Fiscal Policy

Fiscal policy refers to the management of government spending and tax policies to influence total desired spending so as to achieve the desired level of economic growth and other social objectives. The classical thinker's believed in the laissez faire policy, in which the government adopts a hands-off policy, i.e., it does not interfere with the day to day business activates. But, after the great depression of 1930s, the role of the government has become crucial to stabilize business activities and the GDP.

Fiscal Policy is also called the budgetary policy. Budget is the manifestation of the fiscal policy. The government can prepare three types of budgets: (i) Balanced budget, (ii) Surplus budget, and (iii) Deficit budget.

In the balanced budget, the government total revenue equals the total expenditure.

In the surplus budget, the government total expenditure is less than the total revenue of the government.

In the deficit budget, the government total expenditure exceeds the total revenue.

The Budget balance is the difference between total government revenue and total government spending, i.e., taxes minus government spending.

There are two important tools of fiscal policy:

(i) Government expenditure and (ii) taxation.

In case, the economy is caught in the quagmire of depression or recession, the level of business activities falls, and as a result, the GDP decreases. To increase the level of the GDP and to revive business activities, the government may increase public expenditure and reduced the rates of taxes. Lower tax rates will increase private disposable income and increased government expenditure will also help in rising the desired aggregate spending. Consequently, the level of output, employment and income (GDP) will rise.

On the contrary, if the economy is 'over heated and the actual level of GDP is more than the potential level, the aggregate output (GDP) will exceed aggregate spending, as a result, prices tend to rise and inflationary pressure builds up on the economy. The fiscal policy can be used by the government to restore the desired level of GDP. In such a situation, the government may postpone to restore the desired level of GDP. In such a situation, the government may postpone or cut down its expenditure and increase the trades of taxes or withdraw tax rebates and concessions. As a result, the desired aggregate spending falls and the level of output, employment and income (GDP) also come down to the desired level.