ECO LEC

1. Fiscal Policy
EC-422
Lecture - 7
(November 01, 2023)

2. Public Expenditure and Fiscal Policy
 Before 1930, an approach of limited government, or
laissez-faire, prevailed. With the stock market crash and
the Great Depression, policymakers pushed for
governments to play a more proactive role. When
policymakers seek to influence the economy, they have
two main tools at their disposal—monetary policy and
fiscal policy.
 This unit explore how public expenditure are used to
achieve fiscal objectives of the government.

3. Public Expenditure and Working of
the Fiscal Policy
 Governments influence the economy by changing the level and
types of taxes, the extent and composition of spending, and the
degree and form of borrowing. Governments directly and indirectly
influence the way resources are used in the economy. The basic
equation of national income accounting helps show how this
happens:
GDP = C + I + G + NX
 On the left side is gross domestic product (GDP)—the value of all
final goods and services produced in the economy. On the right side
are the sources of aggregate spending or demand—private
consumption (C), private investment (I), purchases of goods and
services by the government (G), and exports minus imports (net
exports, NX). This equation makes it evident that governments affect
economic activity (GDP), controlling G directly and influencing C,
I, and NX indirectly, through changes in taxes, transfers, and
spending.

4. Public Expenditure and Working of
the Fiscal Policy
 Fiscal policy that increases aggregate demand directly
through an increase in government spending is called
expansionary policy.
 By contrast, fiscal policy is considered contractionary or
tight if it reduces demand via lower spending.
 Besides providing goods and services, fiscal policy
objectives vary. In the short term, governments may focus
on macroeconomic stabilization for example, stimulating
an ailing economy, combating rising inflation, or helping
reduce external vulnerabilities. In the longer term, the aim
may be to foster sustainable growth or reduce poverty
with actions on the supply side to improve infrastructure or
education.

5. Macroeconomic Stability
 Macroeconomic Stability is a situation where economy
grows in a steady and durable way when inflation is under
control, financial system is sound, public finances are in
good shape, economy is resilient to shocks and is not likely
to face crisis.
 The term "Macroeconomic Stability" describes a national
economy that has minimized vulnerability to external
shocks, which in turn increases its prospects for sustained
growth. It is a necessary, but insufficient requirement for
growth.

6. Economic Stability Depends upon
Three factors:
1. Factors External to Economy: Stability depends upon
the factors that are external to the economy and that
the economy alone cannot control. For example,
emergence of crisis in economic partners, or the natural
disasters which destroy physical infrastructure e.g.
Floods, COVID-19, Russia-Ukraine War
2. Factors Intrinsic to Economy: Stability depends upon
factors that are intrinsic to the economy and that the
economy cannot change or can be changed but only
over the time in long run. For example, the state of
economic development, population dynamics, the
presence of natural resources.

7. Economic Stability Depends upon
Three factors:
3. Economic Policies and Collective Actions:
Economic policies are levers that a country has and
can use to affect the state of economy. The
classification of these policies is as follows:
 Fiscal Policy: Which is government’s use of revenue and
spending to affect the economy.
 Monetary and Exchange Rate Policies: It refers to what
central bank does to influence the amount of money in the
economy, overall availability of credit, interest rate and the
exchange rate
 Structural Policies: Refers to design of all type of regulations
and institutions which determine how the economy works
actually.

8. Importance of Economic Stability
 Consider opposite situation i.e. when the economy
grows or contracts in a very erratic way, prices spiral out
of control, financial system is shaky, public finances are
in bad shape or the economy consumes beyond its
means. In this situation when the economy is not stable,
it would be difficult for firms & people to make decision
about their future investment in physical or human
capital, whether or not to buy a house, borrow or lend
money.
 “Economic instability actually makes everyone worse-off.

9. Importance of Economic Stability:
Example from Eurozone
 Convergence criteria (or "Maastricht criteria") are criteria,
based on economic indicators, that European Union (EU)
member states must fulfil to enter the euro zone and that
they must continue to respect once entered.
 According to the Maastricht criteria, stability is measured by
five variables.
1) Low and stable inflation: indicates healthy demand in the
marketplace; however, high or unstable inflation threaten growth.
High inflation alters the value of long term contracts. Volatile inflation
creates uncertainty in the market place, increasing risk premiums.
Since many tax rates are adjusted by average inflation, volatile
inflation can severely alter government revenues and individual
liabilities. The Maastricht criteria capped inflation at 3%.

10. Importance of Economic Stability:
Example from Eurozone
2) Low long-term interest rates: Reflect stable future inflation expectations. While
current inflation rates may be acceptably low, high long-term rates imply higher
inflation to come. Keeping these rates low implies that the economy is stable and
is likely to remain so. The Maastricht criteria restricted long-term rates to the
range of 9%.
3) Low national debt relative to GDP: indicates that the government will have the
flexibility to use its tax revenue to address domestic needs instead of paying
foreign creditors. Additionally, a low national debt permits lenient fiscal policy in
times of crisis. The Maastricht criteria capped debt at 60% of GDP.
4) Low deficits: prevent growth in the national debt. When government
expenditure exceeds revenue the deficit is financed by selling bonds.
Furthermore, when the government offers debt in the market, it drives up interest
rates and consequently debt service increases. The Maastricht criteria capped
the deficit at 3% of GDP
5) Currency stability: allows importers and exporters to develop long-term growth
strategies and in reduces investors' needs to manage exchange-rate risk. For
national accounting, currency stability reduces the threat posed by debt issue in
foreign coin. The Maastricht criteria permitted fluctuation of at most 2.5%.

11. Thank you