What is fiscal policy? solved

1-What do you mean by fiscal policy?

Ans: Fiscal policy refers to the deliberate changes made by the government in its expenditure, taxation and borrowing to achieve the predetermined macroeconomic goals like economic growth, high rate of employment, price stability, economic equality etc. Fiscal policy can be used as an effective tool of changing aggregate demand and aggregate expenditure in the economy by which the economy is regulated.

Like monetary policy, fiscal policy can also be categorized as expansionary and contractionary fiscal policies.

1-Expansionary fiscal policy

Expansionary fiscal policy refers to the fiscal policy which expands public expenditure and disposable income in the economy to stimulate aggregate demand. This type of fiscal policy is adopted when there is depression and recessionary trends are seen in the economy due to fall in aggregate demand.

2-Contractionary fiscal policy

Contractionary fiscal policy refers to the fiscal policy which contracts public expenditure and disposable income in the economy to dampen aggregate demand. To check the inflationary pressure in the economy this type of fiscal policy is implemented.

2- Explain the objectives of fiscal policy.

The objectives of fiscal policy may defer country to country and they may not be the same in different situations. However, the objectives of monetary policy in an economy are as follows.

1-Price stability

One of the objectives of fiscal policy is to maintain price stability. Fiscal policy keeps the price level stable by using its tools like public spending, borrowing and taxation.

2-High employment rate

Achieving a high employment rate is also the objective of fiscal policy. The government uses its fiscal tools so as to increase public spending in infrastructure development and cut taxes. It stimulates aggregate demand and high employment can be achieved.

3-Capital Formation/economic growth

The objective of fiscal policy is also to increase the rate of capital formation so as to accelerate the rate of economic growth. In order to increase the rate of capital formation, the fiscal policy is designed to encourage savings and investment and discourage unnecessary consumption spending.

4-Optimum allocation of resources

To maintain optimum allocation of resources is also the objective of fiscal policy. Taxation and public expenditure affect the allocation of resources in various sectors. By using taxation and public expenditure, the government can transfer resources from unproductive sectors to productive ones and maintain the optimum allocation of resources.

5-Maintaining equal distribution of Income and Wealth

Fiscal policy aims at equal distribution of income and wealth among different sections of the society. The direct taxes are more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper class. The government invests a significant proportion of its, thus collected, tax revenue in the implementation of poverty alleviation programs to improve the conditions of poor people in society. This is how fiscal policy maintains equal distribution of income and wealth.

6-Maintaining balance of payment

Fiscal policy aims at correcting adverse balance of payment by promoting exports and discouraging imports. By applying fiscal tools, the government can provide incentives with subsidies or tax concessions to increase exports and discourage imports by imposing high taxes. Thus, the balance of payment is maintained.

3-What are the various tools of fiscal policy? Explain.

The tools of fiscal policy are budgetary policy, government expenditure, taxation and public borrowing. All these tools have been explained in short as follows.

1-Budgetary Policy

Budgetary policy refers to the government plan to keep its budget in balance, in surplus or in deficit. Balanced, surplus and deficit budgets affect the economy in different ways, to different extents. Deficit budget expands the output, employment, income and aggregate demand. It also brings inflationary pressure in the economy. Surplus budget weakens economic activities. It dampens output, employment, income and causes recessionary trends in the economy.

2-Government expenditure

Government expenditure includes total public spending on purchase of goods and services, investment on infrastructure development and payment of wages, salaries and transfer payments. The government expenditure is an injection into the economy. Increase in government spending causes an increase in output, employment, income and aggregate demand. It creates inflationary pressure in the economy. A fall in government spending brings adverse situations in the economy.

3-Taxation

A tax is a compulsory payment made by the people to the government with no direct return to the taxpayers. Taxes are classified as direct and indirect taxes. Direct taxes on personal and corporate incomes reduce aggregate demand whereas indirect taxes reduce aggregate supply. When both the taxes are increased, with the fall in aggregate demand and aggregate supply, there will be recession in the economy and on the other hand tax release will push up output, income and employment.

4-Public borrowings

Public borrowings include internal and external borrowings. Governments make borrowings generally to finance budget deficits. Borrowings from public and central banks are the two types of internal borrowings. Borrowings from foreign governments and international organizations are the external borrowings. Borrowings from central banks and foreign countries are injections into the economy which help to increase in output, income, aggregate demand and employment. These borrowings also create inflationary pressure. Borrowings from the public reduce aggregate demand and fall in price level due to time lag.

4-What are the various types of fiscal policy? Explain.

Ans: There is not a unique fiscal policy that can solve all kinds of economic problems in different situations at different points of time. In fact, different kinds of fiscal policies have been suggested by economists and used by the policy-makers in different economic conditions in different countries to achieve specific macroeconomic goals. Following are some fiscal policies which are mainly used by the policy makers in different countries.

1-Automatic stabilization fiscal policy,

2-Compensatory fiscal policy, and

3-Discretionary fiscal policy.

1-Automatic stabilization policy:- This policy takes place when fiscal policy has "built – in – flexibility". Under this policy, budget, taxes and GDP are so arranged in such a way that a change in one variable changes the other itself and automatic stabilization takes place.

When GDP falls, income and consumption both decline. Consequently direct and indirect taxes decline but the government committed expenditure is remaining the same. Government expenditure exceeds its revenue. The budget automatically runs into deficit and the deficit budgeting automatically increases GDP. On the other hand, when GDP shoots up, tax-base income increases. Government expenditure remains the same, the budget runs into surplus which has a negative impact on GDP. This is how deficit and surplus resulting from fluctuation in GDP work as automatic stabilizers of the economy.

2-Compensatory fiscal policy:- Compensatory fiscal policy refers to the deliberate change made by the government in its budgeting to regulate the economy. Under this method, the government adopts surplus budgeting to control inflationary pressure in the economy. On its contrary, the government adopts deficit budgeting to fight depression or recessionary trends in the economy.

3-Discretionary fiscal policy:- Discretionary fiscal policy refers to the arbitrary changes made in taxes and public expenditure by the government to stabilize the economy. The discretionary changes are made to arrest inflationary and recessionary trends in the economy by changing the volume of aggregate demand. When inflationary pressure is high, the government pushes up tax rate and cuts down its spending and on the other hand, at times of recessionary pressure, it cuts down tax rate and increases its spending. This is how the economic stabilization process is carried out through discretionary fiscal policy.