How Fiscal Policy provides Stability, growth and Equity

The objectives of Fiscal policy in developed country is different from those in underdeveloped countries. The main objective of fiscal policy in developed countries is maintaining economic stability. Economic development is the main objective in underdeveloped countries.

The main objectives of fiscal policy are as follows:

1) Stability

2) Growth

3) Equity

Economic Stability

Providing stability to the process of growth and development is the key role of fiscal policy in any economy.

Economy stability means that the level of economic activity is maintained at a stable level so that there are no fluctuations in output and employment.

How Fiscal Policy control Inflation

In the situation of inflation there is a high price rise in the economy, this is due to increase in Aggregate Demand (AD). When there is an increase in AD beyond the full employment level, output remain constant since output cannot be increased as there is full employment, all resources are fully utilized, this leads to an increase the cost of production of existing factors of production and price rises. More and more rise in prices leads to a situation of inflation due to the situation of excess demand .

Fiscal Policy

Fiscal policy is the revenue and expenditure policy of the government. It is also called as the budgetary policy of the government. Through its revenue and expenditure policy, situation of  ---

inflation ( excess demand ) and deflation ( deficient demand ) 

is checked and controlled by varying the size and composition of revenue as well as of expenditure. Fiscal policy leads to the growth and stability of the economy. Fiscal policy is the policy of the government which includes components like taxation, public expenditure and public borrowing. Following are the principal instruments of fiscal policy which, when used in a proper combination to achieve the best possible results in terms of the desired economic objectives like.

Maintaining economic stability

High employment

And, accelerating economic growth

How Monetary Policy Correct deficient demand situation

After going through Fiscal Policy to control the situation of deficient demand, we will know see how monetary policy of the government can be used to solve the situation of decreased aggregate demand.

Monetary Policy:

Monetary policy can be used effectively to control the situation of deficient demand Monetary policy is the policy of the central bank to achieve various policy of economic policy which includes components like bank rate, open market operations, cash reserve and statutory liquidity ratio to correct deficient demand.Following are the principal components of Monetary policy. Along with each component, we are describing the way it is used to correct situations of deficient demand.

How Fiscal Policy Correct deficient demand situation

We have seen that deficient demand leads to deflation in the economy, 

so it’s  necessary to correct this deficient demand situation. Here, we will see how Fiscal Policy of the government will control the situation of deficient demand.

Fiscal Policy: 

Fiscal policy can be used effectively to raise demand in the economy to correct the situation of deficient demand. Fiscal policy is the policy of the government which includes components like taxation, public expenditure and public borrowing.

Following are the principal components of fiscal policy. Along with each component, we are describing the way it is used to correct situations of deficient demand.

a) Government expenditure:

It is the principal instrument of fiscal policy. The government of a country incurs various types of expenditure, mainly:

i) Expenditure on public work programmes like construction of dams, bridges, roads etc.

ii) Expenditure on education and welfare programmes.

iii) Expenditure on defence and law and order.

iv) Expenditure on subsidies to the producer for encouraging production. 

In the situation of deficient demand, the government should increase its expenditure (as said above).

Increasing government expenditure means increasing government spending. We have read in investment multiplier mechanism that expenditure leads income generation.

Expenditure by one person becomes the income of another person.

How Monetary Policy Correct Excess demand situation

After going through Fiscal Policy to control the situation of excess demand, we will know see how monetary policy of the government can be used to solve the situation of increased aggregate demand.

Monetary Policy:

Monetary policy can be used effectively to reduce the excess demand. Monetary policy is the policy of the central bank to achieve various policy of economic policy  which includes components like bank rate, open market operations, cash reserve and statutory liquidity ratio to correct excess demand.Following are the principal components of Monetary policy. Along with each component, we are describing the way it is used to correct situations of excess demand.

Bank rate:

Bank rate is the rate at which the central bank lends money to the commercial banks.

To control the situation of excess demand, bank rate is increased, due to this increase of bank rate by central bank, commercial banks raise the market rate of interest(the rate at which commercial bank lend money to the consumers and investors). This will lead to higher cost of borrowing from commercial banks to the consumers and investors. This reduces demand for credit, thereby leading to less liquidity in the hands of the people.Consumption expenditure and investment expenditure are reduced and aggregate demand (AD) will fall.

How Fiscal Policy Correct Excess demand situation

We have seen that excess demand leads to inflation in the economy, so it’s necessary to correct this excess demand situation.Here, we will see how Fiscal Policy of the government will control the situation of excess demand.

Fiscal Policy:

Fiscal policy can be used effectively to reduce the excess demand. Fiscal policy is the policy of the government which includes components like taxation, public expenditure and public borrowing.

Following are the principal components of fiscal policy. Along with each component, we are describing the way it is used to correct situations of excess demand.

a) Government expenditure:

It is the principal instrument of fiscal policy. The government of a country incurs various types of expenditure, mainly:

i) Expenditure on public work programmes like construction of dams, bridges, roads etc.

ii) Expenditure on education and welfare programmes.

iii) Expenditure on defence and law and order.

iv) Expenditure on subsidies to the producer for encouraging production.

In the situation of excess demand, the government should reduce its expenditure, mainly unproductive expenditure like defence and administrative expenditure, interest payments etc.

Deflationary gap

Deflationary gap is the shortfall in AD from the level required to maintain full employment equilibrium in the economy. In such a situation, there is involuntary unemployment in the economy.

When there is a situation of deficient demand, resources are not fully utilized and there is excess capacity in the economy. The economy moves towards deflation. as the aggregate demand is not sufficient to purchase the potential output, income, output and employment in the economy will fall. Due to excess supply and low demand, prices of commodities fall.

A situation of deflationary pressure emerges in the economy.

Deflationary pressure is proportionate to deficient demand i.e. deflationary gap is a measure of the amount of deficient demand in the economy. 

Greater the deficient demand, greater the deflationary pressure.

Below graph explains the deflationary gap

Deflationary gap

AD : Aggregate demand at full employment

AD₁: Underemployment Aggregate demand

Deficient Demand

Deficient demand refers to the situation when aggregate demand (AD) is in short of aggregate supply (AS) corresponding to fullemployment in the economy.

AD < AS : Corresponding to full employment.

Desired AD in the economy happens to be short of its full employment level. 

It implies that desired AD does not permit production at the full employment, due to deficient demand, equilibrium between desired AD and desired AS is struck at a level lower than full employment in the economy, this is a situation of underemployment equilibrium. 

Deficient demand may be caused by decrease in the value of various components of aggregate demand

i.e.

AD = C + I + G + (X - M)

Thus, deficient demand may be caused by the following factors:

1) Decrease in the consumption expenditure by the household due to increase in the propensity to save and reduction in propensity to consume.

2) Decrease in private investment expenditure.

3) Decrease in government expenditure this may be due to losses in public enterprises. In such a situation, instead of making fresh investment, the government may resort to disinvestment, implying a cut in AD. 

4) Decline in export, owing to lower domestic demand in rest of the world.

5) Rise in imports, owing to lower international prices compared with domestic prices. A rise in import implies a cut in AD as imports are negative components of AD.

6) An increase in tax rates leaving lesser disposable income with the people. This leads to reduction in their capacity to spend

7) Decrease in money supply due to reduction of credit facilities by the commercial banks. 

Below figure illustrates the situation of deficient demand.

deficient demand

AD: Aggregate demand at full employment

AD₁: Aggregate demand corresponding to underemployment

FC: deficient demand

OM: Full employment level of output

ON: equilibrium output owing to underemployment

AD is Full employment Aggregate Demand. The intersection of AD curve with 45^◦ line at F gives us the equilibrium corresponding to full employment level of output M. 

Now, suppose aggregate demand curve shifts downwards to AD₁ due to say, decrease in government expenditure.

At the full employment level of income, the aggregate supply is OM or FM. This is greater than aggregate demand of CM.

The deficient demand at the full employment income is FC 

Deficient demand = FC = AD - AD₁  (FM – CM)

Inflationary gap

Inflationary gap is the excess of Aggregate Demand over and above its level required to maintain full employment equilibrium in the economy.

When there is a situation of excess demand, the level of output does not rise since factors are already fully employed.

Output level remains constant corresponding to full employment. A high level of aggregate spending relative to full employment level of output will generate shortages of goods in the economy, which would push up prices and causes inflation.

A situation of inflationary pressure emerges in the economy.

Inflationary pressure is proportionate to excess demand i.e. inflationary gap is a measure of the amount of excess demand in the economy.

Greater the excess demand, greater the inflationary pressure.

Below graph explains the inflationary gap

Inflationary gap

AD: Aggregate demand at full employment

AD₁: Aggregate demand beyond full employment

AB: Excess demand = inflationary gap

OM: Full employment level of output

Excess Demand

Excess demand refers to the situation when aggregate demand (AD) is in excess and its components of aggregate supply (AS) corresponding to full employment in the economy.

AD > AS : Corresponding to full employment. 

Desired AD in the economy happens to exceed its full employment level.

As it is a situation of full employment, resources are all fully utilized so aggregate supply cannot be raised, increase in demand implies greater pressure on the available goods and services in the economy.

Accordingly, price of existing goods and services tends to rise.

Excess demand may be caused by increase in the value of various components of aggregate demand.

i.e.

AD = C + I + G + (X - M) 

Thus, excess demand may be caused by the following factors: 

1) Increase in the consumption expenditure by the household due to increase in the propensity to consume.

2) Increase in private investment expenditure.

3) Increase in government expenditure, owing to its active participation in the process of growth and social welfare.

4) Increase in export, owing to lower domestic prices in relation to international prices.

5) Decrease in imports, owing to higher international prices compared with domestic prices.

6) A cut in tax rates leaving higher disposable income with the people.

Voluntary and Involuntary Unemployment

Voluntary Unemployment 

Voluntary Unemployment occurs when some people are not willing to work at all, are not willing to work at the existing wage rate, these persons are voluntarily unemployed, i.e. unemployed by their choice.

They may not work due to laziness or otherwise, they are not interested in any gainful job. They are unemployed not out of compulsion but due to their choice. We may include both the ‘idle rich’ and ‘idle poor’ in this category. 

Similarly, there may be some anti-social people like thieves and pickpockets who may be voluntarily unemployed.

We do not include such cases of voluntarily unemployed persons under unemployment, therefore these persons are not considered unemployed.   

Involuntary Unemployment 

Involuntary Unemployment refers to the situation when some people are not getting work, even when they are willing to work at the existing wage rate.

Full Employment

Full employment refers to a situation when all those who are able to work and are willing to work (at the existing wage rate) are getting work. It is a situation when, corresponding to a given wage rate, demand for labor force is equal to supply of labor force, and the labor market is cleared (it is in a state of equilibrium).

Two situations must be noted in this definition:

1) Full employment does not mean that everyone is employed. People who are voluntarily unemployed, such as ‘idle rich’, are not employed because they are not willing to work. They are not treated as unemployed.

2) There might be some amount of frictional unemployment owing to technological improvements, decrease in demand for the product of some industries, or because some person may be changing jobs or because of structural changes in the economy. It may take some time for these persons to get a new job. So, these people may remain temporarily unemployed.

Investment Multiplier At a Glance

The working of the Multiplier assumes the following process:

multipler-process

Change in investment causes change in income. As a result, consumption changes. Consumption expenditure of one person is an income of the other.

Hence, change in consumption leads to change in income. This process continues till ∆C falls to zero.

MPC is the core factor in the process of income generation. Higher the MPC, greater is the conversion of income into consumption expenditure. Accordingly, greater is the generation of income. As, it is expenditure that is converted into income.

Expenditure is the injection into the income generation process, saving is the leakage.

For Detailed Study -

1. Investment Multiplier

2. Graphic Presentation of Multiplier

How Multiplier Mechanism Works

Let us understand the logic behind the direct relationship between MPC and multiplier through Multiplier Mechanism. It runs like this:

1) Suppose AB industry limited spends Rs. 100 crore in setting up a new plant i.e  ∆I = Rs. 100 crore.

This will lead to creating more demand for goods and services required for the setting up of this new plant. There will more demand for machinery, raw materials, labour etc.

This will generate income for all those people who are associated with the setting up this plant and leading to more output and income.

As a result national income in the first will increase by an amount equal to amount of investment i.e  ∆Y = Rs. 100 crore

2) This ∆Y = Rs. 100 crore would be split into ∆C and ∆S as a part of income is spent and a part of it is saved.

3) In round – 2, ∆C would be converted  into ∆Y as people who receive this new income (Rs. 100 crore) directly from the building of the factory will spend some of it on consumer goods like food, clothing, TV, cars, etc.

Here comes an important point:

The exact amount of additional consumption expenditure depend on the MPC(c).

Suppose MPC is 0.8, then 

MPC = ∆C / ∆Y (as discussed in consumption function)

∆C = MPC (∆Y)

∆C = 0.5(100)

     = Rs. 50 crore

If  MPC is 0.4, then

∆C = 0.4(100)

     = Rs. 40 crore

Relationship between Investment multiplier and Marginal propensity to consume

There is a direct relationship between multiplier and MPC. Higher the value of MPC, higher the multiplier affect and lower is the value of multiplier, lower the multiplier effect. 

We have already derived the multiplier formula i.e 

K = 1 / 1-MPC

Now we see the multiplier effect by taking different values of MPC

If MPC = 0.5 

K = 1 / 1-MPC

K = 1 / 1-0.5

    = 1 / 0.5

    = 2

Derivation of Investment Multiplier Formula

The multiplier formula can be derived by using the simple equilibrium condition for the two sector model i.e  

Y = C + I 

When there is an increase in investment by (∆I), it will lead to increase in income (∆Y) and this induces increase in consumption (∆C) i.e

∆Y = ∆C + ∆I 

Since, change in total consumption (∆C) equals change in income multiplied by MPC (marginal propensity to consume, “c”)

∆Y = c∆Y + ∆I

∆Y - c∆Y = ∆I

∆Y(1-c) = ∆I

∆Y = ( 1 / 1-c)  ∆I 

∆Y/ ∆I = 1 / 1-c

Graphic Presentation of Multiplier

Investment multiplier can also be explained with the help of the a diagram, as shown below:

investment multiplier

1) Income is shown along the X axis and Aggregate demand on Y axis.

2) The initial equilibrium is at point A, When AD = C + I

Investment Multiplier

Investment multiplier or output multiplier refers to the number by which change in investment (∆I) multiplies to become change in output/income (∆Y).It is measured as the ratio between change in output/income and change in investment.

K =  ∆Y / ∆I

K = Multiplier

∆Y = Increase in output/income

∆I = Increase in investment

Determination of Equilibrium Income and output

Saving And Investment Approach for determination of equilibrium income and Output

An alternative approach to the determination of equilibrium level of income is Saving Investment approach.According to this approach, equilibrium is struck at that level where planned investment equals planned saving.

i.e S = I

Since S refers to ‘withdrawal’ from the circular flow and I refers to ‘injection’ into the circular flow, equilibrium condition can be stated as:

Withdrawal = injection

Determination of Equilibrium Income and output

After discussing about consumption and investment function in my previous posts, we are now in a position to study and analyse the equilibrium level of income and output.

Basic Assumptions:

1) Short Period analysis – Keynesian theory of equilibrium output is determined only with reference to short period of time.Short run is defined as a period of time during which level of output is determined exclusively by the level of employement in the economy. Technology is assumed to remain constant.

2) Closed economy – Keyenes discuss the theory of equilibrium GDP in the context of a closed economy.This is an economy which has no relations with  the rest of the world,there is no import or export.

Its two sector economy consisting of the household sector and business sector.All the decisions concering consumption expenditure is taken by the individiula household, while the business firms take decisions regarding investment.