FISCAL POLICY TO CURB INFLATION

Definition: Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are change in the level and composition of taxation and govt spending in various sectors. The control of inflation has become one of the dominant objectives of government economic policy in many countries. Effective policies to control inflation need to focus on the underlying causes of inflation in the economy. For example if the main cause is excess demand for goods and services, then government policy should look to reduce the level of aggregate demand. If cost-push inflation is the root cause, production costs need to be controlled for the problem to be reduced. Fiscal policy increases the rate of leakages from the circular flow and reduces injections into the circular flow of income and will reduce demand pull inflation at the cost of slower growth and unemployment. Advantages of using fiscal policy are that it can significantly impact the national income and therefore have immediate effect on the economy. In addition, taxes on negative externalities decrease consumption of negative externalities or demerit goods. Similarly, subsidizing merit goods or public goods will increase the consumption. Another advantage is that tax cuts on wages encourage people to work and therefore, shift the long run aggregated supply curve to the right. Lastly, different rate of taxes on different levels of income reduces gap between the rich and the poor. Not only controlling aggregated demand, fiscal policy in long term can benefit the society in many different ways. However, there are some disadvantages of fiscal policy. One of them is its inflexibility. Changes in direct taxes or government spending may take considerable time because of both political and moral reasons. For example, taxing rich people more than the others might be unfair for them. Another disadvantage of fiscal policy is that another problem can rise when solving the other. For example, stimulating aggregated demand to decrease the demand-deficient unemployment may worsen inflation because right shift in aggregated demand will cause rise in price level. Reversely, decreasing aggregated demand in order to decrease inflation will cause demand-deficient unemployment.

I think fiscal policy is not better strategy to curb inflation because of following: Fiscal policy has a very important affect on the division of total output. This is one major negative effect of fiscal policy. Recall that the tools of fiscal policy are taxes and government spending. When the government increases government spending, there should be an indirect increase in output, as mitigated by the government spending multiplier. In reality, government spending does not change output as the government spending multiplier would seem to indicate. It does, instead, significantly change the interest rate. A rise in the interest rate has a strong affect on investment. That is, as the interest rate rises, investment falls. This is because the interest rate is the opportunity cost of holding money, and as this increases, taking out loans becomes relatively less attractive. When the government increases spending, the interest rate rises and investment falls. This is called crowding out. That is, increases in government spending tend to replace, or crowd out, private investment. This works because the total level of output is fixed by the factors of production, thus causing there necessarily to be an equal and opposite change from an increase in government purchases. Because investment is more sensitive to interest rates than either consumption or net exports, investment takes the primary hit from the fiscal policy change. For this reason, crowding out always occurs when expansionary fiscal policy is used. In the long run, this crowding out may hamper economic growth since investment affects the factors of production, which do affect total output. When taxes decrease, consumption immediately rises because disposable income rises. But, since total output is fixed by the factors of production and government spending is fixed by fiscal policy, a change in consumption is met by and equal and opposite change in investment. Here again the case exists where a change in fiscal policy crowds out investment. In this way, a trade off is created between the short run and long run effects of fiscal policy upon the economy due to government spending and taxes replacing, or crowding out, private investment. KONGANDLA RAVITEJA (PGP/SS/12-14/ISBE)