Quiz 12: Fiscal Policy: Incentives, and Secondary Effects


Since the rate of inflation and unemployment is high in the economy and the growth of real GDP is also slow a discretionary fiscal policy will not be able to give the desired results due to time lags in its implementation, therefore a fiscal policy with automatic stabilizers like taxes on corporate profits or progressive income taxes will be the proper fiscal policy for the next twelve months. My fiscal policy suggestions will be as follows: The dependence on a discretionary fiscal policy should be reduced because it involves a time lag to become effective till when the measures undertaken may become ineffective and many times the measures taken by the government are politically motivated. Therefore the automatic stabilizers should be the key players in making the fiscal policy effective because they do not require any laws or bills to be passed, they act automatically, they are inbuilt into the structure of the economy, as the criteria for the rules is met the taxes or transfer payments are paid or received. Whether the budget should be balanced or not is a debatable issue, whereas a balanced budget is an ideal situation where the country manages its expenditures in a way that it does not exceed the revenues, It is argued that during recessions it is difficult to increase revenue by way of taxes as people have lower incomes and high unemployment and are looking forward to government social security benefits. However it will be beneficial for the country to balance its budget, if a family can balance its monthly budget why can't a nation ? Too much dependence on borrowings, excessive taxation and spending leads to many problems for the nation and its people who have to ultimately face the brunt of it.

CROWDING OUT EFFECT Crowding - out effect implies that when government finances it budget deficit through borrowings demand for loanable funds in loanable funds market increases resulting in a rise in the real interest rates and make borrowings costly for private businesses and households resulting in a decline in investment and consumption spending. In other words, increase in borrowings by government crowd-outs the borrowing by households and businesses. It modify the implications of the basic Keynesian model with regards to fiscal policy in the sense that basic Keynesian model advocates that expansionary fiscal policy in terms of greater government spending stimulates the aggregate demand while crowding - out effect states that increased government borrowings raises the real interest rates and thereby reduces the investment demand and consumption demand resulting in fall in aggregate demand. Thus, crowding - out effect states that expansionary fiscal policy has some secondary effects as well and it's not that it only increases the aggregate demand but also give rise to the forces that partially, if not entirely, offset the impact of expansionary fiscal policy as well. The new classical theory of fiscal policy differs from the crowding - out model in the sense that both these policies state different reasons for the offsetting of the expansionary effect of a deficit. As per crowding - out effect, government borrowings to finance budget deficit will raise the real interest rates and thereby reduce the investment spending and other interest-rate sensitive consumer spending such as spending on consumer durables etc. and thereby offset the expansionary effect of a deficit. On the other hand, as per new classical theory of fiscal policy, government borrowing to finance deficit in current time period implies higher taxes in future so that revenue could be generated to pay the debts. These higher future taxes prompts the households and business to reduce their spending and save resources to pay for the higher taxes in future and hence aggregate demand declines offsetting the expansionary effect of a deficit.

According to one view, this $1,000 tax rebate financed by issuing additional Treasury bonds will increase the after tax income of individuals or will increase the disposable income of the individuals. Increase in this after-tax income or disposable income will induce the individuals to increase their consumption spending. As consumption spending increases, aggregate demand will also increase. This increase in aggregate demand will create the situation of excess demand in the economy the current price level prompting the firms to increase the price of their products. This rise in price level will improve the profit margins of the firms and thereby induce them to expand output. As output gets expanded, more jobs will be created and expansion of employment will take place. It has been stated that this tax rebate is being financed by the issuance of Treasury bonds. This borrowing by government will increase the demand in loanable funds market and hence would result in higher real interest rates. According to another view, tax payers getting this $1,000 in tax rebate realize that this rebate is financed by the issuance of treasury bonds which means higher future taxes (as funds would be needed in future to pay for the debt). This kind of realization will prompt the tax payers to continue their current level of consumption spending and not increase it by amount of tax rebate. Instead, they will save this rebate to pay the higher taxes in future. As current level of consumption remains unchanged, there will be no change in aggregate demand and thus no change in output and employment as well. Also, as people are saving more in order to pay higher taxes in future, supply of loanable funds will increase in proportion to increase in demand for loanable funds (government issuing Treasury bond) and thus real interest rates will remain same.

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