The big question that our finance ministry will face is how to react to the global recession and our stock market crash. Although these are issues which need correction from various economies, let us see what tools are at hand to control the economic fluctuation. Last year -2007 although we saw our GDP grow more than 8%, we were facing with issues like inflation. The Reserve Bank of India which is the principle organization in command of our economy was taking numerous measures to curtail inflation. What essentially were they doing? What is the role of government in these situations?
Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?
To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX
The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.
The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).
Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.
What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.
This could be the opposite when our government has inflationary pressure.
But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!
This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.
Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?
The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers
In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.
Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.
Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.
Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?
To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX
The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.
The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).
Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.
What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.
This could be the opposite when our government has inflationary pressure.
But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!
This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.
Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?
The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers
In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.
Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.
Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.
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