Fiscal Policy

This policy relates to the use of government spending and tax policies to influence total expenditure in order to achieve any specific goal set by the government.

 Objectives of fiscal policy are: Accelerating the rate of economic growth Achieving full employment Price stability Reduction of regional imbalances Reduction of economic and social inequalities through redistribution of income and opportunities.

Instruments of fiscal policy

(a) Taxation: Direct and indirect taxes (b) Pattern of public expenditure (c) Deficit financing vs balanced budget The Keynesian model of national income and output determination predicts that GDP can get stuck at a level below its full potential.

It also suggests how fiscal policy can be used to realize the potential level of GDP. A Change in government spending, changes the equilibrium level of GDP by the size of spending change times the simple multiplier.

 Impact of fiscal policy on real national income (GDP). A change in government spending changes GDP by shifting the AD level parallel to its initial position.

 If tax rates change, the difference between disposable income and national income changes. If government decreases its rate of income tax by 5%,then disposable income rises in relation to national income. The result of this would be a rise in equilibrium GDP.

 The lower the income tax rate, the larger is the simple multiplier. Balanced Budget A balanced budget increases in government spending will have a mild expansionary effect on GDP and a balanced budget decrease will have a mild contractionary effect

Deficit Financing
When government spending is increased with no corresponding increase in tax rates, we call it deficit financing because there is no increase in tax rates, there is no consequent decrease in consumption to cancel the increase in government spending deficit financing based multiplier is much higher than balanced budget multiplier.

Crowding out effect hypothesis

This hypothesis suggests that when government borrows heavily from the markets ( Banks) less amount of money is left for private investment by corporate. Governments entry in money market for large amount of borrowings lead to monetary tightening & increase in the interest rate. The rising interest rates will tend to choke-off or crowd out private (induced) investment.

 Crowding out applies largely to structural deficits coming through tax cuts or higher government spending. This link between deficit financing and private investment is not an absolute law holding good in all conditions as investment depends on many factors such as profit expectations, saving behaviour, foreign exchange rates, state of financial and capital markets,etc. The exact impact of fiscal policy change is difficult to be predicted.