Economic Stabilization: Fiscal Policy Goals of Macroeconomic Policy Stabilizing the economy at a higher level of employment and national output is not the only goal of macroeconomic policy. Ensuring price stability is its another goal. Both inflation and deflation have bad economic consequences. It is therefore desirable to achieve price stability. Similarly, every nation wants to raise the level of living of its people which can be attained through bringing about economic growth. , Macroeconomic policies can play a useful role in raising the rate of saving and investment and therefore ensure rapid economic growth. Thus, three important goals or objectives of macroeconomic policy (both fiscal and monetary) are as follows: 1. Economic Stability at a high level of output and employment. 2. Price Stability 3. Economic Growth Discretionary Fiscal Policy Fiscal policy is an important instrument to stabilize the economy, that is overcome recession and control inflation in the economy. Fiscal policy is of two kinds: Discretionary fiscal policy and Non-discretionary fiscal policy of automatic stabilisers. By discretionary fiscal policy we mean deliberate change in the Govt. expenditure and taxes to influence the level of national output and prices. Fiscal policy generally aims at managing aggregate demand for goods and services. On the other hand, non-discretionary fiscal policy of automatic stabilizers is a built-in tax or expenditure mechanism that automatically increases aggregate demand when recession occurs and reduces aggregate demand when there is inflation in the economy without any special deliberate actions on the part of the Government. In this section we shall confine ourselves to the discussion of discretionary fiscal policy. At the time of recession, the Govt increases its expenditures or cut downs taxes or adopts a combination of both. On the other hand, to control inflation the Govt cuts down its expenditures or raises taxes. In other words, to cure recession expansionary fiscal policy and to control inflation contractionary fiscal policy is adopted. It is worth mentioning that fiscal policy aims at changing aggregate demand by suitable changes in Govt spending and taxes. Thus fiscal policy is mainly a policy of demand management. Fiscal Policy to Cure Recession As we know, the recession in an economy occurs when aggregate demand decreases due to a fall in private investment. Private investment may fall when businessmen become highly pessimistic about making profits in future. As a result of fall in private investment expenditure, aggregate demand curve shifts down creating a deflationary or recessionary gap. It is the task of fiscal policy to close this gap by increasing Govt expenditure, or reducing taxes. Thus there are two fiscal methods to get the economy out of recession. (a) Increase in Government expenditure (b) Reduction of Taxes (A) Increase In Government Expenditure To Cure Recession For a discretionary fiscal policy to cure recession, the increase in Govt expenditure is an important tool. Government may increase expenditure by starting public works, such as building roads, dams, ports, irrigation works, electrification of new areas etc. For undertaking all these public works, Govt buys various types of goods and materials and employs workers. The effect of this increase in expenditure is both direct and indirect. The direct effect is the increase in incomes of those who sell materials and supply labour for these projects. The output of these public works also goes up together with the increase in incomes. The indirect effect of these expenditures is that those who get more incomes spend them further on consumer goods depending on their marginal propensity to consume. As during the period of recession there exists excess capacity in the consumer goods industries, the increase in demand for them brings about expansion in their output which further generates employment and incomes for the unemployed workers and so the new incomes are spent and re-spent further. It may also be further noted that increase in Govt expenditure without raising taxes (and therefore the policy of deficit budgeting) will fully succeed in curing recession if rate interest remains unchanged. With the increase in Govt expenditures and resultant increase in output and employment demand for money for transaction purposes is likely to increase and the money demand curve will shift to the right. Money supply remaining constant, with increase in demand for money rate of interest is likely to rise which will adversely affect the private investment. The decline in private investment will tend to offset the expansionary effect of rise in Govt expenditure. Therefore, if fiscal policy of increase in Govt expenditure (or of deficit budgeting) is to succeed in overcoming recession, the central bank of the country should also pursue expansionary monetary policy and take steps to increase the money supply so that increase in Government spending does not lead to the rise in rate of interest. If supply of money is increased, the rate of interest does not rise despite the increase in demand for money. With rate of interest remaining unchanged, private investment will not be adversely affected and increase in Govt expenditure will have full effect on raising national income and employment. Financing Increase in Government Expenditures and Budget Deficit An important question is how to finance the increase in Government expenditure which is undertaken to cure recession. This increase in Govt expenditure must not be financed by raising taxes because raising taxes because rise in taxes would reduce disposable incomes and consumers’ demand for goods. As a matter of fact, rise in taxes would offset the expansionary effect of rise in Government spending. Therefore, proper discretionary fiscal policy at times of recession is to have the budget deficit of expansionary effect is to be realized. Borrowing A way to finance budget deficit is to borrow from the public by selling interest bearing bonds to them. However, there is a problem in adopting borrowing as a method of financing budget deficit. When the Government borrows from the public in the money market, it will be competing with the businessmen who also borrow for private investment. The Government borrowing will raise the demand for loanable funds which will drive up the interest rate. Creation of New Money The more effective way of financing budget deficit is the creation of new money. By creating new money to finance the deficit, the crowding out of private investment can be avoided and full expansionary of rise in Government expenditure can be realized. (b) Reduction In Taxes To Overcome Recession Alternative fiscal policy measure to overcome recession and to achieve expansion in output and employment is reduction of taxes. The reduction of taxes increases the disposable income of the society and causes the increase in consumption spending by the people. If along with the reduction in taxes, the Government expenditure is kept unchanged, aggregate demand curve C+I+G will shift upward due to rise in consumption. This will have an expansionary effect and the economy will be lifted out of recession and national income and employment will increase. Fiscal Policy to Control Inflation: When due to large increases in consumption demand by the households or investment expenditure by the businessmen, or bugger budget deficit caused by too large an increase in Government expenditure, aggregate expenditure increases beyond what the economy can potentially produce by fully employing its given resources, it gives rise to the situation of excess demand which results in inflationary pressures in the economy. This inflationary situation can also arise if there is a large increase in the money supply in the economy. In these circumstances, inflationary gap occurs which tends to bring about rise in prices. If successful steps to check the emergence of excess demand or close the inflationary gap are not taken, the economy will experience inflation. Thus, fiscal policy measures to control inflation are: 1) Reducing Government Expenditure 2) Increasing Taxes Reducing Government Expenditures If there is a balanced budget to start with and Government reduces its expenditure, say on subsidies, transfer payments, while keeping taxes constant, this will create budget surplus and will result in removing excess demand in the economy. It is important to note that in the developing countries like Pakistan, the main factor responsible for inflationary pressures is heavy budget deficit of the Government for the last several years resulting in excess aggregate demand. Raising taxes to Control Inflation: As an alternative to reduction in Government expenditure, the taxes can be increased to reduce aggregate demand. For this purpose, especially personal direct taxes such as income tax, wealth tax, corporate taxes can be raised. The hike in taxes reduces the disposable incomes of the people and thereby force them to reduce their consumption demand. Non-Discretionary Fiscal Policy: Automatic Stabilizers In this non-discretionary fiscal policy, the tax structure and expenditure pattern are so designed that taxes and Government spending vary automatically in appropriate direction with the changes in national income. That is, these taxes and expenditure pattern without any special deliberate action by the Government automatically raise aggregate demand in times of recession and reduce aggregate demand in times of inflation which help in ensuring economic stability. These fiscal measures are therefore called automatic stabilizers or built-in stabilizers. Built-in stability of tax revenue and Government expenditure of transfer payments and subsidies is created because they vary with national income. Lets discuss some of these below: Personal Income Taxes: The tax structure is so designed that revenue from these taxes directly varies with income. Moreover, personal income taxes have progressive rates; the higher rates are charged from the upper income brackets. As a result, when national income increases during expansion and inflation, increasing percentage of the people’s income are paid to the Government. Thus, through causing a decline in their disposable income these taxes automatically reduce people’s consumption and therefore aggregate demand. Corporate Income Taxes: Companies or corporations as they are called now, also pay a percentage of their profits as tax to the Government. Like personal income taxes, corporate income tax rate is also generally higher at higher levels of corporate profits. As recession and inflation affect corporate taxes greatly, they have a powerful stabilizing effect on aggregate demand; the revenue from them rises greatly during inflation and boom which tends to reduce aggregate demand and revenue from them falls greatly during recession which tends to offset the decline in aggregate demand.
