Ag. Econ.

:-502
Macro Economics Theory & Application

Submitted To:- Submitted By:-

N. J. Ardeshna Jalu Swati N.
 Introduction
• Fiscal Policy is a part of macro economics policy.
• This policy is also known as budgetary policy.
• One major function of the government is to stabilize
• economy.
• Current Indian govt wants to achieve fiscal deficit target by
not reducing expenditure but increasing tax collection.
• Keynesian economics, when the government changes the
levels of taxation and governments spending, it influences
aggregate demand and the level of economic activity.
 Meaning
• The word fiscal means ‘state treasury’ and fiscal policy refers
to policy concerning the use of ‘state treasury’ or the
government finances to achieve the macroeconomic goals.
• Fiscal policy involves the decisions that a government makes
regarding collection of revenue, through taxation and about
spending that revenue.
• It is sister strategy to monetary policy through which a central
bank influences a nation’s money supply.
 Definition
• Fiscal policy can be defined as the policy of the government
regarding changes in taxes, government deemed in the
economy.
• A policy under which government uses its expenditure and
revenue programe to produce desirable effect and avoid
undesirable effects in the national income production and
employment.

Arthur smith
 How fiscal policy works?
• Fiscal policy is based on the theories of British economist John
Maynard Keynes. Also known as Keynesian economics.
• this theory basically states that governments can influence
macroeconomic productivity levels by increasing or decreasing
tax levels and public spending.
• This influence, in turn, curbs inflation (generally considered to
be healthy when between 23%), increases employment and
maintains a healthy value of money.
• Fiscal policy is very important to the economy.
 Differences
Monetary policy
Fiscal policy
• Deals with taxation and • Deals with money supply.
government spendings. • Is controlled by the central
• Is administered by the bank (RBI) through interest
government through rates and lending rates.
various laws and • Measures can be not time to
policies get
• Measures take time to
get
 Objectives
• The main objective of fiscal policy is to control inflation or
deflation in the market i.e. maintaining economic stability.
• It helps in diverting resources from undesirable channels to
desirable channels.
• Helps in achieving welfare objectives i.e. basically to reduce
inequalities between rich and poor and increase welfare.
 Objectives
1. Development by effective mobilization of resources
2. Reduction in inequalities of income and wealth
3. Price stability and control of inflation
4. Employment generation
5. Reducing the deficit in the balance of payment
6. Increasing national income
7. Development of infrastructure
 Type of fiscal policy
1.Natural:-This is the equilibrium phase for the economy. In
this case the government spending is entirely funded by tax
revenue and there is no need of borrowing.
2.Expansionary:-This is the phase where the government
spending exceeds tax revenue. This happens during the time
of recessions.
3.Contractionary:-This is the phase where the government
spending is lower than tax revenue. This is undertaken to
pay down government debt.
 Expansionary Fiscal Policy
• When an economy is in a recession, expansionary fiscal policy
is in order. Typically this type of fiscal policy results in
increased government spending and/or lower taxes.
• A recession results in a recessionary gap meaning that aggregate
demand (ie, GDP) is at a level lower than it would be in a full
employment situation. The actions of this expansionary fiscal
policy would result in a shift of the aggregate demand curve to
the right, which would result closing the recessionary gap and
helping an economy grow.
 Contractionary Fiscal Policy
• Contractionary fiscal policy is essentially the opposite of
expansionary fiscal policy. When an economy is in a state
where growth is at a rate that is getting out of control (causing
inflation and asset bubbles), contractionary fiscal policy can be
used to rein it in to a more sustainable level. If an economy is
growing too fast or for example, if unemployment is too low, an
inflationary gap will form. In order to eliminate this
inflationary gap a government may reduce government
spending and increase taxes.
 Method of Funding
• Recovery of loans:-The central government grants loans to
various states inside and outside the country. When
government recovers these loans the government gets more
money that it can now utilize for the welfare.
• Disinvestment:- Government holds equity or shares of the
public sector enterprises. It can raise funds by selling its
holding in the market. It leads to reduction in assets held
by the government.
Cont…
• Borrowings:-It basically means that the government is
borrowing money from various institutions be it inside or
outside the country.
The government may choose to borrow funds from public by
issuing bonds or treasury bills. The government can also
borrow funds from financial institutions like world bank or
any other country.
• Taxes:-The most effective way for the government is to
increase tax rates or impose new taxes.
 Instruments of Fiscal Policy
• Budgetary surplus and deficit
• Government expenditure
• Public debt
• Taxation
 Public Debt
• Public debt refers to borrowing by a government from within
the country or from abroad, from private individuals or
association of individuals or from banking and NBFIs.
• It can be classified in three ways:
i. Internal and external
ii. Productive and unproductive
iii. Short term and long term
 Type of Debt
• Internal public debt: When the government borrows from
within the country be it from the citizens or financial
institutions or the central bank.
• This is called internal borrowing.
• External public debt: When the government borrows funds
from international market be it any financial institutions or
any nation in particular.
• Acquiring loan from outside is comparatively difficult as the
other party first studies the financial position of the country
and then only grants a loan.
 Cont…
• Productive debt: The debt that is expected to create
assets which will yield income sufficient to pay the principal
amount and the interest on it, is known as ‘productive
debt’.
• In other words, they are expected pay their way, they are
self- liquidating.
• Unproductive Debt: On the other hand, unproductive debt is
the debt that is raised for financing unproductive assets or
heavy unproductive expenditures.
• Such a debt is a deadweight debt.
 Cont……
• Short Term Loan:-The loans which are to be repaid
within a period of one year.
• The loan provided usually is for a limited amount.
• It is used to fulfil short term needs of the government.

• Long Term Loan :-The loans which are to be repaid after a

period of one year.
• The loan provided here can be for a huge amount.
It is very helpful for long term projects.
 Taxation
• Tax is a legal compulsory payment paid to the government
by the people.
• It is the most common and effective way for the
government to influence the aggregate demand in the
economy.
• There are two types of taxes
i. Direct Tax
ii. Indirect Tax
 Cont..
• Direct Tax: It is the tax where the liability to pay and the
incidence lie on the same person.
✓ example: income tax, corporate tax, property tax etc.

• Indirect Tax: When the liability to pay and the

incidence of the tax lie on a different person.
✓ example: sales tax, VAT, service tax etc.
 Cont…
• During the time of inflation (when aggregate demand is
more than aggregate supply) the government increases the
tax rates and may also impose new tax rates.
• This would result in reduction in the money supply
in the economy and will control the inflationary gap.
 Cont…
• During the time of deflation (when aggregate demand is less
than aggregate supply) the government reduces the tax
rates and may also cut of some taxes temporarily.
• This would result in an increase in the money supply in
the economy and will control the deflationary gap.
 Budgetary Surplus
• It is a situation where the revenue earned by government is
more than the expenditure.
• The surplus amount is used for repayment of loans or can be
kept as a reserve for the future.
• It can also be used to make desired purchases that were
delayed and for the development of the economy.
• It is a sign that the government is running the economy
efficiently.
 Budgetary Deficit
• It is a situation where the revenue earned by the
government is less than its expenditure.
• At this time the government reduces its expenditure on
public welfare, increases tax rates and may also opt for
borrowings.
• The surplus from previous years can be used.
• It is a sign that the government is not running
efficiently.
 Government Expenditure
• During the time of inflation the government decides to
reduce its expenditure on public welfare like police, military,
courts, education etc.
• This results in the fall of aggregate demand.
• Which leads to reduction in the inflationary gap.
Cont….
• At the time of deflation (when aggregate demand is less
than aggregate supply) the government decides to increase
its expenditure for the welfare of the people.
• This injects money in the economy and helps remove
unemployment and increases the aggregate demand.
• It leads to reduction in deflationary gap.
 Problems of Fiscal Policy
• One of the many problems with fiscal policy is that it tends to
affect particular groups disproportionately.
• A tax decrease might not be applied to taxpayers at all income
levels, or some groups might see larger decreases than others.
Likewise, an increase in government spending will have the
biggest influence on the group that is receiving that spending,
which in the case of highway spending would be construction
workers.
 Fiscal Straitjacket
• The concept of a fiscal straitjacket is a general economic
principle that suggests strict constraints on government
spending and public sector borrowing, to limit or regulate
the budget deficit over a time period.
• This term originated from the definition of straitjacket
(anything that severely confines, constricts, or hinders).
• Various states in the United States have various forms of
self-imposed fiscal straitjackets.