UNIT 6

Fiscal and Monetary

Policy
 BUSINESS CYCLE

❖It is the fluctuations in economic activities-these fluctuations are characterized by

alternating waves of expansion and contraction- Cyclical Fluctuations

❖These ups and downs in the economic activity moving like a wave at regular intervals

is known as business cycle/ trade cycle

DEFINITION

Keynes defined “A trade cycle is composed of periods of good trade

characterized by rising prices and low unemployment percentages,
alternating with periods of bad trade characterized by falling prices
and high unemployment percentages.”

R. A. Gordon defined business cycle as consisting of “recurring

alteration of expansion and contraction in aggregate economic activity,
the alternating movements in each direction being self-reinforcing and
prevailing virtually all parts of the economy”.
 CHARACTERISTICS OF BUSINESS
CYCLE
➢ A business cycle is a wave-like movement. The period of prosperity and depression
can be alternately seen in a cycle.
➢ Cyclical fluctuations are recurring in nature. The various phases are repeated is
followed by depression and the depression again in followed by a boom
➢ Business cycles are cumulative and self-reinforcing in nature. Each movement
feeds on itself and keeps up the movement in the same direction. Each phase contain
in itself the seed for other phase.
➢ Business cycles are pervasive in their effects. The cyclical fluctuations affect each
and every part of the economy.
➢ The up and down movements are not symmetrical. The downward movements
are not symmetrical. The downward movement is more sudden and violent than
the upward movement. The upward movement is slower and wave has gentle
slopes.
➢ Trade cycles are ‘international’ in character in the sense that fluctuations in one
country get transmitted to other countries.

➢ Periodicity of a trade cycle is not uniform-(five to ten years). Every cycle

exhibits similarities in its nature and direction though no two cycles are exactly
the same. In the words of Samuelson: “No two business cycles are quite the
same. Yet they have much in common. Though not identical twins, they are
recognizable as belonging to the same family.”

➢ The recovery of consumer goods industries from recessionary tendencies is

generally quicker than that of investment goods industries
 There are four
phases

Prosperity,
Recession
Depression
Revival/recovery
Prosperity (Boom/Expansion)
✓ All round optimism in the economy—income, employment, output, and price level tend to
rise.

✓ Increased consumer confidence, high levels of business activities, the existing production
capacity is utilized at its full capacity.
✓ Expansion of credit

✓ The products fetch above normal price which is above higher profit, attract more
investors-Idle funds go to productive investment

✓ More and more new machines are made use and business of the capital goods industry also
shoots up.

✓ The price of the factors of production increases, additional workers are employed at higher
wage rate.
❑The increase in the prices of input leads to an increase in the prices of final

products, while the income of individuals remains constant.

❑As a result, the demand for products starts falling.

✓ Businessmen now come to learn that they have overstepped the limit.

✓ High optimism now gives birth to pessimism. This ultimately slows down the

economic expansion and paves the way for contraction.

❑ Peak phase refers to the phase in which the increase in growth rate of

business cycle achieves its maximum limit.

❑ In peak phase, the economic factors, such as production, profit, sales, and

employment, are higher, but do not increase further.

❑ In peak phase, there is a gradual decrease in the demand of various products

due to increase in the prices of input. (Scarcity)

RECESSION
• Fear and Panic
• This stage starts when prosperity ends
• A recession begins when the economy reaches a peak of activity and ends when the
economy reaches its trough or depression.
• A recession is a significant decline in economic activity spread across the
economy normally visible in production, employment, real income and other
indications.
• The supply now exceed demand-producers come to notice that their stock piling
up. They are compelled to give up the future investment plans.
• The order for new equipment and raw materials are cancelled.
• A business even cuts down its existing business.
• Bankers insist on repayment, stock accumulate and business failure increase
and unemployment leads to fall in income, expenditure, prices, profits and
industrial and trade activities
• Desire for liquidity increase all around producers are compelled to reduce price
so that they can find money to meet their obligations
• Consumers who expect a still further decline in prices postpone their
consumption
• Some firms are forced into bankruptcy.
• The failure of one firm affects other firm with whom it has business connections.
There is a general distress-Utmost suffering of business
DEPRESSION/CONTRACTION
❑ Level of economic activity is extremely low
❑ Underemployment of both men and material is the characteristics of this phase.
❑ General demand falls faster than production. Producers are compelled to sell their goods at a
price which will not even cover the full cost.
❑ Manufactures of both investment goods and consumer goods are forced to reduce the volume
of production. As a result workers are laid off. The remaining workers are poorly paid
▪ In this phase, it becomes difficult for debtors to pay off their debts. As a result, the rate of interest
decreases; therefore, banks do not prefer to lend money. Consequently, banks face the situation of
increase in their cash balances
▪ Prices of shares and securities fall down-investors do not invest in Stock market
❑ Pessimism prevails in the economy the less confident investors are not ready to take up new
investment projects. The aggregate economic activity is at its bottom
▪ During the trough phase, the economic activities of a country decline below the
normal level.
▪ In this phase, the growth rate of an economy becomes negative.
▪ Apart from this, the level of economic output of a country becomes low and
unemployment becomes high.
▪ In trough phase, many weak organizations leave industries or rather dissolve.
 RECOVERY (Pessimism leads to Optimism)
✓ Turning Point of Business cycle from Depression to Prosperity
✓ The workers now come forward to work at low wages.
✓ As the prices are at its lowest the consumers, who postponed their consumption expecting a still
further fall in price, now starts consuming.
✓ The banks, with accumulated cash reserves, now come forward to gives loans at easier terms and
lower rates.
✓ As demand increases the stock of goods become insufficient. The economic activity now starts
picking up. Investment pick up.
✓ Increased income increases demand, resulting in rise in prices, profits, investment.
✓ The wave of recovery once initiated soon begins to feed upon itself.
✓ Stock markets become live thus hastening the revival.
✓ Optimism develops among the entrepreneurs.
✓ Bank loans and demand for credit starts rising.
Fiscal Policy

❖ Refers to government policy in respect of public expenditure, taxation and Government

borrowing.

❖ It is the means by which the government adjusts its spending levels and tax rates to monitor and

influence a nation’s economy, especially macroeconomic conditions.

❖ Fiscal policy influences output, employment and income through taxation, government

spending and borrowing

❖ Fiscal policy is largely based on ideas from British economist John Maynard Keynes.

❖ It helps control inflation, address unemployment, and ensure the health of the currency in the

international market.
DEFNITION

Arthur Smithies defined fiscal policy as “a policy under which the Government uses its
expenditure and revenue programs to produce desirable effects and avoid undesirable
effects on the national income, production and employment”.

Fiscal policy is the government programme of making discretionary changes in the

pattern and level of its expenditure, taxation and borrowings in order to achieve
certain economic goals such as economic growth, employment, income equality and
stabilization of economy on a growth path
 TOOLS /INSTRUMENTS OF
FISCAL POLICY
TAXATION
▪ Includes Direct And Indirect Taxes
▪ Determines the extent of disposable income and lower corporate tax increase the profit and
promote further investment
▪ Direct And Indirect Taxes influence the aggregate demand
▪ During Inflation, to decrease the aggregate demand- taxes are charged from public(existing
tax rate are raised and new tax are imposed)
▪ Recession- tax rates are lowered to increase income and increase the aggregate demand
Public Expenditure
▪ Expenditure incurred by the Central or State Govt or local bodies for satisfying
common objectives
▪ Government’s expenditure towards consumption, investment and transfer
payment
▪ Public expenditure is instrumental in adjusting consumption and investment to
achieve full employment
▪ Includes capital expenditure, subsidy payments, transfer payments and social
security benefits
Government expenditure include:
1. Current expenditure
2. Capital expenditure
3. Transfer payments (aids,welfare Programs)
▪ During recession-new wave of public works-employment of labour and purchase
of multitude of goods and services –generate income to labour and suppliers of
material-income is spend on purchase of consumer goods-extent depends on
MPC
▪ Since increase in the demand leads to increase in the production
▪ Where to find the resources to increase expenditure? One source is tax or deficit
financing
▪ The public investment will increase the confidence of businessmen and
willingness to invest
▪ During inflation-to control aggregate demand less public expenditure is incurred by the
government
▪ Deflation- more public expenditure is incurred by the government to raise the
aggregate demand
 PUBLIC DEBT
▪ Borrowings of The Government
▪ To bridge the gap between income and expenditure of the Government
▪ Two types of debt: Internal and External debt
▪ Internal debt are those debts which are borrowed by the Government from people who are living
within the country
▪ External debt are Debt owed to foreign creditors, including other governments, international
organizations (e.g., IMF, World Bank), or foreign investors.
▪ During inflation-government borrows money from people in order to decrease the availability of
money and aggregate demand fall also price of goods will fall-Borrowing from public through sale of
securities and bonds reduces the aggregate demand
▪ Repayment of debt by government increase availability of money and increase the aggregate demand
DEFICIT FINANCING

▪ The process of covering a budget deficit (the gap between what the government spends and
what it earns through taxes and other sources) by borrowing money or printing new
currency or issuing treasury bills
▪ The government can borrow, print currency or sell public assets
▪ Risks
▪ Inflation: If a government resorts to printing money to cover deficits, it can cause inflation or
hyperinflation, eroding the value of money and decreasing purchasing power.
▪ Public Debt: Continuous deficit financing through borrowing increases public debt. High levels of
debt can be a burden on future generations and may lead to higher interest rates and reduced fiscal
flexibility.
▪ Dependence on Foreign Aid/Loans: Excessive reliance on external borrowing can make a country
vulnerable to exchange rate risks and foreign debt crises, especially if the borrowed funds are not
used productively.
 OBJECTIVES

1) Price Stability
❖ Tool to control Inflation and Deflation
❖ Inflation is rise in the general price level and fall in the value of money- Controlled by
imposing new taxes and increasing the existing tax rates, by reducing public expenditure and
increase public borrowings, encouraging voluntary saving and surplus budget
❖ Deflation is fall in the general price level and generate unemployment -Fall in existing taxes,
less public borrowing, more public expenditure and deficit financing
❖ Price stability is important to keep value of money stable, eliminate economic fluctuations
bring stability in economy, check arbitrary redistribution of income and wealth and promotes
economic welfare
2)Achieve Full employment
• Full employment refers to the situation where people willing to work at existing wage are able to work
• Maintaining full employment in developing countries and creation of more employment in under-
developed countries
• To achieve full employment, government will increase effective demand by raising public
expenditure and will reduce taxes so that level of investment can be increased

3)Reduce inequality in income and wealth

• Progressive taxation and targeted social welfare programs can help in redistribution of wealth and
decrease economic inequality.
• To increase economic welfare unless the benefits of economic development in a economy is shared by
all in the form of pension, health benefits, free education, subsidies etc
• Achieving social equality and economic justice cannot allow large inequalities in income and wealth
4)Exchange rate stability
• The international trade and balance of payment position is very much affected by exchange rate
stability
• Effective fiscal policy encourage foreign capital
• The balance of payment position is improved by providing subsidies, tax concessions and inflow of
foreign capital
• Improve public expenditure, investment increases, local production increases reduces reliance on
imports
• Increase tax on import which reduce import and stimulate exports

5) Achieving Economic growth

▪ Economic growth is increase in per capita income for long period of time
▪ Economic growth enables the economy to produce more goods and service and increase standard of
living
▪ Stimulate economic activity by adjusting government spending and tax
6)Achieving Economic Stability
• Economic spending is made in the stable level so that there is no fluctuation in the output and
employment
• Economic stability requires that cyclical fluctuation in economic activities are eliminated
• Economic downturn- Government spending increase, tax cut and increase demand
• Inflation- Reduce spending and increase tax

7) Built in Stabilizers
• Work automatically to counteract economic cycles
• Automatic changes in tax collections and transfer payments of public expenditure programmes
so as to produce stabilizing effect on aggregate demand
• Increase government spending and decrease tax- Economic downturn
• Economic policies and program automatically adjust to change in economic conditions
without government action
How Built-in Stabilizers Work
Example of Tax Collections:
Progressive Taxation: In a progressive tax system, individuals pay a higher percentage of
their income in taxes as they earn more. If the economy falters and incomes decline, tax
liabilities automatically decrease, leaving more disposable income for consumers. This
can help support spending during tough times.
• Relief in corporate and sales tax

Example of Transfer Payments:

Unemployment Insurance: During a recession, more people lose their jobs and qualify
for unemployment benefits. These payments provide essential financial support,
maintaining consumer spending and helping to stabilize demand in the economy.

Other Welfare programs

Programs such as food assistance, housing subsidies, and Medicaid.
AUTOMATIC STABILIZERS
• Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to
alter the economy (deliberate)
• Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy
(sometimes called automatic stabilizers)

Automatic stabilizers are automatic fiscal changes as the economy moves through
different stages of the business cycle – such as a fall in tax revenues from the circular
flow during a recession or an increase in state welfare benefits when the
unemployment rate is rising.

How Nondiscretionary Fiscal Policy Works

Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or
contractionary stimulus can be given automatically.
Unemployment insurance, the progressive income tax, and welfare programs serve as the built-in policies.
 How Nondiscretionary Fiscal Policy Works

If the economy is in recession, those who lose their jobs are granted
unemployment and/or welfare benefits and they owe less in taxes.
If the economy is growing at an unsustainable rate, people are making a lot of
money and are faced with higher tax rates and there are fewer people eligible
for government benefits.

There are “Built-in Macro Parameters”

Changes to government spending and/or tax revenue occur as a result of
changes in the economic cycle.
The built-in macro parameters like Govt spending, Govt Revenue (Tax and
Public debt) automatically restore stable situations
The government does not change its policies: deliberate tax policies and
expenditure patterns are not made.
Impact of Automatic Stabilizers during Boom
Automatic Stabilizers during recession
 TYPES OF FISCAL POLICY
Expansionary Fiscal Policy
• Reduce Unemployment
• Designed to stimulate the economy during the contractionary phase of business cycle or when there is
an anticipation of a business cycle contraction
• During Recession-overall economic activity declines-fall in GDP, lower aggregate demand and
consumer spending rising unemployment
• Government cut taxes (Direct and indirect) leaving the taxpayers with money – Purchasing power
increases and demand increases-aggregate demand, output and employment increase.
• Increase in Public expenditure-pump money to economy and increase aggregate demand-increase
output and employment
• Resorting to Expansionary fiscal policy-Budget deficit (Tax cuts) (Expenditure Exceeds income)
• Increase in Government spending and Decrease in Personal and/ Corporate tax
 Contractionary Fiscal policy
✓ Applied during Inflation
✓ Restrain the levels of economic activity during inflationary phase or when there is a business cycle
expansion inducing inflation
✓ Deliberate policy of the government to curtail aggregate demand and economic activity
✓ Aimed at eliminating “Inflationary Gap”
✓ Decrease Government spending
✓ Increase Personal income tax or corporate tax
✓ Lead to a smaller budget deficit or large Budget surplus

✓ Decrease in Government spending and Increase in personal and/ corporate tax

Expansionary Fiscal Policy Contractionary Fiscal policy

Expansionary fiscal policy is defined as the policy Contractionary fiscal policy is defined as the type
that works towards promoting the consumption in of fiscal policy that works toward contracting the
the economy. It works for expansion of the economy
economy.

It increase the aggregate demand It results in reduction of the aggregate demand

Consumption increases with expansionary fiscal Consumption decreases

policy

Increase in purchasing power Decline in purchasing power

It is not used to keep inflation on check It is implemented to keep inflation in check

Increase in fiscal deficit is indicative of Decrease in fiscal deficit is indicative of

expansionary fiscal policy contractionary fiscal policy
 LIMITATIONS OF FISCAL POLICY

➢ Recognition lag : Macro economics variables are not easily comprehensible. There is a difficulty in collecting
accurate and timely data and there may be a delay on the part of government to recognize the need of policy
change
➢ Decision lag: Need for Government intervention is identified, evaluate policies and there is a delay in making
decision on the appropriate policy. Decision lag in government intervention refers to the delay between
recognizing a need for action and implementing an appropriate policy
➢ Implementation lag: identified appropriate policy –delays in bringing legislation and implementing them on
account of bureaucracy
➢ Impact lag: Outcomes are not visible for some time (observable effects on the economy, including output,
employment, and inflation.)
➢ Difficulty in changing instantly Government spending and taxation Policies
➢ Public works cannot adjust easily along with the movements of the trade cycle- huge gestation periods like wise
urgent public projects cannot be postponed for reasons of expenditure cuts to correct fluctuations in business
cycle
➢ Certain fiscal policy measures causes disincentives (Increase in corporate tax adversely effect the
incentives of firm to invest)
➢ Deficit financing increase purchasing power of people-Production of goods and services in
underdeveloped will not match up with the increase in demand- will result in increase in prices
➢ Increase in borrowing- burden on future generation-no productive utilization of money-sufficient
surpluses will not be generated to service debts
➢ Crowding Out. Expansionary fiscal policy of increased government spending to increase AD
may cause “Crowding out” Crowding out occurs when increased government spending results
in a decrease in the size of the private sector. For example, if the government increase spending
it will have to increase taxes or sell bonds and borrow money, both methods reduce private
consumption and investment. If this occurs, AD will not increase or increase only very slowly.
Increased government borrowing increase interest rates. To borrow more money the interest rate
on bonds may have to rise, causing slower growth in the rest of the economy.
CROWDING OUT

✓ Crowding out refers to the phenomenon where increased government spending or borrowing
leads to a decrease in private investment and economic activity.
✓ Government borrowing to finance budget deficits can also crowd out private investment by
competing for limited financial resources.
✓ Crowding out can undermine the effectiveness of fiscal policy in stimulating the economy, as
the increase in government spending or borrowing is offset by a decrease in private investment.
✓ The degree of crowding out depends on factors such as the size of the government's budget
deficit, the state of the economy, and the responsiveness of private investment to changes in
interest rates.
✓ Government spending replaces private spending , the latter is said to be crowded out
Difference between Fiscal Policy Monetary Policy
Fiscal Policy and It is a macro-
It is a macro-
Monetary Policy economic policy used
economic policy used
by the government to
by the Central Bank
Definition adjust its spending
to influence money
levels and tax rates to
supply and interest
monitor and a
rates.
nation’s economy
Controlled by the Controlled by the
Institutional Control
Government Central Bank
To influence the
To influence the
Prime Objective money supply and
economic condition
interest rates.
Bank Rate, Cash
Public Expenditure,
Reserve Ratio,
Major Tools Taxation, Public
Statutory Liquidity
Borrowing etc
Ratio etc.
Focuses on Economic Growth Economic Stability