Lecture 10 : Fiscal policy

 To better understand fiscal policy we need to

better understand the potential output and output
gap (Measuring output gap for fiscal policy)
 How to identify overheating, undereating and
potential output
 Why don’t we allow AD AS framework to act and
allow macroeconomic stability?
 Fiscal policy : Short run impact of fiscal policy :
Discretionary or Automatic stabilizers

Overview of class
 The highest level of output that is consistent with
non-accelerating level of inflation (stable
inflation).
 Above a certain level of output, the economy is
running too “hot”, generating inflation
 Some equivalent concepts:
 Full employment (employment at potential
output)

Potential output
  Natural rate of unemployment(unemployment
at potential output)
 Full capacity utilization (capital utilization at potential output)
 However potential output means
 Not the maximum level of output
 Full employment and full capacity utilization do
not imply the maximum employment or capacity
utilization possible
 Higher output will lead to accelerating inflation
Potential output
Output gap is
An economic measure of the difference between
actual output and potential output.
Percentage deviation from potential output

Output Gap
Output gap redefined
 Short Run: Guidance in calibration of
macroeconomic policy
 Fiscal policy, Monetary policy, Automatic
stabilizers
 Medium and Long Run: Guidance in formulating
macroeconomic structural reforms

Why output gap estimation is important?

 Output above potential level
 Strong growth in aggregate demand ( We know
how to anlayze this)
 Employment above full employment
 Capacity utilization above full level
 Accelerating inflation

How to interpret output gap

 Output at potential level
 The level of output is consistent with:
 Full employment
 Full capacity utilization
 Stable inflation
 Output below potential level
 Implication of negative output gap
 High unemployment and low capacity utilization
 Weak demand
 Low and/or falling inflation
 OUTPUT AND PRICES LOW
Interpreting output gap
 Implementing AD AS framework vis-à-vis Fiscal
policy
 The AD/AS model illustrates how fiscal policy can
counteract the effects of economic shocks.
 The model predicts that the economy can automatically
correct itself.
 Lawmakers often intervene because automatic
correction can be a painful and slow process.
 So we need a faster policy: Correcting AD when
output falls and prices fall
Why Fiscal policy
 Short term calibration of the economy using AD

Economy Fiscal Policy

 How does fiscal policy affect aggregate demand

in short-term?
 Does government help to return the economy
back to potential, or does it actually exacerbate
the business cycle?
Why Fiscal policy ?
 For this we need a counter-cyclical fiscal policy
Why?
 When economy is in boom, we want to tighten,
to restrain the aggregate demand and vice-
versa
 Is fiscal policy affecting Aggregate supply?
Govt exp on education and health: Labour
productivity
 What is the implication in the medium term ?
 Fiscal policy refers to government decisions
about the level of taxation or government
spending.
 Fiscal policy affects the economy by influencing
aggregate demand (AD).
 Changes in government spending, G, impact AD
directly.
 Tax policies directly affect consumption, which
impacts AD.

What is fiscal policy?

 Bringing back output gap and connecting to
fiscal policy

Expansionary and contractionary fiscal policy

Discussion on Stimulus on 2008
 Indian economy began to slow down in 2007-08
(April-March) after reaching a GDP growth of 9.8
per cent in the last quarter of 2006-07.
 In the first half of the financial year 2008-09, the
grow
 Monetary policy The pre-crisis slowdown
attributed to tightening of monetary policy right
from September 2004 in response overheating
and inflation rising

Background of the Stimulus

 The monetary tightening became harder in 2006-
07 and later in early 2008-09 as the huge rise in
world commodity prices pushed India’s inflation
also high.
 The first impact of the global crisis on India was
felt in the stock market in January 2008:
Reversal of inflows from foreign institutional
investors (FIIs) into the country.
 Direct result of the massive de-leveraging of US
banks after the financial meltdown.
 The FIIs withdrew funds from all over the
emerging markets for meeting the liquidity
requirements.
 Capital inflows under external commercial
borrowings, short-term trade credit and external
borrowing by banks dropped sharply from April
2008.
 The crisis then moved to the foreign exchange
market (Stage 3). The rupee began to tumble
from end-April 2008 to November 2008 by about
20 per cent
 The Reserve Bank of India intervened by selling
dollars to smoothen the fall of the rupee. The
heavy selling led to a massive depletion of the
stock of reserves from US$ 315 billion in May
2008 to US$ 246 billion in November 2008.
 In the second half of 2008-09, these dramatically
changed: merchandise exports declined by 18
per cent, imports by 11 per cent
 Credit crunch
 Growth slowed and prices peaked
 WPI peaked at 12.9 per cent in early August
2008
 Response from Government
 Monetary policy response
 Mid-October to ease the situation by a series of
rate cutting and liquidity injecting measures till
April 2009.
C+I’+G+X-M
What is happening on ground
 Fiscal policy
 Consequently, in India also, three fiscal stimulus
packages have been unveiled since December
2008 to help the economic recovery.
 These have been largely in the form of a
reduction in taxes and duties (NT) and, to some
extent, incentives to the export sector (NT) and
infrastructure development projects (G).
 The first fiscal stimulus package was introduced
on 7 December 2008, the second on 2 January
2009, and the third one on 24 February 2009.
 These included: across-the-board central excise
duty reduction by 4 percentage points;
 Additional plan spending of Rs. 200 billion;
 Additional borrowing by state governments of
Rs. 300 billion for plan expenditure;
 Assistance to certain export industries in the form
of interest subsidy on export finance, refund of
excise duties/central sales tax, and other export
incentives; and a 2 percentage-point reduction in
central excise and service tax.
Ist stimulus
30000 crores on infrastructure
Excise duty reduction forgoing 8700 crores
Subsiding cost of export 1100 crores
IInd stimulus
Improve and facilitate the supply of finances
Infrastructure finance 30,000 crores
FDI limit : additional credit supply 56,000 crores
Higher depreciation of commercial vehicles (50%)
for CVvs bought between Jan- Mar 2009.
Such depreciation is available both for business and
profession. Would it mean that the assessees
engaged in professions such as law, medicine and
audit would be eligible for 50 per cent deduction for
depreciation for cars used for profession
JNURM: New buses for state government
Exemption of countervailing duties for steel and
cement
IIIrd Stimulus
Cut in central excise duties, service tax
Amounting to 29100 crores
 MOTIVATION
The sharp rise in government consumption growth
cushioned the sharp drop in aggregate demand and
prevented a much sharper fall in GDP growth in the
second half of 2008-09.
TARGET
Achieving 6.8 per cent rate of growth of the Indian
economy in the fiscal year 2008-09 and 8 per cent
in 2009-10 and 8.6 per cent in 2010-11.

Effect of stimulus
 ACHIEVED
 6.7 per cent in 2008-09 but again rose to 8.6 per
cent in the year 2009-10 and to 9.3% in 2010-11.
However, due to slowdown in the US and other
developed countries, lower growth of agriculture
due to weak monsoon and European debt crisis
India’s growth will fell to 6.2 per cent or in 2011-
12.

Stimulus found its objective