to save less and liquidity within the system increased. Public consumption was down,
however private sector investment more than compensated for it. The economy and GDP of
Ireland was growing.

Macro-Economic tools related to case

Monetary Policy:
Monetary policy is a collection of measures that a monetary authorities can use to encourage
long-term economic growth by limiting the amount of money accessible to the country's banks,
consumers, and enterprises.
The objective of the policy is to keep the animal spirit of the economy moving at a balanced
pace that is neither too fast nor too slow. The central bank may raise loans lending rates to
discourage expenditure or lower borrowing interest rates to encourage greater borrowing and
spending.
The primary weapon available to it is the country's cash. The national bank sets the rates it
charges to advance cash to the country's banks. At the point when it raises or brings down its
rates, all monetary organizations change the rates they charge their clients in general, from
enormous organizations getting for significant ventures to home purchasers applying for
contracts.
Monetary Policy is generally handled by an independent central bank in most of the countries.
Fiscal Policy:
The use of government spending and tax policies to impact economic circumstances,
particularly macroeconomic variables such as aggregate demand for goods and services,
employment, inflation, and economic growth, is referred to as fiscal policy.
Fiscal policy is sometimes contrasted with monetary policy, which is implemented by central
bankers rather than elected leaders.
The use of government spending and tax policies to impact economic circumstances is referred
to as fiscal policy. Fiscal policy is primarily founded on the views of John Maynard Keynes,
who claimed that governments could regulate economic activity and stabilise the business
cycle.
During a recession, the government may use expansionary fiscal policy to boost aggregate
demand and boost economic growth by decreasing tax rates. A government may follow a
contractionary fiscal strategy in the face of rising inflation and other expansionary signs.
Marginal Propensity to Consume (MPC):
The marginal propensity to consume (MPC) is defined in economics as the share of an
aggregate increase in income that a consumer spends on goods and services rather than
conserving it. The marginal propensity to consume is determined as the change in consumption
divided by the change in income in Keynesian macroeconomic theory.
Unemployment Rate:
The unemployment rate shows economic experts how many people in the available labour pool
(the workforce) are unable to find job. When the economy develops over time, as seen by the
GDP growth rate, unemployment levels will be relatively low. This happens as and when (real)
GDP levels rise, we realise that the return is higher, and as a result, more employees are
anticipated to be aware of the higher levels of output.
Exchange Rate:
The value of one country's currency in relation to the currency of another country or economic
zone is known as an exchange rate. For example, how many India Rupees (INR) does it take
to buy one US Dollar (USD). Most exchange rates are free-floating, meaning they increase and
fall in response to market supply and demand. Some exchange rates are not free-floating
(fixed) and are tied to the value of other currencies. They may also be subject to restrictions.
India has a hybrid exchange rate, which means it is not totally reliant on market forces.
Initially when Irelands debt was high and its economy was not doing very well, the government
had to borrow at high cost, and it was not competitive in the export market. To become
competitive Ireland devalued its currency.

Learnings
1. A nation with a substantially stronger currency will struggle to balance its exports to
other countries, resulting in a trade imbalance with countries with weaker currencies.
So, sometimes its beneficial to devaluate the country’s currency and boost the exports.
But if you are highly dependent on import this devaluation will increase your import
bills.
2. During a recession, the government and central bank should intervene immediately and
give the necessary push to counteract the economy's cyclical nature.
3. Building trust in the economy can increase a country’s output even if the government
tries to implement contractionary fiscal policy i.e., decrease public spending and higher
tax rate.