Ch-2 Fiscal Policy Flashcards
Q1) what are the objectives of fiscal policy?
The most common objectives of fiscal policy are :
🔷Achievement and maintenance of full employment,
🔷maintenance of price stability,
🔷acceleration of the rate of economic development, and
🔷 equitable distribution of income and wealth,
🔷 Eradication of poverty.
🔷Removal of regional imbalances in different parts of the country.
Q2) what are the instruments of fiscal policy?
🔷 the tools of fiscal policy are taxes , government expenditure , public debt and the government budget.
Q3) explain government expenditure as an instrument of fiscal policy ?
🔷 government expenditure is an important instrument of fiscal policy.
🔷 Government expenditure include capital expenditure on public works, relief expenditures, subsidy payments of various types, transfer payments and other social security benefits.
🔷 Government expenditure include :
- current expenditure to meet the day to day running of the government,
- capital expenditures which are in the form of investments made by the government in capital equipments and infrastructure, and
- transfer payments i.e. government spending which does not contribute to GDP because income is only transferred from one group of people to another without any direct contribution from the receivers.
🔷 During a recession,
- government may increase expenditure in public works, such as construction of roads , irrigation facilities, sanitary works, ports, electrification of new areas ect .
- these expenditures directly generate incomes to labour and suppliers of materials and services.
- the incomes generated are spent on purchase of consumer goods.
- this leads to an increase in demand for various goods which further leads to expansion in production in those industries as well.
- additionally , a programme of public investment will strengthen the general conference of businessman and consequently their willingness to invest.
- Primary employment in public works programmes will induce secondary and tertiary employment, and before long the economy is put on an expansion track.
🔷During inflation,
- Government expenditure is reduced.
- reduced incomes on account of decrease public spending helps to to eliminate excess aggregate demand.
Q4) define Taxes as an instrument of fiscal policy?
🔷Taxes form the most important source of revenue for government.
🔷Taxation policies are effectively used for establishing stability in an economy.
🔷Tax as an instrument of fiscal policy consists of changes in rates of taxes which aimed at encouraging or restricting private expenditure on consumption and investment.
🔷Taxes determine the size of disposable income in the hands of the general public which in turn determines aggregate demand and possible inflationary and deflationary gaps.
🔷The structure of tax rates is varied in the context of the overall economic conditions prevailing in an economy.
🔷During recession and depression, the tax policy is framed to encourage private consumption and investment. A general deduction in income taxes leaves higher disposable incomes with people inducing higher consumption. Low corporate taxes increase the prospects of profits for business and promote further investment. The extent of tax reduction depends on the size of the the recessionary gap and the magnitude of the multiplier.
🔷During inflation, new taxes can be levied and the rates of existing taxes are raised to reduce disposable incomes and to wipe off the surplus purchasing power.
🔷However, excessive taxation usually stifles new investments and therefore the has to be cautious about a policy of tax increase.
Q5) define public debt as an instrument of fiscal policy?
🔷A rational policy of public borrowing and debt repayment is a potent weapon to fight inflation and deflation.
🔷Public debt may be internal or external; when the government borrows from its own people in the country, it is called internal debt. On the other hand, when the government borrows from outside sources, the debt is called external debt.
🔷Public debt takes two forms namely, market loans and small savings.
🔷In the case of market loans, long term capital bond and Government treasury are issued which are traded in debt markets. For financing capital projects, long-term capital bonds are issued and for meeting short-term government expenditure, treasury bills are issued.
🔷The small savings represent public borrowings, which are not negotiable and are not bought and sold in the market. In India, various types of schemes are introduced for mobilising small savings e.g., National Savings Certificates, National Development Certificates, etc.
🔷Borrowing from the public through the sale of bonds and securities curtails the aggregate demand in the economy.
🔷Repayment of debt by governments increase the availability of money in the economy and increase aggregate demand.
Q6) define budget as an instrument of fiscal policy?
🔷Government’s budget is widely used as a policy tool to stimulate or contract aggregate demand as required.
🔷The budget is simply a statement of revenues earned from taxes and other sources and expenditures made in a year.
🔷The net effect of a budget on aggregate demand depends on the government’s budget balance.
🔷A government’s budget can either be balanced, surplus or deficit.
🔷A balanced budget results when expenditures in a year equal its revenues for that year. Such a budget will have no net effect on aggregate demand since the leakages from the system in the form of taxes collected are equal to the injection in the form of expenditures made.
🔷A budget surplus that occurs when the government collects more than what it spends, though sounds like a highly attractive one, has in fact a negative net effect on aggregate demand since leakages exceed injections.
🔷A budget deficit wherein the government expenditure in a year is greater than the tax revenue it collects has a positive net effect on aggregate demand since total injections exceed leakages from the government sector.
🔷While a budget surplus reduces national debt, a budget deficit will add to the national debt.
🔷A nation’s debt is the difference between its total past deficits and its total past surpluses. If a government has borrowed money over the years to finance its deficits and has not paid it back through accumulated surplus, then it is said to be in debt.
Q7) what is the types of fiscal policy?
EXPANSIONARY FISCAL POLICY :
🔷Expansionary fiscal policy is designed to stimulate the economy during the contractionary phase of a business cycle or when there is an anticipation of a business cycle contraction.
🔷This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in all types of government spending and / or a decrease in taxes.
CONTRACTIONARY FISCAL POLICY:
🔷Contractionary fiscal policy is basically the opposite of expansionary fiscal policy.
🔷Contractionary fiscal policy is designed to restrain the levels of economic activity of the economy during an inflationary phase or when there is anticipation of a business-cycle expansion which is likely to induce inflation.
🔷This is carried out by decreasing the aggregate expenditures and aggregate demand through a decrease in all types of government spending and/ or an increase in taxes.
🔷Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a larger budget surplus.
Q8) how can contractionary fiscal policy be achieved ? Or Define the contractionary fiscal policy . what measures under this policy are to be adopted to eliminate the inflationary gap ?
Contractionary fiscal policy refers to the deliberate policy of government applied to curtail aggregate demand and consequently the level of economic activity. In other words, it is fiscal policy aimed at eliminating an inflationary gap. This can be achieved either by:
i) DECREASE IN GOVERNMENT SPENDING : with decrease in government spending, the total amount of money available in the economy is reduced which in turn trim down the aggregate demand.
ii) INCREASE IN PERSONAL INCOME TAXES AND / OR BUSINESS TAXES: an increase in personal income taxes reduce disposable incomes leading to fall in consumption spending and aggregate demand. An increase in taxes on business profits reduces the surplus available to businesses, and as a result, firms investments shrink causing aggregate demand to fall. Increased taxes also dampen the prospects of profits of potential entrants who will respond by holding back fresh investments.
iii) A combination of decrease in government spending and increase in personal income taxes and/or business taxes .
Q9) write a short note on fiscal policy for reduction in inequalities of income and wealth ?
Or examine what type of fiscal policy measures are useful for redistribution of income in an economy ? Or fiscal policy plays a significant role in reducing inequality and achieving equity and social justice . Do you agree? Substantiate your answer with example .
🔷 fiscal policy is a chief instrument available to governments to influence income distribution and plays a significant role in reducing inequality and achieving equity and social justice.
🔷few such measures to achieve desired distributional effects:
i) A progressive direct tax system ensures that those who have greater ability to pay contribute more towards providing the expenses of govt and the tax burden is distributed fairly among the population.
ii) Indirect taxes can be differential: for example, the commodities which are primarily consumed by the richer income group, such as luxuries, are taxed heavily and the commodities consumed by lower income group are taxed light.
iii) A carefully planned policy of public expenditure helps in redistributing income from the rich to the poorer sections of the society. This is done through spending programmes targeted on welfare measures for the disadvantaged such as ,
a) poverty alleviation programmes.
b) free or subsidized medical care, education, housing, essential commodities etc. to improve the quality of living of poor.
(c) infrastructure provision on a selective basis.
(d) various social security schemes under which people are entitled to old-age pensions, unemployment relief, sickness allowance etc.
(e) subsidized production of products of mass consumption.
(f) public production and/or grant of subsidies to ensure sufficient supply of essential goods, and
(g) strengthening of human capital for enhancing employability etc.
Q10) write a short note on limitations of fiscal policy?
1) it gives rise to different types of legs which are :
a) RECOGNITION LAG : The economy is a complex phenomenon and the state of the macro economic variables is usually not easily understood . Just as in the case of any other policy, the government must first recognize the need for a policy change.
b) DECISION LAG : Once the need for intervention is recognized, the government has to evaluate the possible alternative policies. Delays are likely to occur to decide on the most appropriate policy.
c) Implementation lag: even when appropriate policy measures are decided on, there are possible delays in bringing in legislation and implementing policy are not them.
d) IMPACT LAG : impact lag occurs when the outcomes of a policy are not visible for some time.
2. Fiscal policy changes may at times be badly timed due to the various lags so that it is highly possible that an expansionary policy is initiated when economy is already on a path of recovery and vice versa.
3. There are difficulties in instantaneously changing government’ spending and taxation policies.
4. It is practically difficult to reduce government spending on various items such as defence and social security as well as on huge capital projects which are already midway.
5. Public works cannot be adjusted easily along with movements of the trade cycle because many huge projects such as highways and dams have long gestation period. Besides, some urgent public projects cannot be postponed for reasons of expenditure cut to correct fluctuations caused by business cycles.
6. Due to uncertainties, there are difficulties of forecasting when a period of inflation or deflation may set in and also promptly determining the accurate policy to be undertaken.
7. Supply-side economists are of the opinion that certain fiscal measures will cause disincentives. For example, increase in profits tax may adversely affect the incentives of firms to invest and an increase in social security benefits may adversely affect incentives to work and save.
8. Deficit financing increases the purchasing power of people. ( Inflation )
9. Increase is government borrowing creates perpetual burden on even future generations as debts have to be repaid. External debt burden has been a constant problem for India and many developing countries.
10. If governments compete with the private sector to borrow money for spending, it is likely that interest rates will go up, and firms’ willingness to invest may be reduced. Individuals too may be reluctant to borrow and spend and the desired increase in aggregate demand may not be realized. This phenomenon is known as crowding out .
Q11) write a short note on crowding out ? Or describe the meaning and mechanism of crowding out effect of public expenditure ?
🔷Crowding out effect is the negative effect fiscal policy which may generate when money from the private sector is crowded out to the public sector.
🔷 In other words, when spending by government in an economy replaces private spending, the latter is said to be crowded out.
🔷For example, if government provides free computers to students, the demand from students for computers may not be forthcoming . It will crowd out private players also .
🔷 It also raise interest rate in economy :
a) When government increases its spending by borrowing from the loanable funds from market, the demand for loans increases and this pushes the interest rates up .
b) Similarly, when government increases the budget deficit by selling bonds or treasury bills, the amount of money with the private sector decreases and consequently interest rates will be pushed up.
🔷 Private investments are sensitive to interest rates and therefore some private investment spending is discouraged.
🔷Fiscal policy becomes ineffective as the decline in private spending or completely offset the expansion in demand resulting from an increase in government expenditure.
Q12) what are the automatic stabilizer (non discretionary fiscal policy) vs discretionary fiscal policy? Or What is non discretionary fiscal policy and how it occurs ?
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Q12) write a short note on pump priming and compensatory spending?
🔷 a distinction is made between the two concepts of public spending during depression , namely, the concept of pump priming and the concept of compensatory spending.
🔷 Pump priming assume that when private spending becomes deficient, certain volumes of public spending will help to revive the economy.
🔷 Compensatory spending is said to be resorted to when the government spending is carried out with the obvious intention to compensate for the deficiency in private investment.
