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.

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

Expenditure by one person becomes the income of another person.

For example: A new road is being constructed by the government, for this various factors of production will be required like labour, raw materials etc.

This work will generate income to these factors of production, leading to increased purchasing power and more demand in the economy.

So in the situation of excess demand (when AD needs to be reduced), the government reduce their expenditure programmes. This reduces purchasing power with the people there demand falls and excess demand can be reduced.

b) Taxes:

Taxes are compulsory payment made to government by the household and the producing sector.

The government can use the instruments of taxation to correct excess demand. An increase in direct tax reduces the disposable income (purchasing power, more money will be given as tax) and will lead to decrease in consumption expenditure (fall in demand).

Similarly, increase in business (producers) taxes, leads to fall in investment (mainly luxurious goods) by the producers. Thus, when excess demand (AD needs to be decreased) is to be corrected, tax burden on the households and the producer is increased.

c) Public borrowing/ public debt:

In modern times, borrowing by the government has become a normal method of government finance along with other sources of public finance like taxes, fees, etc. Borrowing by the government leads to public debt i.e. loans raised by the government from within the country or from outside the country.

The government may borrow from individuals, business enterprises and banks, etc.

When there is a situation of excess demand (AD needs to be reduced), the government steps up public borrowing by offering attractive rate of interest. This reduces liquidity with the people, thus aggregate expenditure also reduces.

d) Deficit Financing:

The policy of meeting of deficit between government expenditure and revenue through the creation of new money.

In India, deficit financing means borrowing by the government from the RBI. The RBI lends money to the government by issuing more currency.Additional currency causes additional purchasing power in the economy.

When there is a situation of excess demand (AD needs to be reduced),deficit financing needs to be reduced, which will reduce the government ability to spend. As a result AD will fall.