Fiscal Policy as an Economic Stabilization Measure

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Fiscal Policy refers to the various decisions undertaken by the government regarding public expenditures and revenue. There are a large number of sub-policies that are encompassed by the fiscal system. But all the policies can be broadly categorized as being either ‘Public Expenditure’ or ‘Public Revenue’. It can be said that the fiscal policy is a direct government intervention in the economic processes of an economy.

The fiscal policy is very objective in nature, since it creates decisions that can be uniformly applied to the entire economy or to a segment of the economy. The fiscal policy is considered to be more direct than the monetary policy in its impact on the economy. While the monetary policy’s success depends on the banking / financial system, the fiscal policy operates in an inherent manner in the economy. The fiscal policy’s sub-policies are:

The Annual Budget of the government – this is a policy statement that directs all economic activities for at least a year.

Public Debt – this helps the government to raise resources on a quid-pro-quo basis.

Deficit Financing – wherein the government can order its Central Bank to release additional money equivalent to the size of the deficit in its budget.

The Taxation structure – through this fiscal tool the government is able to raise resources on a non-quid-pro-quo basis.

A wide range of public expenditures – covering productive items (like: irrigation projects, industrial investments, EOC and SOC) and unproductive items (like: welfare measures and general administrative expenses).

Depending upon whether the Fiscal Policy increases or decreases the public expenditure in the economy, it is possible to categorize the fiscal policy into two types:

An Expansionary Fiscal Policy – in this case, there is an increase in public expenditure and so there is an improvement in the income generating capacity in the economy. An expansionary fiscal policy causes the multiplier effect to operate leading to an overall macro-expansion.

A Contractionary Fiscal Policy – in this case, the government’s expenditure falls causing a reduction in the income generating capacity in the economy on account of the operation of the reverse multiplier.

Higher government expenditures will raise aggregate demand both directly via the increase in the government’s demand for goods and services and also indirectly via the expenditure multiplier process. The higher aggregate demand will raise incomes and thereby increase the demand for money. Assuming there is no change in the money supply, there will be excess demand in the money market, which will raise the ROI. However, investment expenditure is negatively related to the ROI. Therefore, the higher ROI will reduce investment expenditure and thereby lead to a reduction in the aggregate demand. There are two counteracting effects on aggregate demand as a result of a fiscal expansion. The first effect, that of increased government expenditure, is expansionary. The second effect, which is contractionary, is known as the crowding out of private expenditure as a result of the increase in government expenditure.

Showing the COE with the help of IS – LM curves:

In an economy with unemployed resources there will not be full crowding out because the LM schedule would then not be vertical. A fiscal expansion will raise the ROI, but income will also rise. Crowding out therefore becomes a matter of degree. The increase in aggregate demand raises income. With the rise in income, the level of saving rises. This expansion in saving, in turn, makes it possible to finance a larger budget deficit without completely displacing private borrowing or investment.

In Fig. 1, when an expansionary fiscal policy is in operation, i.e., public expenditure increases; this leads to an increase in the aggregate demand. On account of this increase, there is an...