\ Na Vipul’s™ Central Banking (tm Chapter 6 Macro Economic Policy ~ Fiscal Policy 6.1 Introduction 6.2 Objectives and Instruments 6.3 Fiscal Policy during Inflation and Deflation 6.4 Contra Cyclical Fiscal Policy and Discretionary Fiscal Policy | 6.5 Limitations of Fiscal Policy 6.6 Striking Balance between Inflation and Growth through Monetary and Fiscal Policies 67 Questions SC81 Macro Economic Policy — Fiscal Policy 6.1. INTRODUCTION: Modern states are termed as welfare states. They perform a variety of functions to ensure a high level of socio economic welfare. Development of various sectors of the economy, improving the standard of living of the people, maintaining a higher level of employment and income etc. are some of the prime objectives of modern governments. In short stabilising the economy at higher levels of output and employment has become the most important concern of the governments at present. This is termed as Economic Stabilisation. Before 1930s it was believed that the invisible hand of the market mechanism would ensure economic stability and there was no need for the government to interfere in economic activities. This belief did not work during the depression of 1930s. Government's intervention was advocated by J. M. Keynes to bring about a revival in the economy. Since then economic stabilisation has been targeted by all governments and to achieve this a number of measures have been taken. Macroeconomic policy guides the governments in attaining ®conomic stability. The two important instruments of Macroeconomic policy are: (1) Monetary policy, and (2) Fiscal policy. The main goal of macroeconomic policy is economic Stabilisation. At the same time there are certain other objectives alo to be achieved in the process of ensuring economicPE UIT Wr.” 16™ Central Bankin Fa ; vipa’ (ty oor ‘ ‘ in 82 g ¢ macroeconomic Policy ¢,, tt or + objectives © 1. stabilisation. The main object oe ere! be outlined as follows: suring @ high level 4 | Oye sev ail’ and er t () Attaining full employment ® ae an? output. tae o mooilis ¥ i and t (2) Maintaining a stable price level ¢ ge . the i wth. (3) Accelerating the rate of economic em) ig oonmel eg are used by governments ,| "she gov Monetary and fiscal policies @ a ve higher a ion and effectiveness of the ent, achieve these objectives. The operatio! olor 4 public two policies can be analysed as follows: ait an = im n (2) MONETARY POLICY: fol weapo? ing about ec Monetary policy is concemed with money supply, credit ato bring creation by banks and rate of interest. Tt is formulated and } smamie growth and implemented by the Central bank. In India, for e.g. the Reserve Bank of India is mainly responsible for implementing the monetary policy. Till the Great Depression of 1930s, this policy was mainly used to ensure economic stability. By controlling money supply and credit creation, stability was ensured in the economy. However, effective in bringing about a Tecov i i position to fiscal poli ee icy. At present alias MONEIATY POlcies is used tg gag eatin OF fiscal a macroeconomic policy, ® achieve the objectives % during the 1920s monetary policy was nt (2) FISCAL Poticy, Fiscal policy ig 4 Powerful j . me i on to achieve a hada trument in the hands of rough fiscal pot; et of icy the Bovernment eS N influence tio™ produc! to-economic objectiv® |”wv 83 Macro Economic Policy — Fiscal Policy distribution, consumption and resource allocation. Fiscal policy is formulated and implemented by the government to achieve certain pre-determined objectives. Fiscal policy is concerned with public revenue, public expenditure and public debt. The government mainly uses the budget policy to bring about desirable changes in the economy. Through taxation, the government mobilises resources to meet its ever increasing expenditure. At the same time taxes reduce private spending. When the government incurs public expenditure, it leads to more employment, higher level of output - and income. Along with taxation and public expenditure, public debt also serves as a useful weapon to the government to mobilise more resources and also to bring about economic stability. Thus, through fiscal policy economic growth and development can be accelerated. * 6.2 OBJECTIVES AND INSTRUMENTS: Fiscal policy is pursued by modern governments to achieve Certain objectives. The objectives differ from country to country depending upon their own economic condition and priorities, However, the main objectives are: {) To achieve optimum allocation of resources. 2) To increase effective demand and thereby to achieve full employment and maintain it. ) To ensure price stability. 4) To bring about greater equality in the distribution of income and wealth.vipul’s™ Central Banking (ay) a number of instruments of figc,) i ives To achieve these objecti ‘The main instruments cy policy are available to the government: be analysed as follows: (1) Taxation: Apart from being the main source of ore tothe government, taxation isa powerful fiscal weapon in the hang ent. Through taxation the government can of the governm distribution ang influence production, consumption, allocation of resources. Governments impose both direct and indirect taxes. To ensure equity, generally a progressive system of taxation is followed. Under this system, taxes are levied on the principle of ability to pay. Hence the rich are taxed more than the poor. By giving suitable tax incentives Consumption of certain goods is encouraged by reducing the tax rate while the consumption of harmful goods is discouraged by hiking the tax rate in every budget. Resource | allocation to the various sectors and to the various regions is | also influenced by tax incentives. Economic equality, stability: accelerating economic growth and employment generatio* can be enhanced through taxation, Public Expendi i 2 ic Expenditure: The expenditure incurred by th government can have a profound infiuen ariov’ ce on vi government are administratj ti expenditure, expenditure j ve expenses, _ defen” agriculture, industry, transport Syacto Economic Policy ~ Fiscal Policy ow 85 be provided to the various sectors, interest payments etc. If the public expenditure is productive, it has favourable effects ‘on the economy. In the case of advanced countries public expenditure is incurred during depression to increase effective demand and thereby to bring about a revival in the economy. In the case of developing countries, if public expenditure is used to strengthen social and economic infrastructure, the productive capacity of the economy can be enhanced significantly. By spending on social welfare programmes like education, health facilities, sanitation etc. and also by focussing on social security measures like old age pension, unemployment allowance etc. the government can reduce inequalities in the distribution of income and wealth. By providing subsidies, the production of essential goods can be encouraged. If the public expenditure is unproductive, than the economy will suffer from adverse consequences like inflation, misallocation of resources, shortages, greater inequality etc. Thus the effects of public expenditure as a fiscal weapon depends upon the way it is incurred by the government. 8) Public Debt: When the expenditure of the government exceeds its revenue, it resorts to public debt. It is also helpful to the government to finance a war or to meet unexpected expenditure due to natural calamities etc. Apart from a source of revenue to the government, it is also useful to the 8overnment to control inflation. The government borrows from both internal and extemal sources. The func's thus mobilised should be used for productive purpos's like development of infrastructure, industrial sector, agriruiture86 (4) vipul’s™ Central Banking (ay etc. then such public debt becomes self-financing. y,, projects will start yielding income which can be used f,, repayment. Thus economic growth can be acceleratey through public debt without additional burden. Whi. depending upon public debt, the government has to te careful in utilising the funds. If the funds are used fy unproductive purposes, then the burden of public debt wi) be very high. Deficit Financing: Deficit financing is another useful fiscal weapon for modern governments to achieve their soci economic objectives. Deficit financing is resorted by governments when their expenditure exceeds their revenue. It refers to borrowing from the Central bank or running down cash balances of the Central government with the Centr bank. Whenever the government borrows from the Central bank, securities are issued by the government against whit currency notes are issued by the Central bank. The government can use the funds for exploiting the unused and underutilised resources. Deficit financing leads to mot money supply. Due to this demand for goods\and serve” will increase. If adequate su; x ply is not ? there will be inflation in the forthcoming,aNcin_ macro Economic Policy Fiscal Policy owe 87 6.3 FISCAL POLICY DURING INFLATION AND DEFLATION: The problems of inflation and depression are addressed by modern governments through fiscal policy. The budgetary policy of the government is adjusted in such a way that inflationary and deflationary tendencies can be controlled. Various instruments of the fiscal policy namely taxation, public expenditure and public debt are used by the government to bring about stability in the economy. Inflation refers to a situation of a continuous rise in the price level. It arises due to a variety of factors. Some of them are, increase in money supply, increase in demand for goods and services, excessive credit creation, too much of deficit financing increase in cost of production and due to scarcity of goods and Services. To control inflation, generally government adopts a Surplus budget policy. To have a surplus budget, either taxes are increased or expenditure of the government is reduced or both are done at the same time. The policy adopted by the government during inflation is also termed as contractionary fiscal policy. Taxation policy is used by the government to control the rise in Prices beyond a safe limit. As long as the inflation is a mild one, it helps the economy in a positive way. Once it becomes running Inflation, ithas serious repercussions for the economy. During the Petiod of inflation, government uses the progressive system of ation. Under this eyten therm pecilo ae ar more, while “ Poor people are taxed lightly or exempted totally. It is based ‘he principle of ability to pay. By increasing direct ta ‘es ie “Some tax, wealth tax etc. the disposable income of the >reople—_=_ qipen's central Banking (a, 88 ag ine in demand for goods ang i 10 dec! Gees New taxes which ate stal xpenditure tax can also he © can be reduced. This will lead t can services and thereby prices like anti-inflationary in character i a nt. levied by the governmer fas nod govern Along with taxation, vnlationaty pressures can be i inflation. 1 a : expenditure to control in! Bie Ee eenciture i esate controlled by reducing unprodu 4 i jnistrative expenses ety, defence expenditure subsidies, administ Though it is not easy to reduce public expenditure Reps the i tinued el | popular ones like subsidies, conscious and contint forts should be made by the government to reduce unproductive expenditure. 6.4 CONTRA CYCLICAL FISCAL POLICY AND DISCRETIONARY FISCAL POLICY: Public finance is interpreted in two ways namely ‘sound finance’ and ‘functional finance’. Classical economists considered public aoe as sound finance. According to them public finance’s main function was to mobili 'se resources and enable the The Great Pressi shifted the Nature ion of 19305 i Ce aurn ‘ mead finance Duri te finang Keynesian EconomieMacro Economic Policy — Fiscal Policy vue 89 world war time, public finance had become significant as market mechanism failed to bring about stability. The government had to interfere through fiscal operations. All modern governments use the tools of public finance namely taxation, public expenditure and public debt to control business fluctuations and also to achieve growth and development. : In the modern era, tools of public finance are used by governments to accelerate growth rate, reduce poverty, unemployment, inequality etc. By adopting a progressive system of taxation governments mobilize revenue and at the same time ensure equity. Public expenditure of all economies — developed or developing - has been increasing rapidly due to various factors like rise in population, provision of subsidies, development Projects, rising defence needs, etc. It is used by government to influence: production and consumption. Public debt, again is a Potent fiscal weapon to absorb excess money supply in the *conomy and helps to control inflation. All the three tools are used in combination to face the evil effects of trade cycles. Thus Public finance plays a significant role in the modem times in ‘conomic development. 6.5 LIMITATIONS OF FISCAL POLICY: Fiscal policy is widely used by modem governments to achieve the various objectives. Fiscal policy gained its popularity after the Breat depression of 1930s. However over a period of time, the ‘omplexities of modern states required a combination of fiscal and ™onetary policy and not exclusive dependence on fiscal policy. 's is because fiscal policy has its own limitations. They are:gipat's™ central Banking (gy full employment ap, (1) The objectives of fiscal POUCH ™ . If the governney price stability are conflicting in 74 Occ e cl aims at full employment iyo Dore baal leading to inflation. On is given importance, the sure and increase the (@ yn etc. it ma) the contrary : government may curtail jj, x rates to curb demang, eet productio! would be affected ang hence full employment is not possible- (2) Fiscal policy is used during inflation and deflation. When these fluctuations occur, there is time lag to introduce corrective measures as it cannot be immediately recognized. In the meantime the problem persists and often gets aggravated. Even after the fiscal measures are introduced to correct inflation or deflation, the impact be felt only after some time as there is a time lag here also. (3) Public authorities should be able to assess the situati toestimate the quantum of expenditure tequired, the limit Of taxation, subsidies to be given etc. tn circumstances, the effects f 4 estimated. of fiscal policy cannot For example, subsidies difficult to te. agricultural income . Qe aewo o1 13 cro Economic Policy ~ Fiscal Policy social and political factors. In such cases fiscal policy becomes ineffective. The limitations of fiscal policy indicate that it should be ombined with monetary policy to achieve the objectives. Both are omplimentary to each other and not mutually exclusive. During depression time, deficit budget of the government should be supplemented by a cheap monetary policy and during inflation a rplus budget should be adopted along with a dear monetary policy to bring about economic stability. Thus a combination of both monetary and fiscal policy is preferable to achieve the arious socio-economic objectives. 6.6 STRIKING BALANCE BETWEEN INFLATION AND GROWTH THROUGH MONETARY AND FISCAL POLICIES: The monetary policy of the RBI aims at price stability with omic growth. To accelerate the growth investments through eral credit has to be adopted. This may lead to inflation acrificing the objective of price stability. If price stability is Peramount credit will be controlled, then growth rate may slow “own. Hence a balancing act is required on the part of the central Pank to achieve both the objectives. In the initial decades of planning, the Reserve Bank of India ence: ‘abled the government to cover the fiscal deficit through adhoc vote “asury bills. The accommodative monetary policy helped the strict Svernment to discharge its functions. However this process salled automatic monetisation led to inflationary spiral. The twinviput’s™ Central Banking (ty 92 cre d economic growth could Tot i nment expenditure. Thus they netary policy and fisgy objectives of price stability 4m | achieved due to financing of gover | was no harmonisation of objectives orm | operations of the government. The year 1991 was a tuming point in the economic me , India due to the introduction of liberalisation, privatisation any globalisation. Reforms introduced in the various sectors helpej the economy to accelerate the growth rate. The Banking secty, reforms initiated in 1991 and 1998 resulted in significant improvements in the banking sector. Many initiatives were taken to remove the conflict between monetary and fiscal policy and ty ensure a balance between inflation and growth. Some of th notable reforms introduced are: (1) Monetisation of the government's deficit through adhu treasury bills was withdrawn. ) The Fiscal Responsibility and Budget Management Act 208 | necessitated fiscal discipline on the part of the governmét! Which also led to better coordination between monetary al | fiscal policies. @) i in better implementation, of the monetary Li ] spa, eee Policy. @ iter liberalisation, more capital started a the) inn cy op nae ing wet leme was introduced b) lis y the RBI j central bank intervenes in ae Under this, # t when inflow © ign capital increases. To contro} eae ‘iation PAES SER TTT ro nae Macro Economic Policy — Fiscal Policy vow 93 é which will affect exports, the central bank buys dollars 'Y ang ; from the market by exchanging Indian rupee. This leads ‘ to more money supply in the economy. To prevent inflation, the RBI absorbs this excess money supply by selling - histoy government bonds. Market stabilisation scheme is a classic ‘ tisation, example of better coordination between monetary and fiscal ctors h policies. nking say (5) The financial crisis in 2008 made it obligatory for \ signif governments and central banks to follow a liberal policy. Ss were While adapting to this change, the RBI had to ensure control policy -at of inflation without compromising on the growth target. By controlling credit and regulating the repo rate, the RBI has been pursuing its goals of price stability with economic growth. Both the government and the central bank need to have 3 cooperation and coordination to achieve a higher growth rate ment Act without the inflationary spiral. While the autonomy and e gover™ independence of the central bank needs to be respected by the government, the compulsions of the government need to be recognised by the central bank. A consensus is required to achieve the twin objectives without compromising the underlying ter su! Principles of monetary and fiscal policies. 6.7 QUESTIONS: (1) (A) Fill in the blanks: ot St2! (@) Public debt is mobilised during. e (b) + — system of laxation helpe to reduce inflation. ven” if f [Ans.: (a) inflation (b) progressive]vipul’s™ Central Banking (BB) 94 we the sentences: (B) Choose the correct alternative and rewrite trolled by using (1) Inflation and recession are co! (a) Monetary Policy (b) Fiscal Policy (c) Both (a) & (b) (4) None of these (2). Under deficit financing, the central government borrows from the (a) commercial banks (b) central bank (¢) both (d) foreign institutions [Ans.: (1 - c); (2 - b)] (2) State whether the following statements are true or false: (a) During recession government increases its expenditure. (b) Fiscal policy is formulated by the central bank. () Fiscal and monetary policies should be combined to ensure stability (2) Fiscal policy relies on the use of taxes and spending by the government to influence aggregate demand, (e) There is no conflict between monetary and fiscal policies. (Public debt refers to the borrowings of the public. [Ans.: a) True (b) False (¢) True (4) True (e) False (f) Falsey (3) Match the following: j (1) Progressive taxation (2) Surplus budget (3) Repayment of public debt (4) Fiscal policy (5) Monetary policy (1+); (2-0); (3- by; (4 - (5 ~ ay Rae non NC meMacro Economic Policy ~ Fiscal Policy oo (4) Define the following: bas (c) Inflation. (a) Fiscal policy. (e) Deflation. (f) Deficit financing. (g) Balanced growth. (5) Explain the objectives of fiscal policy. (6) Define fiscal policy and discuss the objectives of fiscal policy. (7) Explain any two instruments of fiscal policy. (8) Describe the various instruments of fiscal policy. (9) Explain how fiscal policy should be used during inflation and deflation. (10) Explain meaning and instruments of fiscal policy. (May 19) (11) Write short notes on: (a) Fiscal policy. (b) Limitations of Fiscal Policy. (May 19) (c) Striking a balance between monetary and fiscal policies. wag