ICAI Notes- Unit 4: Fiscal Policy | Business Economics for CA Foundation PDF Download

 Page 1


1.  
  
BUSINESS ECONOMICS 
 
 7.72 
LEARNING OUTCOMES 
UNIT – 4: FISCAL POLICY 
 
 
 
 
After studying this Chapter, you will be able to – 
• define fiscal policy and list out its objectives 
• explain the various instruments of fiscal policy 
• describe the expansionary and contractionary fiscal policies  
• elucidate the limitations fiscal policy 
 
 
 
4.1 INTRODUCTION  
The governments of all countries pursue numerous policies to accomplish their economic 
goals such as rapid economic growth, equitable distribution of wealth and income, reduction 
of poverty, price stability, exchange rate stability, full-employment, balanced regional 
development etc.  Government budget is one among the most powerful instruments of 
economic policy. The important tools in the budgetary policy could be broadly classified into 
public revenue including taxation, public expenditure, public debt and finally deficit financing 
to bridge the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into what is called 
fiscal policy. In other words, through the use of these instruments governments intend to 
favourably influence the level of economic activity of a country. These, in fact, form the subject 
matter of fiscal policy. 
Fiscal policy is the deliberate policy of the government under which it uses the instruments of 
taxation, public expenditure and public borrowing to influence both the pattern of economic 
activity and level of aggregate demand, output and employment.  Fiscal policy is in the nature 
of a demand-side policy. An economy which is producing at full-employment level does not 
require government action in the form of fiscal policy.  
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
Page 2


1.  
  
BUSINESS ECONOMICS 
 
 7.72 
LEARNING OUTCOMES 
UNIT – 4: FISCAL POLICY 
 
 
 
 
After studying this Chapter, you will be able to – 
• define fiscal policy and list out its objectives 
• explain the various instruments of fiscal policy 
• describe the expansionary and contractionary fiscal policies  
• elucidate the limitations fiscal policy 
 
 
 
4.1 INTRODUCTION  
The governments of all countries pursue numerous policies to accomplish their economic 
goals such as rapid economic growth, equitable distribution of wealth and income, reduction 
of poverty, price stability, exchange rate stability, full-employment, balanced regional 
development etc.  Government budget is one among the most powerful instruments of 
economic policy. The important tools in the budgetary policy could be broadly classified into 
public revenue including taxation, public expenditure, public debt and finally deficit financing 
to bridge the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into what is called 
fiscal policy. In other words, through the use of these instruments governments intend to 
favourably influence the level of economic activity of a country. These, in fact, form the subject 
matter of fiscal policy. 
Fiscal policy is the deliberate policy of the government under which it uses the instruments of 
taxation, public expenditure and public borrowing to influence both the pattern of economic 
activity and level of aggregate demand, output and employment.  Fiscal policy is in the nature 
of a demand-side policy. An economy which is producing at full-employment level does not 
require government action in the form of fiscal policy.  
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.73 
 
 
 7.73 
PUBLIC FINANCE 
The classical economists held the belief that the government should not intervene in the 
economy because the market mechanism makes the economy self-adjusting and keeps the 
economy at or near the natural level of real GDP at all times. Since the economy always tends 
to have stable prices and operates at full employment where the resources are utilized at their 
full capacity, and there will be no unemployment. The government should have a balanced 
budget and any deliberate fiscal policies are unnecessary. 
The significance of fiscal policy as a strategy for achieving certain socio economic objectives 
was not recognized or widely acknowledged before 1930 due to the faith in the limited role 
of government advocated by the then prevailing laissez-faire approach. The depression 
resulted in very low aggregate demand along with high levels of unemployment.  The 
classical economics could not provide any solution to this problem. In 1936, the British 
economist John Maynard Keynes in his book ‘The General Theory of Employment, Interest, 
and Money’ advocated increase in government spending to combat the recessionary forces 
in the economy and to solve the problem of unemployment.  In recent times, especially after 
being threatened by the global financial crisis and recession, many countries have preferred 
to have a more active fiscal policy. 
4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the government, are 
derived from the aspirations and goals of the society. We have seen in our previous unit on 
market failure that it is the responsibility of the government to provide various goods and 
services like, highways, primary education healthcare etc  to ensure social welfare.  
Since nations differ in numerous aspects, the objectives of fiscal policy also may vary from 
country to country.   However, the most common objectives of fiscal policy are:  
• Achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth,  
The importance as well as order of priority of these objectives may vary from country to 
country and from time to time. For instance, while stability and equality may be the priorities 
of developed nations, economic growth, employment and equity may get higher priority in 
developing countries.  
Governments may directly as well as indirectly influence the way resources are used in an 
economy. Fiscal policy is a powerful tool for managing the economy because of its ability to 
influence the total amount of output produced viz. gross domestic product. The ability of 
© The Institute of Chartered Accountants of India
Page 3


1.  
  
BUSINESS ECONOMICS 
 
 7.72 
LEARNING OUTCOMES 
UNIT – 4: FISCAL POLICY 
 
 
 
 
After studying this Chapter, you will be able to – 
• define fiscal policy and list out its objectives 
• explain the various instruments of fiscal policy 
• describe the expansionary and contractionary fiscal policies  
• elucidate the limitations fiscal policy 
 
 
 
4.1 INTRODUCTION  
The governments of all countries pursue numerous policies to accomplish their economic 
goals such as rapid economic growth, equitable distribution of wealth and income, reduction 
of poverty, price stability, exchange rate stability, full-employment, balanced regional 
development etc.  Government budget is one among the most powerful instruments of 
economic policy. The important tools in the budgetary policy could be broadly classified into 
public revenue including taxation, public expenditure, public debt and finally deficit financing 
to bridge the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into what is called 
fiscal policy. In other words, through the use of these instruments governments intend to 
favourably influence the level of economic activity of a country. These, in fact, form the subject 
matter of fiscal policy. 
Fiscal policy is the deliberate policy of the government under which it uses the instruments of 
taxation, public expenditure and public borrowing to influence both the pattern of economic 
activity and level of aggregate demand, output and employment.  Fiscal policy is in the nature 
of a demand-side policy. An economy which is producing at full-employment level does not 
require government action in the form of fiscal policy.  
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.73 
 
 
 7.73 
PUBLIC FINANCE 
The classical economists held the belief that the government should not intervene in the 
economy because the market mechanism makes the economy self-adjusting and keeps the 
economy at or near the natural level of real GDP at all times. Since the economy always tends 
to have stable prices and operates at full employment where the resources are utilized at their 
full capacity, and there will be no unemployment. The government should have a balanced 
budget and any deliberate fiscal policies are unnecessary. 
The significance of fiscal policy as a strategy for achieving certain socio economic objectives 
was not recognized or widely acknowledged before 1930 due to the faith in the limited role 
of government advocated by the then prevailing laissez-faire approach. The depression 
resulted in very low aggregate demand along with high levels of unemployment.  The 
classical economics could not provide any solution to this problem. In 1936, the British 
economist John Maynard Keynes in his book ‘The General Theory of Employment, Interest, 
and Money’ advocated increase in government spending to combat the recessionary forces 
in the economy and to solve the problem of unemployment.  In recent times, especially after 
being threatened by the global financial crisis and recession, many countries have preferred 
to have a more active fiscal policy. 
4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the government, are 
derived from the aspirations and goals of the society. We have seen in our previous unit on 
market failure that it is the responsibility of the government to provide various goods and 
services like, highways, primary education healthcare etc  to ensure social welfare.  
Since nations differ in numerous aspects, the objectives of fiscal policy also may vary from 
country to country.   However, the most common objectives of fiscal policy are:  
• Achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth,  
The importance as well as order of priority of these objectives may vary from country to 
country and from time to time. For instance, while stability and equality may be the priorities 
of developed nations, economic growth, employment and equity may get higher priority in 
developing countries.  
Governments may directly as well as indirectly influence the way resources are used in an 
economy. Fiscal policy is a powerful tool for managing the economy because of its ability to 
influence the total amount of output produced viz. gross domestic product. The ability of 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.74 
fiscal policy to influence output by affecting aggregate demand makes it a potential 
instrument for stabilization of the economy. We shall now see how this happens by 
investigating into the fundamental equation of national income accounting that measures 
gross domestic product (GDP) according to expenditures.  
GDP = C + I + G + NX 
The right side of the equation shows the different sources of aggregate spending or demand.  
We know that the market demand is influenced by government actions such as tax rates and 
government expenditure. The governments can influence the level of economic activity (GDP) 
by directly controlling G (government expenditure i.e purchases of goods and services by the 
government) and indirectly influencing C (private consumption), I (investment), and NX (net 
exports or exports minus imports), through changes in taxes, transfer payments and public 
expenditure.  
4.3 TYPES OF FISCAL POLICY  
As we are aware, while pursuing fiscal policy, the government makes deliberate attempts to 
adjust revenues, expenditures and public debt to eliminate unemployment during recession 
and to achieve price stability during in inflation. Contra cyclical fiscal policy or fiscal policy 
measures to correct different problems created by business-cycle instability are of two basic 
types namely, expansionary fiscal policy and contractionary fiscal policy.  
a)  Expansionary Fiscal Policy 
Expansionary fiscal policy is designed to stimulate the economy during the contractionary 
phase of a business cycle or when there is an anticipation of a business cycle contraction. A 
recession is said to occur when the overall economic activity declines, or in other words, when 
the economy ‘contracts’.  A ‘demand-deficient’ recession sets in with a period of falling real 
GDP, low aggregate demand and reduced consumer spending and rising unemployment. To 
combat such a slump in overall economic activity, the government can resort to expansionary 
fiscal policies. We may technically refer to this as a policy measure to close a ‘recessionary 
gap’. How does the government achieve this?  
• The government may cut all types of taxes, direct and indirect, leaving the taxpayers 
with extra money to spend so that there is more purchasing power and more demand 
for goods and services. Consequently aggregate demand, output and employment 
increase.  
• An increase in government expenditure (discussed in detail below) will pump money 
into the economy and increase aggregate demand. This in turn will increase output 
and employment. 
© The Institute of Chartered Accountants of India
Page 4


1.  
  
BUSINESS ECONOMICS 
 
 7.72 
LEARNING OUTCOMES 
UNIT – 4: FISCAL POLICY 
 
 
 
 
After studying this Chapter, you will be able to – 
• define fiscal policy and list out its objectives 
• explain the various instruments of fiscal policy 
• describe the expansionary and contractionary fiscal policies  
• elucidate the limitations fiscal policy 
 
 
 
4.1 INTRODUCTION  
The governments of all countries pursue numerous policies to accomplish their economic 
goals such as rapid economic growth, equitable distribution of wealth and income, reduction 
of poverty, price stability, exchange rate stability, full-employment, balanced regional 
development etc.  Government budget is one among the most powerful instruments of 
economic policy. The important tools in the budgetary policy could be broadly classified into 
public revenue including taxation, public expenditure, public debt and finally deficit financing 
to bridge the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into what is called 
fiscal policy. In other words, through the use of these instruments governments intend to 
favourably influence the level of economic activity of a country. These, in fact, form the subject 
matter of fiscal policy. 
Fiscal policy is the deliberate policy of the government under which it uses the instruments of 
taxation, public expenditure and public borrowing to influence both the pattern of economic 
activity and level of aggregate demand, output and employment.  Fiscal policy is in the nature 
of a demand-side policy. An economy which is producing at full-employment level does not 
require government action in the form of fiscal policy.  
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.73 
 
 
 7.73 
PUBLIC FINANCE 
The classical economists held the belief that the government should not intervene in the 
economy because the market mechanism makes the economy self-adjusting and keeps the 
economy at or near the natural level of real GDP at all times. Since the economy always tends 
to have stable prices and operates at full employment where the resources are utilized at their 
full capacity, and there will be no unemployment. The government should have a balanced 
budget and any deliberate fiscal policies are unnecessary. 
The significance of fiscal policy as a strategy for achieving certain socio economic objectives 
was not recognized or widely acknowledged before 1930 due to the faith in the limited role 
of government advocated by the then prevailing laissez-faire approach. The depression 
resulted in very low aggregate demand along with high levels of unemployment.  The 
classical economics could not provide any solution to this problem. In 1936, the British 
economist John Maynard Keynes in his book ‘The General Theory of Employment, Interest, 
and Money’ advocated increase in government spending to combat the recessionary forces 
in the economy and to solve the problem of unemployment.  In recent times, especially after 
being threatened by the global financial crisis and recession, many countries have preferred 
to have a more active fiscal policy. 
4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the government, are 
derived from the aspirations and goals of the society. We have seen in our previous unit on 
market failure that it is the responsibility of the government to provide various goods and 
services like, highways, primary education healthcare etc  to ensure social welfare.  
Since nations differ in numerous aspects, the objectives of fiscal policy also may vary from 
country to country.   However, the most common objectives of fiscal policy are:  
• Achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth,  
The importance as well as order of priority of these objectives may vary from country to 
country and from time to time. For instance, while stability and equality may be the priorities 
of developed nations, economic growth, employment and equity may get higher priority in 
developing countries.  
Governments may directly as well as indirectly influence the way resources are used in an 
economy. Fiscal policy is a powerful tool for managing the economy because of its ability to 
influence the total amount of output produced viz. gross domestic product. The ability of 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.74 
fiscal policy to influence output by affecting aggregate demand makes it a potential 
instrument for stabilization of the economy. We shall now see how this happens by 
investigating into the fundamental equation of national income accounting that measures 
gross domestic product (GDP) according to expenditures.  
GDP = C + I + G + NX 
The right side of the equation shows the different sources of aggregate spending or demand.  
We know that the market demand is influenced by government actions such as tax rates and 
government expenditure. The governments can influence the level of economic activity (GDP) 
by directly controlling G (government expenditure i.e purchases of goods and services by the 
government) and indirectly influencing C (private consumption), I (investment), and NX (net 
exports or exports minus imports), through changes in taxes, transfer payments and public 
expenditure.  
4.3 TYPES OF FISCAL POLICY  
As we are aware, while pursuing fiscal policy, the government makes deliberate attempts to 
adjust revenues, expenditures and public debt to eliminate unemployment during recession 
and to achieve price stability during in inflation. Contra cyclical fiscal policy or fiscal policy 
measures to correct different problems created by business-cycle instability are of two basic 
types namely, expansionary fiscal policy and contractionary fiscal policy.  
a)  Expansionary Fiscal Policy 
Expansionary fiscal policy is designed to stimulate the economy during the contractionary 
phase of a business cycle or when there is an anticipation of a business cycle contraction. A 
recession is said to occur when the overall economic activity declines, or in other words, when 
the economy ‘contracts’.  A ‘demand-deficient’ recession sets in with a period of falling real 
GDP, low aggregate demand and reduced consumer spending and rising unemployment. To 
combat such a slump in overall economic activity, the government can resort to expansionary 
fiscal policies. We may technically refer to this as a policy measure to close a ‘recessionary 
gap’. How does the government achieve this?  
• The government may cut all types of taxes, direct and indirect, leaving the taxpayers 
with extra money to spend so that there is more purchasing power and more demand 
for goods and services. Consequently aggregate demand, output and employment 
increase.  
• An increase in government expenditure (discussed in detail below) will pump money 
into the economy and increase aggregate demand. This in turn will increase output 
and employment. 
© The Institute of Chartered Accountants of India
 1.75 
 
 
 7.75 
PUBLIC FINANCE 
• A combination of increase in government spending and decrease in personal income 
taxes  and/or business taxes 
While resorting to expansionary fiscal policy, the government may run into budget deficits 
because tax cuts reduce government income and the government expenditures exceed tax 
revenues in a given year. 
b)  Contractionary fiscal policy 
Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. 
Contractionary fiscal policy is designed to restrain the levels of economic activity of the 
economy during an inflationary phase or when there is anticipation of a business-cycle 
expansion which is likely to induce inflation. Contractionary fiscal policy refers to the 
deliberate policy of government applied to curtail aggregate demand and consequently the 
level of economic activity. In other words, it is fiscal policy aimed at eliminating an ‘inflationary 
gap’.  In other words, if the state of the economy is such that its growth rate is extraordinarily 
high causing inflation and asset bubbles, contractionary fiscal policy can be used to confine it 
into sustainable levels.  
Contractionary fiscal policy works through: 
• Decrease in government spending: With decrease in government spending, the total 
amount of money available in the economy is reduced which in turn has the effect of 
reducing the aggregate demand.  
• Increase in personal income taxes and/or business taxes: An increase in personal 
income taxes reduces disposable incomes leading to fall in consumption spending and 
aggregate demand. An increase in taxes on business profits reduces the surpluses 
available to businesses, and as a result, firms’ investments shrink causing aggregate 
demand to fall. Increased taxes also dampen the prospects of profits of potential 
entrants who will respond by holding back fresh investments.   
• A combination of decrease in government spending and increase in personal income 
taxes and/or business taxes. 
Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a 
larger budget surplus.    
We have understood in general that governments influence the economy through their 
policies in respect of taxation, expenditure and borrowing. To sum up: 
• during inflation or when there is excessive levels of utilization of resources, fiscal policy 
aims at controlling excessive aggregate spending, and  
© The Institute of Chartered Accountants of India
Page 5


1.  
  
BUSINESS ECONOMICS 
 
 7.72 
LEARNING OUTCOMES 
UNIT – 4: FISCAL POLICY 
 
 
 
 
After studying this Chapter, you will be able to – 
• define fiscal policy and list out its objectives 
• explain the various instruments of fiscal policy 
• describe the expansionary and contractionary fiscal policies  
• elucidate the limitations fiscal policy 
 
 
 
4.1 INTRODUCTION  
The governments of all countries pursue numerous policies to accomplish their economic 
goals such as rapid economic growth, equitable distribution of wealth and income, reduction 
of poverty, price stability, exchange rate stability, full-employment, balanced regional 
development etc.  Government budget is one among the most powerful instruments of 
economic policy. The important tools in the budgetary policy could be broadly classified into 
public revenue including taxation, public expenditure, public debt and finally deficit financing 
to bridge the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into what is called 
fiscal policy. In other words, through the use of these instruments governments intend to 
favourably influence the level of economic activity of a country. These, in fact, form the subject 
matter of fiscal policy. 
Fiscal policy is the deliberate policy of the government under which it uses the instruments of 
taxation, public expenditure and public borrowing to influence both the pattern of economic 
activity and level of aggregate demand, output and employment.  Fiscal policy is in the nature 
of a demand-side policy. An economy which is producing at full-employment level does not 
require government action in the form of fiscal policy.  
CHAPTER OVERVIEW 
 
© The Institute of Chartered Accountants of India
 1.73 
 
 
 7.73 
PUBLIC FINANCE 
The classical economists held the belief that the government should not intervene in the 
economy because the market mechanism makes the economy self-adjusting and keeps the 
economy at or near the natural level of real GDP at all times. Since the economy always tends 
to have stable prices and operates at full employment where the resources are utilized at their 
full capacity, and there will be no unemployment. The government should have a balanced 
budget and any deliberate fiscal policies are unnecessary. 
The significance of fiscal policy as a strategy for achieving certain socio economic objectives 
was not recognized or widely acknowledged before 1930 due to the faith in the limited role 
of government advocated by the then prevailing laissez-faire approach. The depression 
resulted in very low aggregate demand along with high levels of unemployment.  The 
classical economics could not provide any solution to this problem. In 1936, the British 
economist John Maynard Keynes in his book ‘The General Theory of Employment, Interest, 
and Money’ advocated increase in government spending to combat the recessionary forces 
in the economy and to solve the problem of unemployment.  In recent times, especially after 
being threatened by the global financial crisis and recession, many countries have preferred 
to have a more active fiscal policy. 
4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the government, are 
derived from the aspirations and goals of the society. We have seen in our previous unit on 
market failure that it is the responsibility of the government to provide various goods and 
services like, highways, primary education healthcare etc  to ensure social welfare.  
Since nations differ in numerous aspects, the objectives of fiscal policy also may vary from 
country to country.   However, the most common objectives of fiscal policy are:  
• Achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth,  
The importance as well as order of priority of these objectives may vary from country to 
country and from time to time. For instance, while stability and equality may be the priorities 
of developed nations, economic growth, employment and equity may get higher priority in 
developing countries.  
Governments may directly as well as indirectly influence the way resources are used in an 
economy. Fiscal policy is a powerful tool for managing the economy because of its ability to 
influence the total amount of output produced viz. gross domestic product. The ability of 
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.74 
fiscal policy to influence output by affecting aggregate demand makes it a potential 
instrument for stabilization of the economy. We shall now see how this happens by 
investigating into the fundamental equation of national income accounting that measures 
gross domestic product (GDP) according to expenditures.  
GDP = C + I + G + NX 
The right side of the equation shows the different sources of aggregate spending or demand.  
We know that the market demand is influenced by government actions such as tax rates and 
government expenditure. The governments can influence the level of economic activity (GDP) 
by directly controlling G (government expenditure i.e purchases of goods and services by the 
government) and indirectly influencing C (private consumption), I (investment), and NX (net 
exports or exports minus imports), through changes in taxes, transfer payments and public 
expenditure.  
4.3 TYPES OF FISCAL POLICY  
As we are aware, while pursuing fiscal policy, the government makes deliberate attempts to 
adjust revenues, expenditures and public debt to eliminate unemployment during recession 
and to achieve price stability during in inflation. Contra cyclical fiscal policy or fiscal policy 
measures to correct different problems created by business-cycle instability are of two basic 
types namely, expansionary fiscal policy and contractionary fiscal policy.  
a)  Expansionary Fiscal Policy 
Expansionary fiscal policy is designed to stimulate the economy during the contractionary 
phase of a business cycle or when there is an anticipation of a business cycle contraction. A 
recession is said to occur when the overall economic activity declines, or in other words, when 
the economy ‘contracts’.  A ‘demand-deficient’ recession sets in with a period of falling real 
GDP, low aggregate demand and reduced consumer spending and rising unemployment. To 
combat such a slump in overall economic activity, the government can resort to expansionary 
fiscal policies. We may technically refer to this as a policy measure to close a ‘recessionary 
gap’. How does the government achieve this?  
• The government may cut all types of taxes, direct and indirect, leaving the taxpayers 
with extra money to spend so that there is more purchasing power and more demand 
for goods and services. Consequently aggregate demand, output and employment 
increase.  
• An increase in government expenditure (discussed in detail below) will pump money 
into the economy and increase aggregate demand. This in turn will increase output 
and employment. 
© The Institute of Chartered Accountants of India
 1.75 
 
 
 7.75 
PUBLIC FINANCE 
• A combination of increase in government spending and decrease in personal income 
taxes  and/or business taxes 
While resorting to expansionary fiscal policy, the government may run into budget deficits 
because tax cuts reduce government income and the government expenditures exceed tax 
revenues in a given year. 
b)  Contractionary fiscal policy 
Contractionary fiscal policy is basically the opposite of expansionary fiscal policy. 
Contractionary fiscal policy is designed to restrain the levels of economic activity of the 
economy during an inflationary phase or when there is anticipation of a business-cycle 
expansion which is likely to induce inflation. Contractionary fiscal policy refers to the 
deliberate policy of government applied to curtail aggregate demand and consequently the 
level of economic activity. In other words, it is fiscal policy aimed at eliminating an ‘inflationary 
gap’.  In other words, if the state of the economy is such that its growth rate is extraordinarily 
high causing inflation and asset bubbles, contractionary fiscal policy can be used to confine it 
into sustainable levels.  
Contractionary fiscal policy works through: 
• Decrease in government spending: With decrease in government spending, the total 
amount of money available in the economy is reduced which in turn has the effect of 
reducing the aggregate demand.  
• Increase in personal income taxes and/or business taxes: An increase in personal 
income taxes reduces disposable incomes leading to fall in consumption spending and 
aggregate demand. An increase in taxes on business profits reduces the surpluses 
available to businesses, and as a result, firms’ investments shrink causing aggregate 
demand to fall. Increased taxes also dampen the prospects of profits of potential 
entrants who will respond by holding back fresh investments.   
• A combination of decrease in government spending and increase in personal income 
taxes and/or business taxes. 
Contractionary fiscal policy should ideally lead to a smaller government budget deficit or a 
larger budget surplus.    
We have understood in general that governments influence the economy through their 
policies in respect of taxation, expenditure and borrowing. To sum up: 
• during inflation or when there is excessive levels of utilization of resources, fiscal policy 
aims at controlling excessive aggregate spending, and  
© The Institute of Chartered Accountants of India
1.  
  
BUSINESS ECONOMICS 
 
 7.76 
• during deflation or during a period of sluggish economic activity when the rate of 
utilization of resources is less, fiscal policy aims to compensate the deficiency in 
effective demand by boosting aggregate spending.  
We shall now describe the application of each of the fiscal policy tools. 
4.4 THE INSTRUMENTS OF FISCAL POLICY  
The tools of fiscal policy are taxes, government expenditure, public debt and the government 
budget. We shall discuss each of them in the following paragraphs.  
4.4.1 Government Expenditure as an Instrument of Fiscal Policy 
Government expenditure is an important instrument of fiscal policy.  Public expenditure 
includes governments’ expenditure towards consumption, investment, and transfer payments. 
Government expenditure constitutes a considerable part of the total expenditure in the 
economy. Fiscal policy relates to decisions that determine whether the government’s 
expenditure is more or less than what it receives. A reduction or increase in it may result in 
significant variations in the country’s total income. As such, public expenditure can be 
instrumental in adjusting consumption and investment to achieve full employment.  
Public expenditures are income generating and include all types of government expenditure such 
as capital expenditure on public works, relief expenditures, subsidy payments of various types, 
transfer payments and other social security benefits. Government expenditures include: 
1. current expenditures to meet the   day to day running of the government,  
2. capital expenditures which are in the form of investments made by the government in 
capital equipments and infrastructure, and  
3. transfer payments i.e. government spending which does not contribute to GDP because 
income is only transferred from one group of people to another without any direct 
contribution from the receivers. 
Government may spend money on performance of its large and ever-growing functions and 
also for deliberately bringing in stabilization.   
During a recession, it may   initiate a fresh wave of public works, such as construction of roads, 
irrigation facilities, sanitary works, ports, electrification of new areas etc. Government 
expenditure involves employment of labour as well as purchase of multitude of goods and 
services. These expenditures directly generate incomes to labour and suppliers of materials 
and services. Apart from the direct effect, there is also indirect effect in the form of working 
of multiplier. The incomes generated are spent on purchase of consumer goods. The   extent 
© The Institute of Chartered Accountants of India