ADVERTISEMENTS:
Fiscal policy instruments (i.e., taxes, government expenditure and public debt), individually or in different combinations, can be employed to deal with the situations of inflations and deflation. During depression, the fiscal policy aims at promoting aggregate spending, increasing employment, and thus raising the economy from the depths of depression. During inflation, on the other hand, the objective of the fiscal policy is to control aggregate spending in the economy.
The operation of various fiscal policy instruments is discussed below:
(A) Contra Cyclical Budgetary Policy:
Budget is a statement of estimated expenditure and income of the government. It is the main tool of fiscal policy to fight the situations of inflation and deflation. Contra cyclical budgetary policy implies the manipulation and managing of the budget with a view to remove cyclical fluctuations.
ADVERTISEMENTS:
If the government spends an amount exactly matched by its receipts, a balanced budget exists; if government expenditures exceed receipts a deficit budget exists; and if government expenditures are less than the receipts, a surplus budget exists.
Budgetary Policy during Depression:
During depression deficit budgeting or expansionary budget policy is suggested. It implies deficit spending by increasing government expenditures. If the budget is initially balanced, then a deficit budget is required to fight depression; if the deficit budget already exists, the anti-depression policy requires an even larger deficit. When government expenditures exceed receipts, larger amount are put into the national income stream than they are withdrawn.
Budget deficit represents the net expenditure of the government, which increases national income by the multiplier times the increase in net expenditure. Thus, the deficit budget policy has an expansionary effect on national income. For example, given the marginal propensity to consume (MPC) to be .5, a deficit of Rs. 100 crores will increase the national income by Rs. 200 crores (Multiplier = 1/1-MPC = 1/1- .5 = 2).
ADVERTISEMENTS:
The expansionary effect of a deficit budget is shown in Figure-1. Y-line is a 45°-line representing equality between income and expenditure. C-line is the consumption function. C + I + G line represents total expenditure function (including consumption, investment and government expenditure).
At the initial equilibrium, E0, national income is Y0. When government expenditure is increased by ∆G or AB amount, the equilibrium moves from E0 to E1 and the national income increases from Y0 to Y1. The increase in income is greater than the increase in government expenditure (Y0Y1 > AB) by the multiplier times.
There may be budget deficit without increasing government expenditure when taxes are reduced. Reduced taxes increase the disposable income of the people and encourage consumption expenditure. Thus, a combination of increased government expenditure and decreased taxes is a more proper anti-depression policy.
ADVERTISEMENTS:
Budgetary Policy during Inflation:
During inflation, the proper budgetary policy is to have budget surplus by curtailing government expenditure. If the budget is balanced initially, a budget surplus is required to fight inflation; if a surplus budget exists initially, then anti-inflation policy requires a higher surplus; if a large deficit exists initially, the anti- inflation fiscal policy will require a smaller deficit. A surplus budget has deflationary effect on national income.
A budget surplus can also be obtained without reducing government expenditure, if taxes are raised. Increased taxes curtail the disposable income with the people. This will reduce consumption and investment expenditures. Thus, a more effective budgetary policy during inflation would be that which both reduces government expenditure and increases taxes.
(B) Balanced versus Unbalanced Budget:
The classical economists believed in the doctrine of laissez-faire and recommended a policy of government non-intervention in a free-enterprise economy. They were of the view that on the basis of the principle of sound finance, the smallest budget is the best budget.
ADVERTISEMENTS:
They were opposed to the unbalanced budget (i.e., deficit or surplus budget) and favoured a policy of balanced budget in which the receipts and expenditures of the government are usually equalised and the gap between the two is minimum. In other words the government is fiscally least active; it spends very little, taxes very little and borrows very little.
The preference for minimum fiscal activity and balanced budget policy is due to the following reasons:
(i) Balanced budget is a small budget, designed carefully in a rational manner.
(ii) Adoption of balanced budget ensures economic stability. On the other hand, unbalanced budget leads to economic uncertainty and instability.
ADVERTISEMENTS:
(iii) Unbalanced budgets may lead to unnecessary expansion of state functions beyond the capacity of the government. Government has been regarded as an undesirable regulator and inefficient operator of economic activities.
(iv) Unbalanced budgets may result in large unproductive government expenditures, which, in turn, generate inflation.
(v) Unbalanced budgets require public borrowing and continuous unbalanced budgets imply increase in the burden of public debt.
(vi) Unbalanced budgets with public borrowing cause reduction in loanable funds available for productive private investment.
(vii) Unbalanced budget also means increase in taxation either to meet the excessive government expenditures or to repay the public debts on maturity. Increase in taxation has an adverse effect on incentive to work and saving.
Keynesian economics has revolutionized the very concept of fiscal policy in modern times. The concept of sound finance has been replaced by the concept of functional finance and the balanced budget approach has given place to the unbalanced budget approach.
According to the theory of functional finance the fiscal policy should be specially designed and the fiscal instruments should be effectively used to promote the national economic objectives. In a system of functional finance, budget need not always be balanced.
On the contrary, functional finance norm recommends a policy of unbalanced or managed budgets. Government expenditure and revenue should be so manipulated as to achieve the objectives of full employment, economic growth, economic stability and equitable distribution of wealth. Contra-cyclical budgetary policy is suggested for tackling the problems of inflation and depression.
In a developing country, the budgets should be managed in accordance with the requirements of planned process of economic development. However, following an unbalanced budget policy is not an easy job. It is difficult to predict inflation and depression in the economy.
Moreover, adjusting the budget to the rapidly changing economic conditions is still more difficult. Discussions and delays at the political level to finally decide about the budget make things all the more difficult.
(C) Public Expenditure:
In the modern times, public or government expenditure forms the most significant part of the aggregate expenditure of the economy. Changes in public expenditure cause changes in income, output and unemployment. Increase in public expenditure has a stimulating effect on the economy, while decrease in expenditure has depressing effect on the economy.
Public Expenditure Policy during Depression:
During depression, the objective of public expenditure policy is to increase public expenditure to stimulate production, income and employment. While tax reduction affects aggregate demand indirectly through shifts in consumption function, increase in public expenditure increases aggregate demand directly.
If no other types of expenditures (such as, consumption (C), investment (I), or net export (i.e., export minus imports, X-M)) are reduced, this increase in aggregate demand as a result of expansion in public expenditure will lead to manyfold expansion in output, income and employment through multiplier effect.
The ultimate change in real income will be:
∆Y = ∆G [1/(1 – MPC)]
Where ∆Y = Change in real income;
∆G = Change in public expenditure;
MPC = Marginal propensity to consume;
1/(1-MPC) = The multiplier.
The effect of change in public expenditure can be explained with the help of IS-LM curves in Figure-2. An increase in public expenditure shifts the IS curve upwards from IS to ISG by the amount ∆G [1/(1-MPC)]. If the interest rate does not change, income will increase by full multiplier effect from Y0 to Y2. In this situation, the economy will move from equilibrium point A to C.
If the money supply remains unchanged, die increase in public expenditure will not have full multiplier effect. This is because as the increase in public expenditure increases income from Y0 to Y2, the demand for money for transactions and precautionary purpose will increase. This increase in demand for money relative to supply of money causes a shortage of money liquidity.
This shortage will be met by bond sales which raise the rate of interest from i0 to i1. The rise in the interest rate will crowd out (or reduce) private investment and consumption. Finally, the equilibrium will be established at point B at the income level Y1. Thus, the ultimate increase in income is not as high as it otherwise would have been- the multiplier effect is lessened (i.e., Y0 Y1 < Y0 Y2)
Public Expenditure Policy during Inflation:
The anti-inflation policy of public expenditure requires reduction in government expenditure with a view to reduce aggregate demand and contract economic activity in the economy. A decrease in government expenditure shifts the IS curve downwards, by the amount ∆G l/( I-MPC).
At any interest rate, the level of real national income will fall by the amount of reduction in government expenditure times the multiplier and the full multiplier effect results.
But, in reality, the rate of interest does not remain unaffected, and, therefore, a full multiplier effect will not result. Given the money supply (LM curve), a fall in the income level due to reduction in government expenditure will reduce the rate of interest. The lower interest rate will induce more investment and consumption expenditure.
Some of the contraction in the economy resulting from a reduction in government expenditure will be offset by the increase in investment and consumption resulting from a lower interest rate.
On the basis of nature and area of expenditure, public expenditure can be classified into different categories. There are two approaches to public expenditure- (a) compensatory spending, and (b) pump priming. Again, stabilising public expenditures of compensatory as well as pump-priming nature requires two broad areas of public expenditures: (a) public works, and (b) transfer payments.
These different types of public expenditures are discussed below:
1. Compensatory Spending:
Compensatory spending refers to the government spending undertaken with a purpose of compensating for the declines of private investment. In this case, government expenditure is increased to the same extent as the private investment has decreased. When the private investment contracts, the government expenditure expands and the same will continue so long as the private investment is below normal.
2. Pump Priming:
Pump priming refers to large and temporary shocks of government spending undertaken to ‘prime the pump’ of economic activity. The basic idea behind pump priming is when private spending becomes deficient on account of depression, then a big dose of public spending is undertaken to revive the economic activity in the economy.
Soon the economy will reach satisfactory levels of output and employment, and will be moving on the path of steady growth. Then there will be no need of government expenditure.
3. Public Works:
Prof. Clark has defined public works “as durable goods, primary fixed structures, produced by the government.” Expenditures on public works include expenditures on roads, schools, parks, hospitals, airports, post offices, canals, dams, etc. The expenditure on public works is called capital expenditure. This expenditure has great employment generating potentialities.
Primary employment in public works will generate secondary and tertiary employment, and this will lead to a multiple increase in income and output of the country. Investment in public works programmes induces private businessmen to invest more and thereby raise the level of economic activity in the country.
Such public investment should continue till private investment increases to its normal level. When the economy shows signs of recovery, the expenditures on public works should be reduced gradually, and should be given up completely during inflation.
Public works programmes have certain limitations and practical difficulties:
(i) The success of public works programmes depends upon the assumption that sufficient expenditures are incurred by the government on these programmes. But if the required volume of expenditures is not made, these programmes will not be able to check deflationary tendencies.
(ii) Expenditures on heavy projects, like dams, canals, etc., cannot be easily changed on short notice. These expenditures do not help much in controlling recessions and booms.
(iii) There are delays in getting the long term projects started. These projects require proper planning and may involve serious delays in obtaining their final approval from the administration.
(iv) Again certain heavy projects have long gestation period, i.e., they require long period for completion. Such projects started during depression cannot be given up without enormous loss to the government.
(v) Public works may lead to Misallocation of resources. These projects may be located in one region, but the unemployed resources may be located in some other region. The mobility of unemployed resources (particularly of labour) may not be easily achieved.
(vi) Public works are financed through borrowing and thus result in heavy debt burden.
(vii) There are also forecasting problems. The effectiveness of public works programmes require accurate information about the stage of the business cycle through which the economy is passing. It is on the basis of this information that decisions about the nature of the programmes to be started will be taken.
(viii) Public works may lead to wastage of resources by providing employment to misfitting persons.
These projects largely employ ‘blue-collar’ workers. The ‘white-collar’ workers, such as artists, accountants, etc. have to accept the jobs of unskilled workers. Despite those difficulties, the public works programmes cannot be dispensed with all together. They, on the one hand, directly influence employment and output of the country, and on the other hand, indirectly stimulate economic activity through monetary expansion.
4. Transfer Payments:
Transfer payments refer to social security payments, such as, pensions, subsidies, relief payments, unemployment insurance, etc. Expenditure of transfer payments is known as current expenditure.
The purpose of such expenditure is to provide help to the victims of recession to compensate for the fall in their income. Transfer payments are not so effective in stimulating private investment. They mainly tend to raise consumption during depression.
(D) Taxation:
Tax changes are needed to meet the conditions prevailing in the economy. Taxation determines the disposable income and purchasing power of the general public, which, in turn, influence aggregate spending.
Taxation during Depression:
During depression, the proper tax policy is to reduce the burden of tax on the people. This can be done by reducing direct taxes (such as, income tax, corporate tax etc.) and indirect taxes (such as, sales and excise taxes). Such a tax policy is expansionary. It increases the disposable income with the people and thus encourages private consumption and investment.
However, the effectiveness of the general reduction of taxes may be doubted on the ground that during depression inducement to invest is very low and the entrepreneurs may not be encouraged in invest more by reduction in taxes alone.
A reduction in taxes increases aggregate spending, but not by the full amount of tax. Since tax changes affect aggregate demand indirectly through shifts in consumption function, the aggregate demand curve (or AD = (C + I + G) + MPC (∆C) curve) will shift only by MPC (∆C) = MPC (∆T), where (C + I + G) is the total expenditure comprising consumption, investment and government expenditures; MPC represents marginal propensity to consume; ∆C is change in consumption; and ∆T is change in tax. If, for example, taxes fall be Rs.1000, the consumption function will shift upward by MPC (1000), and not by the full Rs. 1000.
In terms of IS-LM curve analysis, a reduction in taxes shifts the IS curve to the right, by a distance equal to the reduction in taxes times tax multiplier. The tax multiplier is negative because increases in taxes decrease national income, while decreases in taxes increase national income.
The effect of a reduction in tax is shown in Figure-3. As a result of a decrease in tax, the IS curves shifts from IS to IST. If the interest rate does not rise, the equilibrium position shifts from point A to C. In this case, full tax multiplier effect occurs and the income increases from Y0 to Y2.
But, if money supply is unaltered, changes in taxes will not have a full multiplier effect. The higher level of income (Y2) as a result of reduction in tax, increases the demand for money for transactions and precautionary purposes (i.e., L1). Thus, given the money supply (or given the LM curve), a shortage of money exists at point C. The increased desire for money is met by bond sales which increase the rate of interest above i0.
Higher interest rate reduces consumption and investment and the real income falls below Y2. This process will continue until the equilibrium is established at point B, where interest rate is i1 and the income level is Y1. Thus, given the money supply, a reduction in tax will not have a full multiplier effect. It will raise the interest rate and thereby crowd out private consumption and investment. Thus, the economy will not expand as much as it otherwise would have.
Taxation during Inflation:
During inflation, the tax policy should aim at- (a) increasing the existing taxes, and (b) living new taxes, in order to take away the surplus purchasing power from the general public. Income tax, expenditure tax, excise duties, all are anti-inflationary as they leave less money with the public to spend and thus lead to the contraction of the economy. Care, however, is to be taken that taxes should not be raised so high as to discourage private investment and thus generate recessionary trends in the economy.
In terms of IS-LM analysis, an increase in taxes will shift the IS curve to the left by a distance equal to the increase in taxes multiplied by the tax multiplier. The economy will contract, but not by the full amount of the tax multiplier effect.
A lower level of national income, resulting from the downward shift in IS curve (due to reduction in consumption function), will reduce the demand for money for transactions and precautionary purposes.
This will create a surplus of liquidity at the original interest rate. The interest rate, therefore, will fall, which will induce an increase in consumption and investment expenditures. Thus, the contraction in the economy due to a tax increase will be offset by a lower interest rate.
(E) Public Debt:
Public debt management, which involves public borrowing, debt servicing and debt repayment, is another important fiscal weapon to fight depression and inflation. During depression, when the taxes are reduced and public expenditure is increased considerably, a deficit appears in the government budget which can be financed in three ways- (a) by borrowing from general public, (b) by borrowing from banking and other financial institutions, and (c) by borrowing from the central bank.
The anti-cyclical public debt policy requires that public debt should be so managed as to increase public borrowing during inflation and restrict public borrowing during depression. In this way, the disposable income of the bond holders and thus the aggregate spending in the economy will decrease during inflation and increase during depression.
The proper public debt policy must keep in view the following considerations:
(i) When the government borrows idle funds with the general public or with the banking and financial institutions, there will be no adverse effect on consumption and investment.
(ii) When the government borrows funds which would otherwise have been invested privately, there will be no change in the net investment; the increase in public investment will be neutralised by the reduction in private investment.
(iii) Just as public expenditure competes with private expenditure, public borrowing also competes with private borrowing. Increase in public borrowing creates shortage of funds for private borrowing.
(iv) There will be crowding out effect of public borrowing. When the government expenditures are financed by borrowing from the public and the money supply remains constant, the resultant increase in real income will increase the public’s demand for money. This shortage of money will raise the interest rate. The higher rate of interest will have crowding out effect and reduce investment.
Figure-4 shows the crowding out effect of public borrowing. When government expenditure is financed by an equal increase in public borrowing (∆G = ∆B), it does not produce full multiplier effect, i.e., ∆B or ∆G (1/( 1-MPC). The IS curve will shift rightward to ISB, but the economy will move from point A to B rather than to C because interest rate rises from i0 to i1 due to public borrowing.
As a result, national income increases from Y0 to Y1 instead of from Y0 to Y2 (or the full multiplier effect). It is because some private investment has been crowded out due to rise in interest rate.
(v) Borrowing from the central bank has no such adverse effect on private investment. It increases the supply of money in the country and thus has expansionary impact on the economy.
(vi) The central bank should also adopt cheap money policy (e.g., having low bank rate) in order to keep the burden of public debt low.
(F) Automatic versus Discretionary Fiscal Policy:
Fiscal policy can be of two types:
1. Discretionary fiscal policy, and
2. Automatic fiscal policy.
1. Discretionary Fiscal Policy:
Discretionary fiscal policy is the deliberate and conscious attempt by the government to promote full employment and price stability by contra cyclical change in public expenditure or taxes or both. Discretionary fiscal policy change involves specific legislation.
During depression, the effective discretionary fiscal policy may take four alternative forms- (a) reducing tax rates and leaving government expenditure unchanged; (b) increasing government expenditure and leaving taxes unchanged; (c) simultaneously reducing taxes and increasing government expenditure; (d) increasing both taxes and government expenditure. On the contrary to control the inflationary pressures, the reverse of these four programmes are suggested.
Limitations:
In practice discretionary fiscal policy suffers from certain difficulties:
(i) Discretionary fiscal policy is selective. It directly affects certain economic sectors to the exclusion of others.
(ii) Discretionary fiscal policy suffers from the problem of administrative inflexibility, which has two types of time lags- first, there is the ‘decision lag, i.e., time required in the decision-making process: second, there is ‘execution lag, i.e., the time required to execute or implement the programme. Thus, in practice, it takes much time to bring about changes in government spending and tax policies.
(iii) There are certain public works programmes which are not flexible enough to be expanded or slowed down for the purpose raising or reducing expenditure on them.
(iv) Then there are also problems of timing and forecasting.
2. Automatic Fiscal Policy or Built-in Stabilisers:
Automatic or non-discretionary fiscal policy operates automatically through the built-in stabilisers to contract fluctuations in economic activity. Thus, automatic fiscal policy refers to the built-in flexibility in the fiscal machinery which involves automatic adjustment of the expenditures and taxes in accordance with the cyclical changes with in the country without any deliberate action of the government.
Built-in stabilisers are those factors which automatically cause government expenditure to rise and tax receipts to fall during economic contraction and cause government expenditure to fall and tax receipts to rise during economic expansion.
The automatic stabilisers tend to support the economy during a recession and restrain the economy during inflation. The government revenues and expenditures are automatically related to changes in national income; tax yields vary directly and government expenditures vary inversely with the movement in national income.
The effects of the built-in stabilisers are; (a) to increase disposable income during upswings of the trade cycle and rising income, and (b) to reduce disposable income during downturn of the trade cycle and falling income. In short, the built-in stabilisers help to even out the fluctuations in economic activity, to fill the valleys and knock down the peaks of the business cycles, without requiring any discretionary judgement by the government.
(i) Progressive Income Tax:
In the progressive tax system, tax rate increases with the increase in income. It relates government revenues to changes in income. Given the tax structure, the tax yields increase with the rise in national income and decrease with the fall in national income.
Thus, during depression, when the incomes of the people tend to fall, their disposable income does not fall as rapidly as their total income because the tax rates are falling at the same lime. Similarly during boom period, when the incomes of the people are rising their disposable income does not rise as rapidly as their total income because of rising tax rates.
(ii) Unemployment Compensation:
The automatic changes in the unemployment compensation lessen the impact of cyclical changes in national income. During depression, the laid-off workers automatically become eligible for unemployment compensation from the government.
Thus, their disposable incomes decline, but at a slower rate than that at which the national income is declining. Similarly, during boom period, there is less unemployment. In this case, less purchasing power is added because less unemployment compensation is paid.
Built-in stabilisers are contra-cyclical in their effects. If the government deliberately does nothing else to stabilise the economy, then through built-in stabilisers a recession automatically generates a budget deficit and inflation automatically generates a budget surplus. This is shown in Figure-5.
We assume:
(a) Government expenditure is fully autonomous and does not change with the change in national income; this is represented by GG curve.
(b) Constant progressive tax structure exists which indicates that taxes vary directly with national income; this is represented by TT curve.
When national income increases from Y0 to Y1 during boom period, tax yields will exceed government expenditure (as shown by the vertical distance between GG and TT curves to the right of point E). This government budget surplus, which occurs automatically during the boom period serves to offset the inflationary pressures. Similarly, when national income falls from Y0 to Y2 during recession, the resultant automatic budget deficit (as shown by the vertical distance between GG and TT curves to the left of point E) will offset the deflationary tendencies.
The automatic stabilisers are superior to the discretionary fiscal policy because of the following advantages:
(a) Automatic stabilisers are contra-cyclical by nature and tend to reduce cyclical fluctuations in economic activity.
(b) They involve built-in flexibility necessary for prompt and effective use.
(c) They are automatic and can be used without the need for policy decision or action by the government.
(d) They avoid lags and delays involved in changing discretionary fiscal programmes.
(e) They also avoid the problems of forecasting and timing of fiscal policy.
Despite their vital significance, the automatic stabilisers also suffer from certain limitations:
(a) It is too much to assumes that the automatic stabilisers themselves can even out the fluctuations in economic activity and, therefore, they should be used as a necessary complement to discretionary action,
(b) The effectiveness of automatic stabilisers depends upon the level of taxes, the elasticity of tax receipts and the flexibility of public expenditure,
(c) Built-in flexibility ignores the secondary effects of stabilisers on after-tax business income and of consumption spending on business expectations,
(d) The automatic stabilisers also do not consider stabilising influence of local bodies, of state governments, and of the private sector.
(G) Alternative Fiscal Programmes:
Tax and government expenditure are the main instruments of fiscal policy. Both of them can be employed in different combinations to combat depression and inflation. Again, the question how the government finances its expenditures also matters and has its impact on the economy.
Taxes and government expenditures affect the IS curve by shifting it upward (when taxes decrease or expenditures increase) or downward (when taxes increase or expenditures decrease).
The way the government expenditures are financed has its impact on the LM curve. If the expenditures are financed by borrowing from the public, the LM curve is not affected. If the expenditures are financed by borrowing from the banking system, the LM curve shifts to the right.
During depression, there are four alternative fiscal programmes (or combinations of taxes and government expenditures) to deal with the problems of unemployment and low growth rate.
1. Unchanged Spending with Reduced Taxes:
In this case, reduced taxes stimulate consumption. Hence, the IS curve increases to IST curve in Figure-6. Since there is no change in the government expenditure, therefore, the existing government expenditure level is maintained.
If this expenditure is met by borrowing from public, the LM curve is not affected. If the expenditure is met by borrowing from the banking system, the LM curve increases to LM1.
The economy moves- (i) from position A to B and income increases from Y to Y1, when taxes arc reduced and the existing government expenditure is financed through public borrowing; and (ii) from position A to C and income increases from Y to Y2 when taxes arc reduced and the existing government expenditure is financed by borrowing from banking system.
2. Increased Spending with Unchanged Taxes:
In this case, when taxes remain unchanged and government expenditure increases, the IS curve shifts upward to ISG (in Figure – 7). If the government expenditure is financed from the public borrowing, it will leave the LM curve unaffected. But, if the expenditure is financed from banking system, the LM curve will shift to LM1.
The economy moves (i) from position A to B and income increases from Y to Y1 when with constant taxes, the increased government expenditure is financed from public borrowing; and (ii) from position A to C and income increases from Y to Y2 when with constant taxes, increased government expenditure is financed from banking system.
3. Increased Spending with Reduced Taxes:
This policy has the greatest impact on the economy because both the instruments (taxes and government expenditure) are in operation and have expansionary effect; both reinforce each other. The IS curve shifts to ISGT (in Figure-8) and this shift is more than that which occurs when either of the two instruments operates singly.
The economy moves- (i) from position A to B and income increases from Y to Y1 when the increased spending is financed by public borrowing; and (ii) from position A to C and income increases from Y to Y2 when the increased spending is financed by banking system.
4. Increased Spending with Increased Taxes:
This is a balanced budget approach in which the increased expenditures are offset by increased taxes. Such a policy produces no deficit and therefore, has no effect on the LM curve. In this case, the effect on IS curve is modest. The small effect on the IS curve is due to increased expenditure shifting it upward to ISG (in Figure – 9), while increased taxes lowering it back to ISGT.
The net effect is, however, to shift the IS curve to ISGT. Thus, ultimately, the economy moves from position A to C (and not to B if there were no tax increase) and the income increases from Y to Y2 (and not to Y, if there were no tax increase).
During inflation, the fiscal policy seeks either to increase taxes or to reduce government expenditure or both.
Alternative combinations of government expenditure and taxes to be adopted to control inflation are:
(i) Increasing taxes, while leaving government expenditure unchanged;
(ii) Reducing government expenditure, while leaving taxes unchanged;
(iii) Simultaneously reducing government expenditure and increasing taxes; and
(iv) Reducing both government expenditure and taxes.
Reducing government expenditure and increasing taxes both shift the IS curve downward and have contractionary effect in the economy. If the government expenditure is reduced by repaying public debt, it will have no effect on the LM curve. But, if the expenditure is reduced by repaying debt to the banking system, it will shift the LM curve to the left, further contracting the economy.
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