Understanding Fiscal Policy

Should there be government intervention in the economy? This is perhaps the most debatable and controversial topic in the whole of economics. In the 19th century and early 20th century, the prevailing theory of economics was the classical laissez-faire approach. Economists believed that there should be minimal or no government interference in times of recession and expansion. In the long run, the market will correct itself. Government intervention will only lead to inflation (Fall of purchasing value of money; 1000 Rs fifty years ago was worth more than 1000 Rs now) and debt* (explained later in the article). But in the 1930s, after the Great Depression (A depression is a severe recession), this theory was abandoned and was replaced by Keynesian economics, named after the economist John Keynes. He opposed the classical theories by saying, “In the long run, we are all dead.” He encouraged government intervention by introducing the ideas of Fiscal and Monetary policy.

Fiscal policy aims at regulating the economy by controlling tax rates and government spending, thereby controlling inflation and unemployment, mitigating consumer losses, and ensuring economic stability. In India, the central government makes fiscal policy.

The three main types of fiscal policies are:

Expansionary fiscal policy:

Suppose the economy is in a recession, people (aka consumers) are reluctant to spend, and the unemployment rate is high. In such a situation the government introduces the expansionary fiscal policy to revive the economy. The way it does it is by cutting personal tax rates, thereby increasing disposable income. It also encourages investing on the producer side by reducing business taxes, thus increasing the company’s profit. Low taxes means excess money with the population, encouraging them to start spending more. The other way is to increase government spending. It might announce plans for creating roads, bridges, etc. Thereby creating jobs and reducing unemployment and, in turn, again, increasing consumer spending. Or it might give additional grants to the state government to increase cash circulation in the economy. Usually, A combination of both these methods is used. But this cannot go on unchecked. Eventually, inflation rates would rise, and a contractionary policy must be introduced.

Contractionary fiscal policy:

When the economy is doing better than its potential, consumer spending is higher than usual, and the Unemployment rate is below average. This needs to be brought under control. Why? If people start spending more than that is produced (i.e., Demand is higher than supply), it will lead to higher inflation. Supply is limited. Everybody wants to buy. The one offering the highest price will get the goods, and so a competition starts results in high prices. This can be brought under control by contractionary fiscal policy. This is just the opposite of expansionary fiscal policy. Taxes are raised, government spending is decreased-which results in lower consumer spending and driving down inflation rates, but increasing unemployment.

Neutral fiscal policy

When the economy is performing moderately, and the government wants to maintain it. Taxes and government spending are neither too high nor too low, close to the historical average. A question that could be asked is, why is there a need to increase consumer spending. Can’t the government themselves spend and make up for the lower spending But from where’s the money going to come? It can’t raise taxes, that would defeat the purpose. It needs to borrow money, resulting in debt. When the government spends more than it earns, it’s known as a deficit. A prolonged accumulation of deficits is called debt. The debt to GDP ratio is often used as a reliable metric to measure a country’s ability to pay back its debts. A lower Debt to GDP ratio indicates that the country is more likely to pay back, increasing investor confidence. (Japan and the United States are notable exceptions, having a Debt to GDP ratio of 2.36 and 1.07 respectively) Similarly, when the government spends less than it makes, it is known as surplus. The contractionary fiscal policy creates a surplus, which in the long run, increases private debt and results in a slower growth rate, sometimes shrinking the economy.

— Avichal Agrawal (Co-founder editor)

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