Fiscal policy is an important macroeconomic tool that is used by the government to influence the economic acitivity. This policy operates through changes in government expenditures and revenues. This policy has its initial impact on the goods market. If we revisit the national income account identity we have a component there called as government spending (G). Government conducts fiscal policy by changing government spending and tax rates (source of revenue for government).
When the consumer confidence is low i.e. people are not willing to spend, the demand for goods and services declines. In such a situation firms see a lot of inventory pile up. They are forced to cut down production, reduce employment and may be at times go for partial shut downs. Due to high attritions and wage cuts purchasing power in the hands of the consumers decreases. This adds to the problem leading to shrinking of the size of the economy and hence the GDP growth rate also comes down. The wheel of economic activity freezes as there is no fresh demand creation and no further expansion.
In such a scenario the role of fiscal policy becomes important. The government in such cases can step up its spending on public works or infrastructure projects (core sector which has the potential of generating employment in the economy). The basic idea is to stimulate demand by providing purchasing power to the consumer. Another way of conducting the fiscal policy is by changing tax rates. The latest budget saw the government deciding to raise the minimum taxable income limit. This will lead to an increase in the disposable income (income less taxes) in the hands of the consumers which is expected to be spent on consumption of goods and services.
The fiscal stimulus works through its primary and secondary effects. Say for instance, government initiates a construction project (say the airport construction, long term in nature i.e. at least a year long) in the city of Hyderabad. The immediate effect of such a move will be employment generation i.e. in the form of recruitment of workers, engineers etc. Also, demand for raw-material like steel, cement etc. will be generated, thus benefiting the allied sectors as well. When wages will be paid out to the workers, they will get purchasing power in their hands which will be spent on consumption of goods and services (s.a. clothes, fmcg, food, automobiles, etc.). The amount of income that will be spent is cY i.e. marginal propensity to consume times the income (marginal propensity to consume, MPC, can be defined as increase in consumption per unit increase in income, say for instance out of every Re 1 increase in income an individual spends Rs. 0.80, then his/her MPC is 0.8). Hence, consumption demand will be stimulated which in turn will stimulate the economic activity in other sectors as well (i.e. consumer durables and non-durables). These are the secondary effects of government expenditure increase (expansionary fiscal policy). Thus, the wheel of econimc activity is again set in motion. The phenomenon of multiplier works here i.e. the result of Rs. 1 million increase in G is more than that i.e. 1/1-c times where c is the marginal propensity to consume. So, if we assume c as 0.8 then multiplier is 5 and the impact of G will be 5 x Rs. 1 million.
Another dormant tool of fiscal policy is transfer payments given by the government in the shape of social security allowances and grants etc, Government can also use taxation and transfers to very well encourage or discourage few sectors and industries, control imports and exports activity etc.
One drawback of fiscal policy is crowding out of private investment i.e. a decline in private investment due to rise in interest rates resulting from increase in government expenditure. An increase in G leads to increases in income and rate of interest. Since rate of interest is the cost of investment, there is a decline in investment. The problem is aggravated if government borrows excessively to finance its fiscal expansion. This process can be understood better with the help of IS-LM framework.
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In case government is investing more it has 2 options
ReplyDelete1)To get money for investment from public(in form of tax)or
2) Borrow from financial markets withing or outside the country
In first case the disposable income of individuals will decrease which may lead to less consumption so isn't like u decrease consumption somewhere to increase consumption somewhere else and the sum of consumption maybe near to present consumption or little more than that.while in second case the debt will increase which will also create problems i guess(i am not clear about second case but what i think is in second case the short term problems may be solved i.e:government can stir consumption in short term but when in long term when it has to repay the investment it has to generate money from public again which will reduce consumption in long term)
I have not considered here printing of currency coz i think its not so easy
Here we also need to see whether crowding out is likely to occur.There are 3 situations:
ReplyDelete1)When economy is operating below the full employement level, and fiscal expansion increases demand then firms can also increase the level of output by hiring more workers.So crowding out is a more realistic possibility when economies at full employement level as then firms cannot increase outputand so increase in demand leads to increase in price.
2)In an economy with unemployed resources there wont be full crowding out as LM curve is not vertical.A fiscal expansion will increase interest rates but even income will rise and so would savings.So the govt spending could be financed through this increased saving without crowding out investment competely.
3)Govt can print more money or monetise the budget deficits so that there is no increase in interest rates and hence no crowding out.
Investment is not a function of interest rate only. Its a function of Income level too. We cannot merely say that a rise in interest rates will lead to decline in investments, where income is rising too simultaneously. Of course when the income level is constant, a rise in interest rate will lead to reduced investments; which is contrary to the outcome of fiscal policy. When there is a change in income levels(increase or decrease), Investment and the interest rate move in the same direction over the business cycle, falling during periods of recession. The above fact can be well illustrated by plotting the investment levels against the interest rates, which give us the invest function curves at different income levels.
ReplyDeleteObviously if there is an increase in income without an increase in the interest rates, the investments would be twice as compared to a situation where both the interest rates and income rise.
With respect to Nilesh’s response, I would like to add that, If the government is willing to invest in development activities and it has to turn to the public, Instead of levying higher taxes they can adopt the public debt policy.( Because higher taxes will have an immediate impact on the disposable income inturn affecting private consumption.)Adopting the public debt policy the government will be able to control the non essential private consumption and raise funds for financing the development expenditure. The government for this purpose can issue debentures, bonds etc. with attractive rates to encourage people to purchase these titles. This would ensure that the public savings are channelized effectively whilst improving employment opportunities.
ReplyDeleteWe might have another concern here that channelizing individual savings to invest in Government debt policies may curb immediate consumption too, However we need to consider the fact that, as Government increases investing in development activities, The cycle begins again, with employment opportunity leading to payment of wages and therefore higher disposable income which inturn increases consumption. This can be a workaround to avoid the tax burden to the public and keep the productivity higher.
To search out the reason, I read the article multiple times, but I failed. I am not getting the rationale behind : Fiscal stimulus increases MPC during the economy down turn. Since everyone is skeptic about their future income, and suddenly gets stimulus from government; does it really provoke people to spend, instead of save for future ?
ReplyDeleteIf so is the case, then saving must increase in the banks in the days of recession, and by hence naturally interest rates will go down, due to drastic reduction in demand and sudden rise in supply of money. Thus, banks will get cash rich and low interest rates should have encouraged investors to look beyond the recession and could build up future progression. But non of the above happened, I mean neither interest rates came down naturally (RBI reduced it) nor companies initiated for future expansion.
On the other hand, of course fiscal stimulus will pour money into the hands of the consumers to encourage consumption, but will consumption rise till the level government anticipated it? And what is the measure for the results of fiscal stimulus, thus injected, to gauge growth indices? Is it GDP (as it will rise as consumption will increase, and government spending will remain almost intact) ?
So, what exactly are the grounds for the fiscal stimulus introduction? Or am I wrong somewhere in deriving the justification?
In continuation to my earlier argument (sorry for inconveniency):
ReplyDeleteIf Government wants to pump in stimulus package, it will have to borrow money (either from domestic market, or from foreign market, or from foreign investment institutions, or from WB/IMF). But end of the day, it’s WE who will have to pay the interest in future – means government is transferring the burden of today’s borrowing on tomorrow’s income (assuming revived economy will be healthier enough to do so). Paul Krugman justified the same logic in his article of 1st Nov. (http://www.nytimes.com/2009/11/02/opinion/02krugman.html?_r=1).
If so is the case that means stimulus in a few sectors will steer the whole economy from recession to revitalization. But by then government will also be focusing upon its growth goals, over and above from repaying the debt (the time when the interest rates will be higher).
So, again I have the same dilemma. What exactly are the grounds for the fiscal stimulus introduction? Or am I wrong somewhere in deriving the justification?
In reference to Ashwini’s argument:
ReplyDeleteGovernment can raise debt from the public, but one more issue knocked me, what I read some 2 weeks back (in ET). It was quoted as, “Here, in order to improve upon the fiscal deficit (11.8% of GDP – originally 6.2% as disclosed by Government) it was recommended to raise debt ratio of “External Public Debt to India’s Total Public Debt” from 10.2% (10 years’ average) to comparable with that of other emerging markets, i.e. 60%.”
Here what I inferred in due course is; since in the time of recession currency get depreciated results in more money infusion, and in later stage (when economy will get healthier) currency appreciation may help in debt repayment. But I am not sure about my inference.
My both the doubts are different, and subjective, what I believe. But I am not sure about the answer !!!
regarding ashiwini's cooment...
ReplyDeletestimulation government expentidure through public debts ie.through issue of bonds have implications of monetary policy since it effects the money supply.if they issue bonds to the general public then the money supply would fall..that i guess mam would explain us in the coming classes.
i feel that the budgeting of a new project would come from borrowing only.
As stated in the article that Govt.expenditure on infrastructure development can save the economy.But when the govt. expenditure is increased beyond a certain limit, it can lead to higher money supply in the economy, leading to inflation & higher supply of credit.This may eventually lead to weaker rupee &stronger dollar.
ReplyDeleteHence Budget allocation is an important tool to balance the economy .Extensive spending by the govt. can hamper the economy of the country.
Also, Change in Fiscal policy can be used by govt. in recession time to control the falling economy.
In bad times government is left with any other choice but to infuse a stimulus package into the economy. that is essentially in form of increase government spending and lowering of interest rates(both income tax rates and lending rates). the whole idea is to provide people with easy credit and increase in disposable income. increased government spending would bring about creation of more jobs. this slowly would have a feel good factor which would lead to increased consumer spending which would start of chain reaction in form of a multiplier effect. government has no choice but to do it else the economy would go into a free fall.but the thing is this works in the short run. in the long run inflation starts to rise. this is so because with high spending the cost of goods tends to rise. so its very important that the stimulus is withdrawn at the apt moment to suck the money out of the system in the form of raising the income tax rates and lending rates. this not only would lead to control of the inflation but also lead to increased government savings, which in turn could be used for partly paying of the debts(domestic or international). with a good forex reserve and also being the 9th largest gold reserves presently india can afford to go abt this policy without worrying too much abt the rising debt.(plz correct me if am wrong)
ReplyDeleteI was also struck with the same doubt which Tapan has raised. I think that during the time of crisis, government not only stimulates the economic activity but also make sure that returns on spending today is bigger than that of saving for tomorrow. Recession periods are often seen with the trends of low interest rates. Moreover, people who were deprived of any funds for a long time gets an alacrity to spend it to meet the wants which could not be fulfilled for a huge hiatus of recession. These are the reason that why people prefer to spend more instead of saving. Of course, the bear segment of the population who are too pessimist and skeptical of the future, still choose to rather save today.
ReplyDeleteAbhishek Sinha.
With reference to ashiwini’s post:
ReplyDeleteI actually dint understand the public debt policy part. If presently the economy is not doing well, this implies that the individual disposal income is less and low PPP is observed, to boost up the activities the government initiates spending(implementing the fiscal policy)… so how can the government go for public debt by issuings bond and securities when there is already less savings existing? Doesn’t it say that consumers have little ability to part with the resources?
Can someone please explain?
bharti
@Bharti I was just giving a workaround to the dilemma posed by Nilesh regarding the balancing effect of taxes and consumption. He mentioned that raising funds for investment by levying taxes would result in lower disposable income for the individuals,in turn it would curb consumption.
ReplyDeleteAnd even in bad times, if the government has to initiate development activities by investing in infrastructure growth, it needs funds which cannot be raised through taxes because it takes a long duration(time lag) to get enforced.Just to support my argument i would like to mention that in the current year 2009, India has reported that the government succeded in generating a revenue of 6279.49 billion as gross
Tax collection whereas the proposed budget expenditure is 9532.31 billion.
In such a scenario the only option would be to raise funds from the public by adopting the public debt policy. And like you mentioned, A bad economimc scenario need not necessarily mean that individual wealth would have declined. And in times of crisis you first try and borrow internally rather than going for external borrowings.
Thanks ashwini..
ReplyDeleteand the other day i got it clarified from mam as well.It is generally the banks who are forced to buy the bonds and others instruments and not the individuals.
Dear Tapan
ReplyDeleteThe fiscal stimulus does not really increase MPC. It increases the purchasing power by providing income to people (when people lose jobs, they don't have income to spend, therfore whatever be the MPC for the economy, when there is no purchasing power in the hands of people they will not be able to spend and the multiplier will not work.) So that means if Tapan has a MPC off 0.8 and TCS increases his salary from Rs. 50,000 tp Rs. 60,000, then he will spend 0.8 x Rs. 10,000 = Rs. 8000 more (Total of Rs. 48,000). While earlier with Rs. 50,000 he was spending only Rs. 50,000 x 0.8 = Rs. 40,000. Now when this aditional Rs. 8000 goes into circulation it will further add to the income generation in the economy. I hope you are clearer on the dobt! If not then do write back.
Adding to what I said earlier, Tapan
ReplyDeleteIt is not always necessary that increase in public savings is an indicator of decline in consumption. In times of recession the confidence of lenders as well as investors is low. As a result of which they are reluctant to lend or invest. Therefore, even when people have surplus funds there is no excess supply. Due to decline in investments, the rates of interest do go down which is what we saw in the shape of RBI reducing them (that is how it is supposed to be). It is not a free market when we talk about banking in India. There are regulatons laid down by RBI.
Companies will not initiate future expansion as they don’t see demand for their products or the consumer confidence is low.
Now when Tapan spends his extra Rs. 8000 on say some consumer durable (a television), then the demand for T.V. increases by 1 set. Similarly, many others will spend on different things and the producers would feel that the demand has revived. They will increase production and thus, the frozen wheel of economic activity will be set in motion. Tapan can also save the whole amount or part of it. Everybody will not do what Tapan does and therefore, some hope would exist for the economic activity to revive.
Once the stimulus is given, the economists would look forward to quarterly GDP numbers which should reflect a growth rate equivalent to that expected to be generated by fiscal stimulus. Savings are leakages which certainly affect the numbers.
Thank you Kirti for the reply.
ReplyDeleteI got the point you put forward. One half is clear.
But here what I wanted to point out was: If income rises, MPC raises! Agree. However, at a same time saving should also go up (what I believe, since I spent 8,000 more but the remaining 2,000 will go to my savings – what earlier was 10,000 – 20% increase in saving, though my MPC increased). If so is the case, then what I wrote earlier should be true, I suppose; “banks will get cash rich and low interest rates should have encouraged investors to look beyond the recession and could build up future progression. But none of the above happened, I mean neither interest rates came down naturally (RBI reduced it) nor companies initiated for future expansion.”
And here we considered MPC=0.8, what may be more or less then this; but for sure the digit will affect savings; and hence should have some impact on the money circulation, and so on the interest rates (in the time of recession, when liquidity is an issue).
Tapan,
ReplyDeleteAll through this analysis the MPC is constant at 0.8. It is just that the additional Rs. 10,000 which u got, 80% 0f it is being spent and 20% saved. MPC is not changing here.
Regarding interest rates, I mentioned that the central bank regulates them so when RBI lowered it that was because due to high cost of credit the economic activity could be hindered. Moreover, when the businesses are not willing to undertake investment activity, due to lowered demand they will not plan any expansion or progression.
Lets understand it like this... Tapan wants to buy a house. Interest rates are very low, say all time low, but at the same time the confidence is so low that he is not sure whether he will be able to retain his job or not. Will he buy a house worth some Rs. 10-15 lakhs? Not just the rate of interest the very repayment of principle will be a problem for him. Should he buy the house? Also, whats your idea of interest rates coming down naturally? (remember its not a free market)
Regarding future progression, we did see some Indian MNCs go for M&As in international market that were available at relatively lower prices than those during good times.
I agree that the savings amount affects the money in circulation and hence credit creation. If only the amount saved is going to bank deposits which too offer low rates of interest in such times. It may all go to gold..... It is only call market rates or some private lending rates that can rise in such a case not the regulated rates of banks.
Nilesh,
ReplyDeleteYou are right to a large extent. If we do not consider printing of money then the government can raise finances to pay back the debt by increasing taxes or by what we are seeing now i.e. disinvestment of PSUs (A short-term relief measure).
To an extent you are right in saying that it will be like today's growth boosted at the cost of tomorrow's growth. It will also depend on the extent by which the economic variables will change. If at all the per capita GDP/income rises at a fast pace then to collect the same amount through taxes the government may have to levy lower tax rates. This is one example, rest I leave up to you to think n write back....
Dear Ashwini,
ReplyDeleteWhen government will raise funds from public it will have monetary policy implications, the money that it can capture will be speculative in nature (there are three types of demands for money - transactionary, speculative and precautionary). Moreover, in a time of recession spending is required (in the long run we can think of ceasing conspicuous consmption). What do you think?
I absolutely agree with Kirti's contention regarding borrowing but I do not buy Ashwini's contention that a govt should go for internal borrowing and not for external sources. Ashwini's contention is that in times of crisis the govt should go for internal funding and not external funding but I feel the reverse is true for a normal economy. First it all depends on the country in question, the economic policies of the country and the stage of economic development. A country like Argentina, Latin America may find it very difficult to resort to external debt except Emergency funding which these countries have resorted to frequently. Argentina has also gone on to the extremes of defaulting on public debt. During recessinary periods a Govt should always go for external borrowing as internal borrowing would impose pressures on an already constrained economy. If the govt borrows internally the consumption would go down and it would also affect the sentiments of the consumer specially during recessionary conditions. During normal circumstances it may not affect the ppl but it would hurt them specially during recession and would also send a wrong signal about the financial viability of the economy and may also lead to loss of trust in the govt and thereby affect the entire monetary system. The paper currency system as we all know is based on trust on the ability of the govt to pay the amount when asked to. Loss of trust on th egovt could lead to dire circumstances and may see ppl converting cash to gold or other tangible assets thereby seriously impacting the economy. Thus it is always safe to resort to external borrowing. And a country like the US which has no difficulties in borrowing should not even consider external borrowing as an option.(The point specifically to be considerd is that the buyers of the govt bonds are commercial banks and not necessarily the general public.(Ever seen anyone public holding bongs on the govt. I've seen none) Thereby these banks have to buy the bonds in large quantities thereby sucking away the liquidity from the financial system.)
ReplyDeleteDear Kirti, I agree with you on the fact that in times of recession it is more important increase government spending to reap the benefits of the multiplier effect and ramp up the economy. But instead of taxing the public raising public debt would be an alternative source of funding the expenditure. However I do understand that it has monetory implications.Thanks for replying :)
ReplyDelete