FISCAL RESPONSIBILTY AND BUDGET MANAGEMENT

Fiscal Deficit and Macroeconomics

HIMACHAL PRADESH NATIONAL LAW UNIVERSITY

SUBMITTED BY: SUBMITTED TO:

AYUSH THAKUR DR. DEEPIKA GAUTAM

1020202137 ASSISTANT PROFESSER

4TH SEMESTER
[Link]
 ACKNOWLEDGEMENT

I wish to take this opportunity to offer my sincere gratitude to my academic supervisor, Dr

Deepika Gautam, Assistant Professor, Himachal Pradesh National Law University, Shimla.
Without his kind direction and proper guidance, this study would have never come to fruition.

I am also greatly indebted to Himachal Pradesh National Law University’s e-library resources
for providing me with the necessary online subscriptions in order to conduct this research
which helped me in making this assignment, especially in these trying times when the
physical resources of the library are inaccessible.

Last but not the least; I would want to thank everyone who guided me throughout the process
of making this study a successful venture.
 INDEX OF AUTHORITIES

1) Introduction

2) What is Fiscal Policy

 Expansionary Fiscal Policy

 Contradictory Fiscal Policy

3) Fiscal Policy effects on Macroeconomics factors

 Inflation
 National Income
 Investments
 Exchange Rate
 Monetary Policy

4) Conclusion

5) Bibliography
 Introduction

Fiscal deficit is an important topic among the economist regarding its causes and effects on
the economy of a country. The difference between the revenues and expenditure of the
government is the fiscal deficit. The government of a country generally has two types of
revenue in its budgetary plan, one is tax and another is non-tax revenue (like duties, fees, and
other duties). On the other hand, government expenditures of a country may include material
consumption of the public sector, salaries of government employees, depreciation of fixed
national capital, as well as various types of transfer to the population. The total revenue and
expenditure of the government seldom coincide. The difference between the two is the
negative fiscal imbalance or the positive fiscal imbalance, which is called the budget deficit
or surplus, respectively. When the fiscal imbalance is positive, it means that government
revenue exceeds the costs that seem to benefit the economy. On the other hand, severe
negative financial imbalances can pose a serious problem for the economy. It is because the
expenditure or costs of the government is more than its revenue. Increasing the expenditure
means that the government took a loan from domestic or abroad. The fiscal deficit in this
situation shows that the government does not have enough income to repay its obligations. If
the country continues to spend more than it earns over time, this will put increasing pressure
on the country's macroeconomic stability. A high negative financial deficit leads to an
unpleasant scenario that the government provides additional expenses more than income
through loans. Borrowing through its impact on interest rates in the country leads to the
formation of capital. Thus, the path of sustainable long-term growth slows down the
economy. Therefore, it is well established that controlling and reducing financial imbalances
is essential to achieving long-term macroeconomic stability and sustaining economic growth
in any country.

Formulas and Measurement of Fiscal Deficit

Fiscal Deficit = Total Expenditure – Total Receipts other than Borrowings

By expanding the term Total Expenditure as Revenue Expenditure and Capital Expenditure
and Total Receipts as Revenue and Capital Receipts, we can rewrite the above formula as:

Fiscal Deficit = (Revenue Expenditure + Capital Expenditure) – (Revenue Receipts + Capital

Receipts other than borrowings)
Now by rearranging the terms:

Fiscal Deficit = (Revenue Expenditure - Revenue Receipts) + Capital Expenditure -

(Recoveries of loans + other Receipts)

What Is Fiscal Policy?

The fiscal policy describes changes to government spending and revenue behaviour to
influence economic outcomes. The government can impact the level of economic activity
(often measured by gross domestic product [GDP]) in the short term by changing its level of
spending and tax revenue. Expansionary fiscal policy, an increase in government spending, a
decrease in tax revenue, or a combination of the two, is expected to spur economic activity,
whereas contractionary fiscal policy, a decrease in government spending, an increase in tax
revenue, or a combination of the two, is expected to slow economic activity. When the
government’s budget is running a deficit (when spending exceeds revenues), fiscal policy is
said to be expansionary. When it is running a surplus (when revenues exceed spending),
fiscal policy is said to be contractionary. From a policymaker’s perspective, expansionary
fiscal policy is generally used to boost GDP growth and the economic indicators that tend to
move with GDP, such as employment and individual incomes. However, expansionary fiscal
policy also tends to affect interest rates and investment, exchange rates and the trade balance,
and the inflation rate in undesirable ways, limiting the long-term effectiveness of the
persistent fiscal stimulus. Contractionary fiscal policy can be used to slow economic activity
if policymakers are concerned that the economy may be overheating, which can cause a
recession. The magnitude of fiscal policy’s effect on GDP will also differ based on where the
economy is within the business cycle, whether it is in a recession or an expansion.

Expansionary Fiscal Policy

During a recession, aggregate demand (overall spending) in the economy falls, which
generally results in slower wage growth, decreased employment, lower business revenue, and
lower business investment. As seen during the current recession caused by the Coronavirus
Disease 2019 (COVID-19) pandemic, recessions often lead to serious negative consequences
for both individuals and businesses.

The government can replace some of the lost aggregate demand and limit the negative
impacts of a recession on individuals and businesses with the use of fiscal stimulus by
increasing government spending, decreasing tax revenue, or a combination of the two.
Government spending takes the form of both purchases of goods and services, which directly
increase economic activity, and transfers to individuals, which indirectly increase economic
activity as individuals spend those funds. Decreased tax revenue via tax cuts indirectly
increases aggregate demand in the economy. For example, an individual income tax cut
increases the amount of disposable income available to individuals, enabling them to
purchase more goods and services. Standard economic theory suggests that in the short term,
fiscal stimulus can lessen the negative impacts of a recession or hasten recovery. However,
the ability of a fiscal stimulus to boost aggregate demand may be limited due to its interaction
with other economic processes, including interest rates and investment, exchange rates and
the trade balance, and the rate of inflation.

Contractionary Fiscal Policy

As the economy shifts from a recession and into an expansion, broader economic conditions
will generally improve, whereby unemployment falls and wages and private spending
increase. With improving economic conditions, policymakers may choose to begin
withdrawing fiscal policy by decreasing the size of the deficit or potentially by applying
contractionary fiscal policy and running a budget surplus. Policymakers may choose to
withdraw fiscal stimulus for several reasons.

 First, persistent fiscal policy when the economy is near full capacity can exacerbate the
negative consequences of fiscal stimuli, such as decreasing investment, rising trade deficits,
and accelerating inflation.

 Second, decreasing the size of the budget deficit slows the growth of public debt. The
government can withdraw fiscal policy by increasing taxes, decreasing spending, or a
combination of the two.

When the government raises individual income taxes, for example, individuals have less
disposable income and decrease their spending on goods and services in response. The
decrease in spending reduces aggregate demand for goods and services, slowing economic
growth temporarily. Alternatively, when the government reduces spending, it reduces
aggregate demand in the economy, which again temporarily slows economic growth. As
such, when the government reduces the deficit, regardless of the mix of fiscal policy choices
used to do so; aggregate demand is expected to decrease in the near term. However,
withdrawing fiscal policy is expected to result in lower interest rates and more investment, a
depreciation of the U.S. dollar and a shrinking trade deficit, and a slowing inflation rate.
These effects tend to spur additional economic activity, partly offsetting the decline resulting
from withdrawing fiscal policy. Whether the decrease in aggregate demand is problematic for
overall economic performance depends on the overall state of the economy at that time.

Fiscal Policy effects on Macroeconomics factors

Inflation:

The goal of fiscal policy is to increase aggregate demand within the economy. However, if
fiscal policy is applied too aggressively or is implemented when the economy is already
operating near full capacity, it can result in an unsustainably large demand for goods and
services that the economy is unable to supply. When the demand for goods and services is
greater than the available supply, prices tend to rise, a scenario known as inflation. A rising
inflation rate can introduce distortions into the economy and impose unnecessary costs on
individuals and businesses, although economists generally view low and stable inflation as a
sign of a well-managed economy.

As such, rising inflation rates can hinder the effectiveness of fiscal policy on economic
activity by imposing additional costs on individuals and interfering with the efficient
allocation of resources in the economy. The Central Bank has some ability to limit inflation
by implementing contractionary monetary policy. If the Central Bank observes accelerating
inflation as a result of additional fiscal policy, it can counteract this by increasing interest
rates. The rise in interest rates results in a slowing of economic activity, neutralizing the
fiscal policy, and may help to slow inflation as well. Inflation has generally remained low
despite relatively high deficit spending during the 11-year expansion between the Great
Recession and the current COVID-19-induced recession. This indicates that in the near term,
the size of this potential offsetting benefit could be relatively small and even prove counter to
the Central Bank’s monetary policy strategy of targeting an average of 2-4% inflation over
time. When fiscal policy is withdrawn, aggregate demand for goods and services in the
economy also tends to shrink, which is expected to slow inflation. Economists generally view
relatively low and stable inflation as beneficial for economic growth, because businesses and
consumers are relatively certain about the future price of goods and can make efficient
decisions concerning investment and consumption over time.

National Income

The national income identity mentions that total output is obtained by adding four important
macroeconomic indicators namely, private consumption, government consumption,
investment, and net exports. The national identity is as follows:

Y = C + G + I + (X – M)

Where Y is total output (gross domestic product or national income), C is consumption

expenditure, G is Government consumption, I is the investment (gross capital formation), X
is exported and M is the imports.

In this simple framework, it is evident that a rise in ‘G’ should increase national income.
However, it depends on how well the government money has been spent. The government’s
capital spending is covered in ‘I’. An increase in government spending keeping taxes constant
will positively affect employment opportunities and income, and it finally results in an output
rise. Different schools of economic thought have varied discussions on the relationship
between fiscal deficit and the growth rate of GDP.

The neo-classical theory argues that Government dis-savings caused by a deficit in the budget
will have a detrimental effect on the growth rate. Any increase in Government borrowing
raises the interest rate, which adversely affects private investment, which in turn affects the
growth rate. Higher external borrowing to fill the investment gap adversely affects the
exchange rate and trade account, which again affects the growth rate unfavorably.

From the Keynesian perspective, Government expenditure will have a multiplier effect on
output and employment. Increased expenditure will augment aggregate demand in the
economy, which improves the profitability of private investment and leads to higher
investment. Overall, higher Government expenditure will have a positive effect on the growth
rate of the economy. According to J.M. Keynes, deficit spending is necessary during times of
depression. And in developing countries too, many policymakers have argued that deficit
financing would be an effective tool to promote economic growth given a large number of
underutilized resources (Nelson & Singh, 1994). Criticisms have cropped up against
Keynesian theory with the emergence of monetarists as mainstream economists.

Monetarists argue that fiscal policy is impotent. Fiscal policy unaccompanied by 3 an

accommodating monetary policy is powerless to influence real output (Blinder & Solow,
1974:62). The monetarists argue that deficit spending carries with it either creation of new
high-powered money, and they call it monetary policy and new bond floatation (in this case
they deny that government spending will be expansionary). Monetarists have built a single
equation model to study the behaviour of the economy. The model is as follows:

Yt = f (Gt, Tt, Mt, Zt)

Where Y is GDP or output, G summarizes government expenditure actions, T includes tax

variables, M combines monetary policy actions and Z includes all other factors which
influence total spending.

Blinder and Solow (1974) criticized the monetarist’s single equation model as it was wrongly
specified and the serious reason was that they treated monetary and fiscal policy as
exogenous. Term exogenous means that it is determined outside the economic system and in
statistical terms, it is independent of error terms. Later on, a framework consisting of
Keynesian theory and monetarists’ theory was developed by J R Hicks and named as IS-LM
curve framework. The ultimate effect of shifts in the IS-LM curve will be on aggregate
demand in the economy. When the fiscal policy is expansionary i.e., when expenditure
increases or tax decreases, the IS curve shifts rightwards. An increase in real government
expenditure leads to a rise in aggregate demand and real output. However, the government
expenditure’s effect depends on how the amount is financed. The effect and its magnitude
will be different when it is financed by printing money and financed through bonds. The IS-
LM framework treats fiscal and monetary policy as exogenous but determines the
endogenous variables like interest rate and output.

Diverging from the above-mentioned theories completely, Ricardo argued that fiscal deficits
are viewed as neutral in terms of their impact on growth. From in Ricardian perspective, the
financing of the budget by deficit is done only to postpone taxes. The deficit in any current
period is exactly equal to the present value of future taxation that is required to pay off the
increment to debt resulting from the deficit. In other words, government spending must be
paid for, now or later, and the present value of spending must be equal to the present value of
tax and non-tax revenues. The concept of fiscal deficit is irrelevant in the Ricardian
perspective. All theories have different views on the relationship between deficit, government
expenditure, and growth.

Investment and Interest Rates

To engage in fiscal policy by either increasing spending or decreasing tax revenue, the
government must increase the size of its deficit and borrow money to finance that stimulus.
This can lead to an increase in interest rates and subsequent decreases in investment and
some consumer spending. This rise in interest rates may therefore offset some portion of the
increase in economic activity spurred by fiscal stimulus. At any given time, there is a limited
supply of loanable funds available for the government and private parties to borrow from a
global pool of savings. If the government begins to borrow a larger portion of this pool of
savings, it increases the demand for these funds. As demand for loanable funds increases,
without any corresponding increase in the supply of these funds, the price to borrow these
funds (also known as interest rates) increases. Rising interest rates generally depress
economic activity, as they make it more expensive for businesses to borrow money and invest
in their firms. Similarly, individuals tend to decrease so-called interest-sensitive spending, the
spending on goods and services that require a loan, such as cars, homes, and large appliances
when interest rates are relatively higher. The process through which rising interest rates
diminish private sector spending is often referred to as crowding out. However, the degree to
which crowding out occurs is partially dependent on where the economy is within the
business cycle: either in a recession or in a healthy expansion. During a recession, crowding
out tends to be smaller than during a healthy economic expansion due to already depressed
demand for investment and interest-sensitive spending. Because demand for loanable funds is
already depressed during a recession, the additional demand created by government
borrowing does not increase interest rates as much and therefore does not crowd out as much
private spending as it would during an economic expansion. Withdrawing fiscal stimulus is
likely to put downward pressure on domestic interest rates, which encourages additional
spending and investment, increasing economic activity. When the government decreases its
budget deficit, the demand for loanable funds decreases because the government reduces the
amount of those funds it is borrowing. The decrease in demand for loanable funds decreases
the price to borrow those funds (i.e., interest rates decline). Declining interest rates encourage
increased business investment into new capital projects and consumer spending into durable
goods by reducing the cost of borrowing.

Exchange Rates and the Trade Balance

Fiscal stimulus can cause interest rates to rise. As domestic rates rise relative to foreign rates,
investors tend to seek out U.S. investments because the relatively high-interest rates mean
relatively high returns on investment. However, as foreign capital flows into the United
States, this can push rates back down as the supply of loanable funds increases, potentially
offsetting the initial rise in rates caused by the stimulus. Nonetheless, increased demand for
U.S. investment from foreign investors also means that the demand for the dollar would
increase as foreign investors exchanged various foreign currencies for dollars that they could
then invest. This increased demand for dollars increases the value of the dollar, referred to as
appreciation. When the dollar appreciates it becomes more expensive relative to other
currencies, it takes more foreign currency to “purchase” one dollar, and, therefore, U.S.
goods and services become more expensive relative to foreign goods and services, causing
exports to decrease and imports to increase. The result is generally an increase in the U.S.
trade deficit, as exports decrease and imports from abroad increase in the United States. An
increasing trade deficit, all else equal, means that consumption and production of domestic
goods and services are falling, partly offsetting the increase in aggregate demand caused by
the stimulus. However, during a recession interest rates are less likely to rise, or are likely to
increase to a lesser degree, due to already depressed demand for investment and spending
within the economy. Without rising interest rates, or if they increase to a lesser degree, the
associated increase in the trade deficit is also likely to be smaller. Withdrawing fiscal
stimulus would also be expected to result in a depreciation of the U.S. dollar and an improved
trade balance with the rest of the world. Assuming the shrinking deficit causes a decline in
U.S. interest rates relative to interest rates abroad, individuals in the United States and abroad
would rather make financial investments outside of the United States to benefit from those
higher interest rates. Individuals shifting their investments outside the United States must first
exchange their U.S. dollars for foreign currency, which decreases the value of the U.S. dollar
relative to foreign currencies. As the U.S. dollar depreciates, foreign goods and services
become relatively more expensive for U.S. residents, and U.S. goods and services become
relatively less expensive for foreign individuals. This generally results in an improved trade
balance as foreign demand for U.S. goods and services (exports) increases and domestic
demand for foreign goods and services (imports) decreases. An increase in net exports
additionally directly increases the size of the U.S. economy, at least partially negating the
decrease in aggregate demand caused by the withdrawal of stimulus. In other words, a higher
interest rate will attract an inflow of foreign financial capital, and appreciate the exchange
rate in response to the increase in demand for U.S. dollars by foreign investors and a decrease
in the supply of U. S. dollars. Because of higher interest rates in the United States, Americans
find U.S. bonds more attractive than foreign bonds. When Americans are buying fewer
foreign bonds, they are supplying fewer U.S. dollars. The depreciation of the U.S. dollar
leads to a larger trade deficit (or reduced surplus). The connections between inflows of
foreign investment capital, interest rates, and exchange rates are all just different ways of
drawing the same economic connections: a larger budget deficit can result in a larger trade
deficit, although the connection should not be expected to be one-to-one.

Monetary Policy:

Fiscal policy is often distinguished from monetary policy, in this fiscal policy deals with
taxation and government disbursement and is commonly administered by a government under
the laws of a legislature, whereas monetary policy deals with the money supply, lending
rates, and interest rates and is commonly administered by a central bank. Fiscal policy deals
with the taxation and expenditure selections of the government. Monetary policy deals with
the supply of cash within the economy and also the rate of interest. These are the main policy
approaches utilized by economic managers to steer the broad aspects of the economy. In most
modern economies, the government deals with fiscal policy whereas the central bank is
answerable for monetary policy. The fiscal policy consists of several components. These
include tax policy, expenditure policy, investment or withdrawal ways, and debt or surplus
management. Economic policy is a vital constituent of the economic framework of a country
and is thus intimately connected with its general economic policy strategy. The fiscal policy
additionally feeds into economic trends and influences monetary policy. Once the
government receives more than it spends, it has a surplus. If the government spends more
than it receives it runs a deficit. To satisfy the extra expenditures, it needs to borrow from
domestic or foreign sources, draw upon its exchange reserves or print an equivalent quantity
of cash. This tends to influence alternative economic variables.

Conclusion

During the initial time of the Nehru era, India was in bad shape. Heavy industry sectors have
a long gestation period so, to upturn the economy one of the bold decisions was taken up in
the second five-year plan in which long-term benefits plans were given importance rather
than short-term plans. Mahalanobis model was implemented in which the investment was
made in the heavy sectors like steel, iron manufacturing, heavy machinery manufacturing,
etc. so that India becomes self-sustainable. Employment level increased and wealth of
individuals and nation increased. Largely, this model proved to be beneficial. Therefore, we
can relate this situation to the present scenario of India where the GDP is showing negative
results, and to turn the GDP figures positive GOI has increased investment in the
infrastructure sector leading to the growth in the demand for labor. Simultaneously, there will
be demand for other commodities like cement, steel, power, and many other related
commodities and this domino effect will ultimately lead to an increase in the creation of
wealth for both individual and nation in long term. Apart from this, the economy is now
operational despite pandemics and may grow at 11.5% during 2021 as per the projection by
IMF. Being a Bright star in Global Economy, the dream of a 5trillion dollar economy for
India may come true a little late maybe by 2026 if the fiscal instruments to boost investment
and employment will be used judiciously. This has already been projected by IMF and the
Fiscal Policy of GoI is very much aligned to the Union Budget 2021 and IMF projection to
achieve the goal. Now this year fiscal plans mean that high spending will support the high
demand and help recovery and since the more fund is allocated for capital expenditure so this
spending may not be inflationary but if the credit demand recovers and if the government
borrowing will be large then, the government borrowing may crowd out the private sector
investment. So, the government has a broad vision for the fiscal position of India and has laid
down strategic plans to back up the fiscal deficit of 6.8% i.e., via monetization of assets,
disinvestment of BPCL, Shipping Corporation of India, Container Corporation of India, etc.,
and even planning to raise money from financial markets by issuing bonds or IPO, for
example planning to launch IPO of Life corporation of India in FY 22. We cannot neglect the
fact that a high fiscal deficit leads to a crisis in an economy & can leave a country in a slump
the way the 1991 Indian economic crisis created a hurdle in the growth of the nation.
However, aiming for a high fiscal deficit is not always a bane for a nation it can prove to be
fruitful only if the required investments and policy implementation take place in the right
direction.

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