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.

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 deficient demand (when AD needs to be increased), the government increase their expenditure programmes.

This will increase purchasing power with the people there demand rises and situation of deficient 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 deficient demand. A decrease in direct tax increases the disposable income (purchasing power, as money that was given as tax will now due to reduction in tax will be used as consumption expenditure) and will lead to increase in consumption expenditure (rise in demand). Similarly, decrease in business (producers) taxes, leads to rise in investment by the producers.Thus, when deficient demand (AD needs to be increased) is to be corrected, tax burden on the households and the producer is decreased. 

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 deficient demand (AD needs to be increased), the government reduces its borrowing from the public. This increases liquidity with the people, thus aggregate expenditure increases. 

d) Deficit Financing:

The policy of meeting 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 deficient demand (AD needs to be increased),deficit financing needs to be increased, which will cause additional purchasing power in the economy. As a result AD will rise.