Macro policy instrument:

Fiscal Policy
 What is Fiscal Policy?

• Govt. decisions about the level of taxation and

public spending are called Fiscal Policy (FP).

• FP is more than just simple budgeting

• Choices about how much to spend, how to spend it, and

how to raise the necessary funds can have dramatic
impacts on the economy
 Objectives of Fiscal Policy

1. Maintaining macroeconomic balance (i.e. containing

inflation, preserving healthy external position/balances,
maintaining debt sustainability)

2. Providing room for counter cyclical policy measures

3. Supporting private investment and promoting savings

4. Striving for inter-generational equity: If govt.

borrowing is high today, the burden of repayment of
the same shits to future generation. Hence, govt. need
to maintain a balance.
 How Fiscal policy affects the economy?
• Fiscal policy affects the economy by influencing (i.e.
increasing or decreasing) aggregate demand (AD).

• From earlier discussion we know that

AD = C + I + G + NX

• Shifts in AD curve translate into higher or lower output

and price levels throughout the economy.

• FP affects AD through two channels: government

spending and tax policy.
 Fiscal policy channel: Government spending

• Government spending affects “G” in the AD equation.

• An increase in govt. spending will generally shift AD

curve out (to the right) and vice versa. Why?

• Govt. spending can have indirect effects on the “C”

and “I” components of AD

• The effect of G on C and I come through mechanisms

called the multiplier effect (discussed earlier) and
crowding out (discussed below).
 Fiscal policy channel: Tax policy

• Govt. takes some money in taxes, before we get a paycheck

• Our consumption therefore depends on disposable income

(i.e. what’s left after taxes) rather than on total income.
• If the tax rate increases, workers will take home less
disposable income, and we can expect them to reduce their
consumption. As a result, the AD curve will shift in (to the
left).
• The opposite effect will occur if the tax rate decreases.

• Thus, tax policy channel of fiscal policy affects AD directly

through consumption (C) part of AD equation.
 Expansionary Vs Contractionary Fiscal Policy

• Expansionary FP describes the overall effect of

decisions about govt. spending and taxation
intended to increase AD

• Increased govt. spending & lower taxes have

expansionary effects

• They shift AD curve to the right

• Contractionary FP describes the opposite and

will have the opposite effect.
How govt. spending/fiscal policy counteract effects of negative demand shocks?

• Suppose there is an economic slowdown

• This would shift the AD curve to the left (see figure in

next slide)

• The decrease in AD causes the economy to produce

below its level of potential output

• The result was lower GDP (output), prices and higher

unemployment
 Housing-market crash
Price level
LRAS

SRAS

P1
E1
P2 E2

AD1

AD2

Y2 Y1 Output
• If nothing else happened, the economy would have
automatically corrected itself-eventually

• Wages would have fallen in response to

unemployment, and lower production costs would
bring other prices down

• This response would cause short-run aggregate supply

curve to shift to the right until the economy returned
to its original level of potential output level at Y1

• In the long run, output would have recovered to its

previous level, with lower overall prices in the
economy
• Why didn’t govt. & policy makers simply wait for this to
happen?

• Because it could have been a painful and very slow

process.

• The wage rate would have had to fall along with other
prices.

• However, this might not happen quickly (due to sticky

nature of the wages)

• When businesses fail and people lose their jobs, they

want their government to do something about it.
• They don't want just to hear that the economy will work
the problems out if they wait long enough.

• As economist John Maynard Keynes once said, "In the

long run, we are all dead.”

• The govt. can try to boost demand, either by spending

more or taxing less, called expansionary policy response

• This kind of expansionary policy is often called

"Keynesian," in recognition of John Maynard Keynes,
who championed the strategy after the Great
Depression of the 1930s.
• The challenge is finding the dosage of fiscal policy that
restores aggregate demand to its prerecession level

• A completely successful stimulus plan would shift the AD

curve all the way back from AD2 to its original position, AD1
(see figure in next slide)

• If the stimulus is only partly successful, then it would move

the curve only part of the way back, from AD2 to AD3

• Even a partially successful stimulus may be better than

nothing since it pushes the economy toward a better
outcome (and economy can continue adjusting toward the
long-run equilibrium over time)
 Government stimulus
Price level
LRAS

SRAS

P3 E3
P2
E2
AD1
AD3
AD2

Y2 Y3 Output
 What is the role of govt. spending/fiscal policy in the
presence of positive demand shocks?
• What should govt. do when economy is growing too quickly?

• People are often happy when economy is booming, but govt.

policy-makers worry that big booms can get out of hand

• Implementing contractionary fiscal policy to slow down economy

is a lot like shutting down a raging party because you are worried
that the guests might regret their choices in the morning!

• It can be the smart thing to do, even though there will be plenty
of grumbling.

• Contractionary fiscal policy slows down economy by cutting govt.

spending or increasing taxes, shifting AD curve back in to the left.
 Economy overheats from too much AD Contractionary fiscal policy lowers prices and output
Price level Price level
LRAS LRAS

SRAS SRAS
P2 P2
P3
P1 AD 2 AD2

AD3
AD 1
AD1
Y1 Y2 Output
Y3 Y2 Output

• The government can spend less or tax more.

• The contractionary policy decreases aggregate demand.
• Output and price levels decrease.
 Limitations of Fiscal Policy
• Though increasing direct government spending
has a larger multiplier effect on output than a
similarly costly reduction in taxes (discussed
below), it doesn’t work that simple.

• In the real world, things are more complicated.

• The following are some of the major limitations

of fiscal policy as a policy tool.
1. Crowding out effect:
• Govt. spending can crowd out (i.e., reduce) private-sector spending
• Crowding out happens when the govt. has to borrow in order to
finance the extra spending.
• When the government borrows money, it increases the demand for
credit, and so increases the price of credit (i.e. interest rate) in the
wider economy.
• A higher interest rate increases the cost of borrowing for
businesses that want to invest thereby leading to a decrease in
borrowing and investment by the private sector.
• The decrease in private investment undermines the positive impact
of govt. spending.
2. Ricardian equivalence:
• Govt.’s often cut taxes in response to recessions
• The idea is that people will spend more money when they
have more cash in their hands
• That spending, in turn, will raise business profits, create
jobs, and help the economy recover
• But tax cuts don't come for free. Govt. will eventually have
to find a way to make up for lost tax revenue (e.g. case of
cutting down taxes on petroleum products in India)
• That means either cutting an equivalent amount of govt
spending or, more frequently, raising taxes in the future to
pay for debt incurred today
• What happens if people see that today's tax cuts just
mean higher taxes tomorrow?
• In that case, people won't want to spend as much
from their tax cuts (i.e. MPC will be less), and stimulus
strategy will be less effective.
• This theory is known as Ricardian equivalence
(developed by David Ricardo).
• This theory predicts that if govts cut taxes but not
increase spending, people will not change their
behavior.
• Because people realize that govt will have to borrow
money to cover financial shortfall created by cutting
taxes
• They realize that at some point in the future, they-or
their children or grandchildren-will eventually have to
repay the extra govt. debt through future tax increases

• Because taxpayers realize that debt will eventually have

to be repaid through future taxes, today's tax cut will
feel more like a loan than a real windfall

• According to Ricardian equivalence theory, rational

people would save what they receive rather than spend
to meet financial obligation of future taxes

• But if people save rather than spend, consumption does

not increase, and tax cut will be unsuccessful in
increasing aggregate demand
3. Time lags:

• There are time lags between when policies are chosen

and when they are implemented

• This means that sometimes it is too late to do any

good.

• Lags in the policy-making process come from three

main sources. They are

(a) Information lag

(b) Formulation lag

(c) Implementation lag

• These three lags in the policy process make conducting
good fiscal policy a tough endeavor

• In fact, the lags may be so large that by the time the

policy takes effect, the economy might have corrected
itself, making the policy unnecessary
(a) Information lag

• Describes time lag involved in understanding what the

current economic situation is (e.g. COVID-19 induced
slowdown).

• It might seem pretty clear that the economy is in a

recession or boom

• But it can take a long time to collect data that tell policy-
makers about GDP, unemployment, and inflation

• GDP figures, for example, are released every three

months, and they report on economic activity that was
happening three or four weeks before.
• These early numbers aren't always accurate, so it may
be six months or more before the true figures are
known

• Three to six months is a short time to register a trend

in the overall economy.

• For instance, it took an entire year's worth of data to

trigger the announcement by the National Bureau of
Economic Research that the U.S. economy was in a
recession in 2008.

• By then, the economy had lost over 1 million jobs

• Just as it takes time to find out how bad things
are, it also takes time to find out if the economy
has reached the end of a recession

• There will be news reports of companies hiring

more workers, but it can take months to discover
if this has translated into real gains for the
economy

• In both cases, policy-makers have to make

important decisions for future, but they only
know where economy was a few months ago
(b) Formulation lag

• Describes the time it takes to decide on and pass legislation

• A policy needs to be drafted and proposed in legislature,

where it becomes a bill

• The bill needs to be debated in the legislature before

getting approved

• Note: This lag occurs only if the govt. attempts to introduce

a stimulus package through a legislation (e.g. American
Recovery and Reinvestment Act of 2009 – a stimulus plan
implemented in US to fight 2006-2007 economic slowdown)
(c) Implementation lag

• Refers to the time it takes for a policy to get

implemented.

• Even after a policy has been proposed and passed, it

may take time for it to take effect.

• It takes time for funds to be disbursed, employees hired,

and materials purchased.

• Even tax cuts can take some time to kick in (because it

takes time for people to spend money)
Fiscal Policy & Public Debt
Expenditure Classifications of Govt.
 Salaries, purchase
Consumption “Current/Revenue”
of goods & services
Expen. expenditure
for current use
(or)
Interest payments; “Current” account
Current Transfer Grants to states, local
Payments govts, & non-profit
institutions; Subsidies;
Pensions

DIRECT: Fixed CF (buildings,

public work etc.) & Increase “Capital” expenditu
Capital formation in work stores (or)
/Investment “Capital” accoun
INDIRECT: Grants for CF; In
vestments in shares of govt. con-
cerns; & Loans for CF (to states
etc.)
• Revenue Expenditure – Refers to expenditure incurred
on day-to-day functioning of govt. Includes salaries,
purchase of goods & services for current use, interest
payments; grants to states, local govts., & non-profit
institutions; subsidies; and pensions. In general
revenue expenditure do not entail creation of assets.

• Capital Expenditure - Expenditure incurred on any

asset creation. Includes fixed capital formation
(buildings, public work etc.), grants for capital
formation, investments in shares of govt. concerns; &
loans for capital formation (to states etc.)
Receipts of Government
 Tax Direct: Mainly corporate tax;
Revenue Income Tax
Revenue
Receipts
(Current earnings) Indirect: Mainly customs duty;
GST; stamp duty
Non-tax
Revenue
User charges on public services
interest receipts; dividends &
profits from PSUs; grants

Capital Public debt or loans;

Receipts recovery of loans; selling shares in a PSU
(Long-term earnings) (divestment)
 Budgetary Imbalances

• When govts. revenue expenditure exceeds

revenue receipts it results in a deficit in revenue
account of govt. budget. This is called revenue
deficit (RD)

RD = Revenue Expenditure – Revenue Receipts

• When there is a revenue deficit, naturally, the

govt. has to resort to borrowing

• How borrowed money can be repaid by govt.?

• The borrowed money need to be repaid with
interest. For this to happen, following are the
requirements:
(a) Additional revenue should be generated (or)
(b) Reduce current expenditure (or)
(c) Use borrowed money for productive purpose so
that it can yield a return to repay debts
• Use of borrowed funds towards creation of
capital assets can help generating revenues in
two ways.

 First, productive assets lead to greater growth,

which in turn generates the buoyancy in tax
revenues.

 Second, user charges (if collected

appropriately) on the newly created assets
generate non-tax revenues.
• If none of the above occurs either fully or partially,
there will be a revenue shortfall to fully meet debt
repayment obligation

• In this case further debt has to be incurred to meet debt

repayment obligation

• If again govt. fails to meet one of the aforementioned

three conditions, it lands up in debt trap (a situation
wherein govt. needs to borrow to repay old debts)

• The gravity of this situation can be understood with the

measure Fiscal Deficit (FD)
• FD = Total expenditure – (Revenue Receipts + Non-debt capital
receipts)

In short, FD represents excess of government expenditure over

‘non-borrowed receipts’ or total borrowing of government
• When govt. attempts to influence the economy by increasing
its expenditure, it may lead to a situation wherein the amount
of money a govt. spends goes beyond the govt’s revenue.
• This scenario is known as budget deficit or high FD.
• Recessions tend to increase FD as during a recession, govt.
spending often increases as part of an expansionary fiscal
policy, while revenue tend to decrease because people are
earning and spending less.
 What is the problem with high FD?
• Crowding out effect: Crowds out private
investment by increasing cost of debt funds (i.e.
interest rates)

• May lead to inflation if FD is financed by way of

deficit financing (i.e. printing currencies). This
happens when output cannot not easily be
increased to meet increased demand arising out
of increased money supply

• Increases interest burden of the govt.

 How does govt. borrow money?

• Govt. borrows money from people by selling

Treasury/Govt. securities (Treasuries/G-Sec).
• Basic idea is that govt. accepts money from people with
an obligation to pay them back by a certain date
• There are two types of Treasuries: Short and Long-term
• Short-term treasuries are short-term promises that the
govt. will pay back money after three months to one
year (Called Treasury Bill – T-Bill).
• Long-term treasuries operate on much longer time
frames (more than a year) (called Govt. bond or dated
securities)
 Short-term Treasuries
• The shortest-term Treasury securities are Treasury bills, also known
as T-bills.

• When an investor (in financial assets) buys a T-bill, they are buying
a promise that the govt. will pay them a set amount of money on a
fixed date - for example, Rs. 1,000 (face or nominal value), three
months or an year from the date of investment.

• Investors bid for T-bills when they are issued, so depending on the
state of market for T-bills, they might pay, say, only Rs. 990 (at a
discount) for this particular promise.

• The Rs. 10 difference is equivalent of interest earned on a savings

account.
• The return on these loans is usually quite low,
but they are liquid (investors money is tied up
in the bond for less than a year)

• Most important, investors consider them to be

very safe, and they thus appeal as a place to
securely park money.

• Based on maturity of T-Bills, in India they can

be classified into 3 types: 91-day TBs, 182-day
TBs and 364-day TBs
 Long-term Treasuries
• For longer-term investments, the govt. issues Treasury notes (T-
notes) or Govt. bonds in 2-, 3-, 5-, 7-, and 10-year increments.

• For those who are even more patient, the govt. offers its longest-
term option: Treasury bonds mature in 30 years and pay a specified
amount of interest every 6 months.

• In India, tenor of Govt. bonds ranges from 5 years to 40 years

• When you purchase a Treasury note, every six months you receive an
interest payment at a set rate.

• These notes pay more in interest than do T-bills since liquidity and
interest paid are inversely related.
 Who buys Treasury Securities?
• Treasury securities are purchased as financial investments by individuals and by other
governments and banks, both in home and abroad. (e.g. China, Japan, Brazil etc. in the
case of United States T-securities)

• Why would people want to hold government debt? The main reason lies in the relative
safety of investment (risk free), especially when compared with other investments.

• When you invest in real estate, the housing market can crash. When you invest in a
company's stock, the company can lose market value or go bankrupt.

• Govts. rarely can declare themselves bankrupt, too, and refuse to pay back money that
people have loaned them.

• Investors generally believe that the odds of govt. defaulting payment are quite low,
essentially zero.

• In India, Banks prefer to buy T-Bill since it is eligible for inclusion in SLR.
 Who issues T-Bills & Govt. Bonds in India?
• RBI by acting upon as the banker and issuing agent to
the GoI issues TBs & Govt. bonds

• They are issued through bidding/auction – competitive

& non competitive - process by RBI

• TBs can be bought from the money market: a wholesale

debt market to low-risk, highly-liquid, short-term
instruments/loans

• Govt. bonds can be bought from the capital market - a

market for long term funds – both equity and debt.
For a detailed information on Govt. securities
market in India, refer the following link

https://m.rbi.org.in/Scripts/FAQView.
aspx?Id=79#3
 Who invests in T-Bills in India?

• Commercial banks

• Financial institutions

• Corporates

• NBFCs

• FIIs

• State governments

• NRIs
 Is govt. debt good or bad?
Benefits of govt. debt
• Allows govt. to be flexible when
something unexpected happens
(e.g. Covid-19 pandemic, global
economic slowdown)
• Borrowed money can be used for
investments (e.g. education,
infrastructure) that will lead to
economic growth and prosperity
and the resultant higher tax
revenues in the long run.
• The revenue can be used to pay
back the debt.
Costs of govt. debt
• The govt. has to pay interest rate on
the borrowed money. Interest
payments on debt are substantial in
many countries.
• Govt. debt can distort the credit
market thereby slow down
economic growth due to crowding
out effect.
• Burden of govt. debt is on future
generation: people today benefit
when govt. spends borrowed
money, but people tomorrow (i.e.
future generation) will have to
repay loans
 Effect of stimulus spending: Which policy is more effective
during recession? – Tax cuts or Govt. expenditure?

• As discussed earlier, a multiplier effect occurs whenever there is

an increase in spending that would not have occurred
otherwise.
• The expenditure multiplier is the amount that G D P increases
when government spending increases by one rupee.

1
Expenditure spending multiplier 
 1 b

• A smaller b (MPC) results in smaller multiplier effect.

• A larger b results in larger multiplier effect.
• The taxation multiplier is the amount that GDP
increases when taxes decrease by one rupee.

b
Taxation multiplier 
 1 b

• Tax cuts boost G D P indirectly through an effect on

consumption.
 Taxation multiplier effect
…is negatively related to GDP:
An increase in taxes reduces consumer spending, which
reduces equilibrium income.

…is greater than one (in absolute value):

A change in taxes has a multiplier effect on income.

…is smaller than the govt spending multiplier:

Consumers save the fraction (1-MPC) of a tax cut, so the
initial boost in spending from a tax cut is smaller than from
an equal increase in G.
 Impact: Stimulus spending Vs Tax cut

Consider a situation where b = 0.6.

• Use this to determine how much GDP will increase

if the government spends an additional Rs. 100
million on highway construction.

• Use this to determine how much GDP will increase

if there are Rs. 100 million in tax cuts.
 Solution
 
1
Expenditure multiplier   2.5
 1  0.6 
Rs. 100 million × 2.5 = Rs. 250 million added to GDP

–Rs. 100 million × –1.5 = Rs. 150 million added to GDP