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Project Report on

BALANCE OF PAYMENT ADJUSTMENT

THROUGH FISCAL POLICY- AN OBSERATION

Submitted by

HEMANT DHANRAJ SONAWANE

MASTERS IN COMMERCE SEM-II

(ECONOMICS OF GLOBAL TRADE AND FINANCE)

ACADEMIC YEAR 2013-2014

Roll No.6272

Submitted to

UNIVERSITY OF MUMBAI

MULUND COLLEGE OF COMMERCE

S.N ROAD, MULUND (W)-MUMBAI 400 080

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DECLARATION

I, Mr. HEMANT DHANRAJ SONAWANE, the student of MULUND

COLLEGE OF COMMERCE, S.N Road, Mulund (W), Mumbai 400 080,

studying in M.Com part-I (ECONOMICS OF GLOBAL TRADE AND FINANCE)

here by declaring that I have completed this project “BALANCE OF PAYMENT

ADJUSTMENT THROUGH FISCAL POLICY- AN OBSERATION” during the

academic year 2013-14. The information submitted is true and original of best

of my knowledge.

Date: Signature:

Place: MUMBAI

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CERTIFICATE

I, Prof. Mrs.C.K. Kaul/ S.A. Pawar, here by certify that Mr. HEMANT

DHANRAJ SONAWANE of MULUND COLLEGE OF COMMERCE,

S.N Road, Mulund (W), Mumbai 400 080, studying in M.Com part-I

(ECONOMICS OF GLOBAL TRADE AND FINANCE) here by declaring that I have

completed this project “BALANCE OF PAYMENT ADJUSTMENT THROUGH

FISCAL POLICY- AN OBSERATION” during the academic year 2013-14. The

information submitted is true and original of best of my knowledge.

Signature: (Project Guide) Signature (Principal)

Signature: (Co-Ordinator) Signature: (External Examiner)

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ACKNOWLEDGEMENT

I would like to express my sincere gratitude to Principal of Mulund College of

Commerce DR. (Mrs.) Parvathi Venkatesh, Course - Coordinator Prof. Rane and our

project guide Mrs.C.K. Kaul/ S.A. Pawar, for providing me an opportunity to do

my project work on “BALANCE OF PAYMENT ADJUSTMENT THROUGH

FISCAL POLICY- AN OBSERATION”. I also wish to express my sincere gratitude

to the non - teaching staff of our college. I sincerely thank to all of them in helping

me to carrying out this project work. Last but not the least, I wish to avail myself of

this opportunity, to express a sense of gratitude and love to my friends and my

beloved parents for their mutual support, strength, help and for everything.

Date: Name: HEMANT DHANRAJ SONAWANE

Reg. No. Signature:

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TABLE OF CONTENTS

SR. NO CONTENTS PAGE NO.

1 CHAPTER 1

INTRODUCTION :

BALANCE OF PAYMENTS

FISCAL POLICY

6

2 CHAPTER 2

HISTORY OF BALANCE OF PAYMENTS ISSUES

11

3 CHAPTER 3

THE IMPACT OF FISCAL POLICY ON THE BALANCE OF

PAYMENTS

ECONOMIC EFFECTS OF FISCAL POLICY

20

4 CHAPTER 4

THE OBJECTIVES OF ECONOMIC POLICY AND THE

BALANCE OF PAYMENTS

OBJECTIVES OF FISCAL POLICY

ALTERNATIVE FISCAL POLICIES

NATURE AND TECHNIQUES

25

5 CHAPTER 5

APPROACHES TO FISCAL POLICY

ROLE O FISCAL POLICIES

32

6 CHAPTER 6

SUMMARY

REFERENCES

BIBLIOGRAPHY

36

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CHAPTER 1

INTRODUCTION

BALANCE OF PAYMENTS

Balance of payments (BoP) accounts are an accounting record of all monetary

transactions between a country and the rest of the world.[1] These transactions include

payments for the country's exports and imports of goods, services, financial capital,

and financial transfers. The BOP accounts summarize international transactions for a specific

period, usually a year, and are prepared in a single currency, typically the domestic currency

for the country concerned. Sources of funds for a nation, such as exports or the receipts

of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for

imports or to invest in foreign countries, are recorded as negative or deficit items.

When all components of the BOP accounts are included they must sum to zero with

no overall surplus or deficit. For example, if a country is importing more than it exports, its

trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways

– such as by funds earned from its foreign investments, by running down central bank

reserves or by receiving loans from other countries.

While the overall BOP accounts will always balance when all types of payments are

included, imbalances are possible on individual elements of the BOP, such as the current

account, the capital account excluding the central bank's reserve account, or the sum of the

two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while

deficit nations become increasingly indebted. The term "balance of payments" often refers to

this sum: a country's balance of payments is said to be in surplus (equivalently, the balsance

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of payments is positive) by a specific amount if sources of funds (such as export goods sold

and bonds sold) exceed uses of funds (such as paying for imported goods and paying for

foreign bonds purchased) by that amount. There is said to be a balance of payments deficit

(the balance of payments is said to be negative) if the former are less than the latter.

Under a fixed exchange rate system, the central bank accommodates those flows by

buying up any net inflow of funds into the country or by providing foreign currency funds to

the foreign exchange market to match any international outflow of funds, thus preventing the

funds flows from affecting the exchange rate between the country's currency and other

currencies. Then the net change per year in the central bank's foreign exchange reserves is

sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange

rate system include a managed float where some changes of exchange rates are allowed, or at

the other extreme a purely floating exchange rate (also known as a purely flexible exchange

rate). With a pure float the central bank does not intervene at all to protect or devalue

its currency, allowing the rate to be set by the market, and the central bank's foreign exchange

reserves do not change.

Historically there have been different approaches to the question of how or even

whether to eliminate current account or trade imbalances. With record trade imbalances held

up as one of the contributing factors to the financial crisis of 2007–2010, plans to address

global imbalances have been high on the agenda of policy makers since 2009.

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FISCAL POLICY

In economics and political science, 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 changes in the level and composition of taxation and

government spending in various sectors. These changes can affect the

following macroeconomic variables in an economy:

Aggregate demand and the level of economic activity;

The distribution of income;

The pattern of resource allocation within the government sector and relative to the private

sector.

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STANCES OF FISCAL POLICY

The three main stances of fiscal policy are:

Neutral fiscal policy is usually undertaken when an economy is in

equilibrium. Government spending is fully funded by tax revenue and overall the budget

outcome has a neutral effect on the level of economic activity.

Expansionary fiscal policy involves government spending exceeding tax revenue, and is

usually undertaken during recessions.

Contractionary fiscal policy occurs when government spending is lower than tax

revenue, and is usually undertaken to pay down government debt.

However, these definitions can be misleading because, even with no changes in spending or

tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues

and of some types of government spending, altering the deficit situation; these are not

considered to be policy changes. Therefore, for purposes of the above definitions,

"government spending" and "tax revenue" are normally replaced by "cyclically adjusted

government spending" and "cyclically adjusted tax revenue". Thus, for example, a

government budget that is balanced over the course of the business cycle is considered to

represent a neutral fiscal policy stance.

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Methods of funding

Governments spend money on a wide variety of things, from the military and police to

services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Taxation

Seigniorage, the benefit from printing money

Borrowing money from the population or from abroad

Consumption of fiscal reserves

Sale of fixed assets (e.g., land)

Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged

securities. These pay interest, either for a fixed period or indefinitely. If the interest and

capital requirements are too large, a nation may default on its debts, usually to foreign

creditors. Public debt or borrowing refers to the government borrowing from the public.

Consuming prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local currency or

any financial instrument that may be traded later once resources are needed; notice, additional

debt is not needed. For this to happen, the marginal propensity to save needs to be strictly

positive.

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CHAPTER 2

HISTORY OF BALANCE OF PAYMENTS ISSUES

Historically, accurate balance of payments figures were not generally available.

However, this did not prevent a number of switches in opinion on questions relating to

whether or not a nations government should use policy to encourage a favourable balance.

Pre-1820: mercantilism[edit]

Up until the early 19th century, international trade was generally very small in

comparison with national output, and was often heavily regulated. In the Middle Ages,

European trade was typically regulated at municipal level in the interests of security for local

industry and for established merchants. From about the 16th century, mercantilism became

the dominant economic theory influencing European rulers, which saw local regulation

replaced by national rules aiming to harness the countries' economic output Measures to

promote a trade surplus such as tariffs were generally favoured. Power was associated with

wealth, and with low levels of growth, nations were best able to accumulate funds either by

running trade surpluses or by forcefully confiscating the wealth of others. Rulers sometimes

strove to have their countries outsell competitors and so build up a "war chest" of gold.

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1820–1914: free trade

Gold was the primary reserve asset during the gold standard era.

From the late 18th century, mercantilism was challenged by the ideas of Adam

Smith and other economic thinkers favouring free trade. After victory in the Napoleonic

wars Great Britain began promoting free trade, unilaterally reducing her trade tariffs.

Hoarding of gold was no longer encouraged, and in fact Britain exported more capital as a

percentage of her national income than any other creditor nation has since. Great Britain's

capital exports further helped to correct global imbalances as they tended to be counter

cyclical, rising when Britain's economy went into recession, thus compensating other states

for income lost from export of goods.

According to historian Carroll Quigley, Great Britain could afford to act

benevolently in the 19th century due to the advantages of her geographical location, its naval

power and economic ascendancy as the first nation to enjoy an industrial revolution. A view

advanced by economists such as Barry Eichengreen is that the first age

of Globalization began with the laying of transatlantic cables in the 1860s, which facilitated a

rapid increase in the already growing trade between Britain and America.

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A gold standard enjoyed wide international participation especially from 1870, further

contributing to close economic integration between nations. The period saw substantial global

growth, in particular for the volume of international trade which grew tenfold between 1820

and 1870 and then by about 4% annually from 1870 to 1914. BOP crises began to occur,

though less frequently than was to be the case for the remainder of the 20th century. From

1880 to 1914, there were approximately 8 BOP crises and 8 twin crises – a twin crises being

a BOP crises that coincides with a banking crises.

1914–1945: deglobalisation

The favorable economic conditions that had prevailed up until 1914 were shattered by

the first world war, and efforts to re-establish them in the 1920s were not successful. Several

countries rejoined the gold standard around 1925. But surplus countries didn't "play by the

rules", sterilising gold inflows to a much greater degree than had been the case in the pre-war

period. Deficit nations such as Great Britain found it harder to adjust by deflation as workers

were more enfranchised and unions in particular were able to resist downwards pressure on

wages. During the Great Depression most countries abandoned the gold standard, but

imbalances remained an issue and international trade declined sharply. There was a return to

mercantilist type "beggar thy neighbour" policies, with countries competitively devaluing

their exchange rates, thus effectively competing to export unemployment. There were

approximately 16 BOP crises and 15 twin crises (and a comparatively very high level of

banking crises.)

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1945–1971: Bretton Woods

Main article: Bretton Woods system

Following World War II, the Bretton Woods institutions (the International Monetary

Fund and World Bank) were set up to support an international monetary system designed to

encourage free trade while also offering states options to correct imbalances without having

to deflate their economies. Fixed but flexible exchange rates were established, with the

system anchored by the dollar which alone remained convertible into gold. The Bretton

Woods system ushered in a period of high global growth, known as the Golden Age of

Capitalism, however it came under pressure due to the inability or unwillingness of

governments to maintain effective capital controls and due to instabilities related to the

central role of the dollar.

Imbalances caused gold to flow out of the US and a loss of confidence in the United

States ability to supply gold for all future claims by dollar holders resulted in escalating

demands to convert dollars, ultimately causing the US to end the convertibility of the dollar

into gold, thus ending the Bretton Woods system. The 1945–71 era saw approximately 24

BOP crises and no twin crises for advanced economies, with emerging economies seeing 16

BOP crises and just one twin crises.

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1971–2009: transition, Washington Consensus, Bretton Woods II

Manmohan Singh, currently PM of India, showed that the challenges caused by

imbalances can be an opportunity when he led his country's successful economic reform

programme after the 1991 crisis.

The Bretton Woods system came to an end between 1971 and 1973. There were

attempts to repair the system of fixed exchanged rates over the next few years, but these were

soon abandoned, as were determined efforts for the U.S. to avoid BOP imbalances. Part of

the reason was displacement of the previous dominant economic paradigm – Keynesianism –

by the Washington Consensus, with economists and economics writers such as Murray

Rothbard and Milton Friedman arguing that there was no great need to be concerned about

BOP issues.

In the immediate aftermath of the Bretton Woods collapse, countries generally tried to

retain some control over their exchange rate by independently managing it, or by intervening

in the foreign exchange market as part of a regional bloc, such as the Snake which formed in

1971. The Snake was a group of European countries who tried to retain stable rates at least

with each other; the group eventually evolved into the European Exchange Rate

Mechanism (ERM) by 1979. From the mid-1970s however, and especially in the 1980s and

early 1990s, many other countries followed the US in liberalising controls on both their

capital and current accounts, in adopting a somewhat relaxed attitude to their balance of

payments and in allowing the value of their currency to float relatively freely with exchange

rates determined mostly by the market.

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Developing countries who chose to allow the market to determine their exchange rates

would often develop sizeable current account deficits, financed by capital account inflows

such as loans and investments, though this often ended in crises when investors lost

confidence. The frequency of crises was especially high for developing economies in this era

– from 1973 to 1997 emerging economies suffered 57 BOP crises and 21 twin crises.

Typically but not always the panic among foreign creditors and investors that preceded the

crises in this period was usually triggered by concerns over excess borrowing by the private

sector, rather than by a government deficit. For advanced economies, there were 30 BOP

crises and 6 banking crises.

A turning point was the 1997 Asian BOP Crisis, where unsympathetic responses by

western powers caused policy makers in emerging economies to re-assess the wisdom of

relying on the free market; by 1999 the developing world as a whole stopped running current

account deficits while the U.S. current account deficit began to rise sharply. This new form

of imbalance began to develop in part due to the increasing practice of emerging economies,

principally China, in pegging their currency against the dollar, rather than allowing the value

to freely float. The resulting state of affairs has been referred to as Bretton Woods

II. According to Alaistair Chan, "At the heart of the imbalance is China's desire to keep the

value of the yuan stable against the dollar. Usually, a rising trade surplus leads to a rising

value of the currency. A rising currency would make exports more expensive, imports less so,

and push the trade surplus towards balance.

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China circumvents the process by intervening in exchange markets and keeping the

value of the yuan depressed." According to economics writer Martin Wolf, in the eight years

leading up to 2007, "three-quarters of the foreign currency reserves accumulated since the

beginning of time have been piled up". In contrast to the changed approach within the

emerging economies, US policy makers and economists remained relatively unconcerned

about BOP imbalances. In the early to mid-1990s, many free market economists and policy

makers such as U.S. Treasury secretary Paul O'Neill and Fed Chairman Alan Greenspan went

on record suggesting the growing US deficit was not a major concern. While several

emerging economies had intervening to boost their reserves and assist their exporters from

the late 1980s, they only began running a net current account surplus after 1999.

This was mirrored in the faster growth for the US current account deficit from the

same year, with surpluses, deficits and the associated build up of reserves by the surplus

countries reaching record levels by the early 2000s and

growing year by year. Some economists such as Kenneth Rogoff and Maurice

Obstfeld began warning that the record imbalances would soon need to be addressed from as

early as 2001, joined by Nouriel Roubini in 2004, but it was not until about 2007 that their

concerns began to be accepted by the majority of economists.

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2009 and later: post Washington Consensus

Speaking after the 2009 G-20 London summit, Gordon Brown announced "the

Washington Consensus is over". There is now broad agreement that large imbalances

between different countries do matter; for example mainstream U.S. economist C. Fred

Bergsten has argued the U.S. deficit and the associated large inbound capital flows into the

U.S. was one of the causes of the financial crisis of 2007–2010. Since the crisis, government

intervention in BOP areas such as the imposition of capital controls or foreign exchange

market intervention has become more common and in general attracts less disapproval from

economists, international institutions like the IMF and other governments.

In 2007, when the crises began, the global total of yearly BOP imbalances was $1680

billion. On the credit side, the biggest current account surplus was China with approx. $362

billion, followed by Japan at $213bn and Germany at £185 billion, with oil producing

countries such as Saudi Arabia also having large surpluses. On the debit side, the US had the

biggest current account deficit at over $1100 billion, with the UK, Spain and Australia

together accounting for close to a further $300 billion.

While there have been warnings of future cuts in public spending, deficit countries on

the whole did not make these in 2009, in fact the opposite happened with increased public

spending contributing to recovery as part of global efforts to increase demand. The emphases

has instead been on the surplus countries, with the IMF, EU and nations such as the U.S.,

Brazil and Russia asking them to assist with the adjustments to correct the imbalances.

.

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Competitive devaluation after 2009

By September 2010, international tensions relating to imbalances had further

increased. Brazil's finance minister Guido Mantega declared that an "international currency

war" has broken out, with countries competitively trying to devalue their currency so as to

boost exports. Brazil has been one of the few major economies lacking a reserve currency to

abstain from significant currency intervention, with the real rising by 25% against the dollar

since January 2009.

Some economists such as Barry Eichengreen have argued that competitive

devaluation may be a good thing as the net result will effectively be equivalent to

expansionary global monetary policy. Others such as Martin Wolf saw risks of tensions

further escalating and advocated that coordinated action for addressing imbalances should be

agreed on at the November G20 summit.

Commentators largely agreed that little substantive progress was made on imbalances

at the November 2010 G20. An IMF report released after the summit warned that without

additional progress there is a risk of imbalances approximately doubling to reach pre-crises

levels by 2014.

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CHAPTER 3

THE IMPACT OF FISCAL POLICY ON THE BALANCE OF

PAYMENTS

One indicator used to determine a country's economic health is the balance of

payments. Numerous factors can directly and indirectly affect a country's current balance of

payments, including interest rates, exchange rates and the country's past and current fiscal

policy. Fiscal policy alone will not dictate a country's current balance of payments status;

however, it can affect this economic measure.

Effect of Fiscal Restraint

A policy of fiscal restraint is typically exercised when a country's economy is

operating at full capacity. In other words, the economy is apparently healthy, employment is

near capacity and inflation begins to set in as a result. The government may respond to rising

inflation by increasing taxes or reducing spending. While a number of other factors determine

the balance of payments, a fiscal policy of restraint will generally cause both the government

and consumers to slow its spending. A general decrease in overall spending can cause the

cash flow leaving the country to decrease as consumers and the government both purchase

less. This will decrease the debit side of the balance of payments.

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Effect of Fiscal Stimulus

When the economy is sluggish and unemployment is rising, a stimulus fiscal policy

may be used to jump-start the economy. By lowering taxes and increasing government

spending, demand increases and jobs are created. When more people are employed and

discretionary spending increases as a result of decreased taxes, consumers purchase more

goods. As a result, the cash flow leaving the country may increase. This increases the debit

side of the balance of payments.

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ECONOMIC EFFECTS OF FISCAL POLICY

Governments use fiscal policy to influence the level of aggregate demand in the

economy, in an effort to achieve economic objectives of price stability, full employment, and

economic growth. Keynesian economics suggests that increasing government spending and

decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing

spending & increasing taxes after the economic boom begins. Keynesians argue this method

be used in times of recession or low economic activity as an essential tool for building the

framework for strong economic growth and working towards full employment. In theory, the

resulting deficits would be paid for by an expanded economy during the boom that would

follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strong

economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits

that removing spending from the economy will reduce levels of aggregate demand and

contract the economy, thus stabilizing prices. But economists still debate the effectiveness

of fiscal stimulus. The argument mostly centers on crowding out: whether government

borrowing leads to higher interest rates that may offset the stimulative impact of spending.

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When the government runs a budget deficit, funds will need to come from public

borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt.

When governments fund a deficit with the issuing of government bonds, interest rates can

increase across the market, because government borrowing creates higher demand for credit

in the financial markets. This causes a lower aggregate demand for goods and services,

contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize

crowding out while Keynesians argue that fiscal policy can still be effective especially in

a liquidity trap where, they argue, crowding out is minimal. Some classical and neoclassical

economists argue that crowding out completely negates any fiscal stimulus; this is known as

the Treasury View which Keynesian economics rejects. The Treasury View refers to the

theoretical positions of classical economists in the British Treasury, who opposed Keynes'

call in the 1930s for fiscal stimulus. The same general argument has been repeated by some

neoclassical economists up to the present.

In the classical view, the expansionary fiscal policy also decreases net exports, which

has a mitigating effect on national output and income. When government borrowing increases

interest rates it attracts foreign capital from foreign investors. This is because, all other things

being equal, the bonds issued from a country executing expansionary fiscal policy now offer

a higher rate of return. In other words, companies wanting to finance projects must compete

with their government for capital so they offer higher rates of return. To purchase bonds

originating from a certain country, foreign investors must obtain that country's currency.

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Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand

for that country's currency increases. The increased demand causes that country's currency to

appreciate. Once the currency appreciates, goods originating from that country now cost more

to foreigners than they did before and foreign goods now cost less than they did before.

Consequently, exports decrease and imports increase.

Other possible problems with fiscal stimulus include the time lag between the

implementation of the policy and detectable effects in the economy, and inflationary effects

driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses

resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a

worker who otherwise would have been unemployed, there is no inflationary effect; however,

if the stimulus employs a worker who otherwise would have had a job, the stimulus is

increasing labor demand while labor supply remains fixed, leading to wage inflation and

therefore price inflation.

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CHAPTER 4

THE OBJECTIVES OF ECONOMIC POLICY AND THE

BALANCE OF PAYMENTS

The main objectives of economic policy are to achieve sustainable high economic

growth, full employment, price stability and balance-of-payments equilibrium. In developing

economies as well as in most industrialised countries the primary objective of economic

policy is usually to grow consistently at full production capacity (or full employment). An

economy that operates below full capacity will generate a smaller aggregate supply than

allowed by its resources and will not be able to retrieve this wealth creation in a later period.

An economy that functions at more than full capacity will normally be characterised by rising

inflation and deficits on the balance of payments.

Price stability and balance-of-payments equilibrium are in many cases regarded as

less important and as secondary objectives to high economic growth and full employment. A

country can live with a moderate rate of inflation and still achieve high growth and

employment creation. Economists differ about the extent of inflation that will begin to

interfere with the objective of high and sustainable economic growth. High price inflation is

generally regarded as detrimental to high economic growth and the allocation of production

resources. Similarly, deflation distorts the efficiency of productive processes. If inflation

becomes very high or when deflation occurs, price stability becomes important and can usurp

economic growth and unemployment as the main economic objective of a country.

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Balance-of-payments equilibrium is also not usually regarded as the overriding objective of

economic policy. There is no reason why a country should maintain balance-of payments

equilibrium at all times. Deficits on the balance of payments are not harmful to the other

economic objectives, provided that they are followed by surpluses at a later stage. A

continuous balance-of-payments disequilibrium will, however, eventually affect economic

growth, employment and price stability. Just as in the case of high inflation or deflation,

balance-of-payments considerations or adjustment can at times become more important than

the achievement of other economic objectives. For instance, during the mid-1980s when

financial sanctions were imposed on South Africa, the prime economic objective in the

country became the maintenance of surpluses on the current account of the balance of

payments to meet the financial obligations that would be falling due. The authorities had to

accomplish this objective at the cost of economic growth and employment creation. Although

balance-of-payments equilibrium is normally not the major objective of economic policy,

balance-of-payments statistics are nevertheless very important in the determination of

economic policy because they provide early signals of untenable developments. Of prime

importance in this regard is the current account balance as an indicator of excess or under-

spending. In the case of most developing countries, it is usually more important as an

indicator of excess spending than as an indicator that saving is not being employed

domestically to finance much-needed investment.

~ 27 ~

Developments in the current account of the balance of payments are consequently of

great importance in the determination of both monetary and fiscal policy. In the next

section, attention will first be given to the role of the current account in determining the

monetary policy stance, and section 4 will concentrate on the current account and fiscal

policy.

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OBJECTIVES OF FISCAL POLICY

The major objectives of fiscal policy are as follows:

Full employment: It is very important objective of fiscal policy. Unemployment reduces the

level of production, and hence the level of economic growth. It also creates many problems to

the unemployed people in their day-to-day life. So, countries try to remove unemployment

and attain full employment. Full employment refers to that situation, where there is no

involuntary unemployment in the economy. To attain this objective, government tends to:

Increase its spending

Lower the personal income taxes

Lower the business taxes, or

Employ a combination of increasing government spending and decreasing taxes

However, in practice, it is difficult to achieve full employment. As the factor markets are not

perfect, factor units may lose their jobs and may not get the new jobs immediately.

Price stability: Both sharp rise and sharp fall in general price level are not desirable. It is

because sharp rise in prices makes many goods and services unaffordable to the consumers

whereas sharp fall in prices discourages the producers to produce goods and services. So,

price stability is desirable.

~ 29 ~

Economic growth: It is also an important objective of fiscal policy. By means of higher rate

of economic growth, the problem of unemployment can also be solved. However, it may

create some problems in the maintenance of price stability. The developed countries, like

USA, UK, Japan, etc. give attention to the relationship of actual growth rate to the potential

growth rate permitted by the consumption – saving ratio, technological considerations and

other factors. The less developed countries give emphasis to the increase in the potential

growth rate as well as the relationship of the actual and potential growth rate.

Resource allocation: Resource allocation refers to assigning the available resources of the

economy to the specific uses chosen among many possible and competing alternatives. It

gives answer to what to produce and how to produce-questions of the economy. Fiscal policy

should ensure the optimum allocation of the resources. It should divert the resources from

unproductive sectors to the productive sectors of the economy. It is the long-run objective of

the government. The emphasis of the government upon the full employment, price stability

and economic growth should not overshadow the resource allocation goal.

Increase in Savings: This policy is also used to increase the rate of savings in the country. In

the developing countries rich class spends a lot of money on luxuries. The government can

impose taxes on them and can provide the basic necessities of life to the poor class on low

rate. In this way by providing incentives, savings can be increased.

Equal Distribution of Wealth: Fiscal policy is very useful for the achievement of equal

distribution of wealth. When the wealth is equally distributed among the various classes then

their purchasing power increases which ensures the high level of employment and

production.

Control Inflation: Fiscal policy is very useful weapon for controlling the rate of inflation.

When the expenditure on non productive projects is reduced or the rate of taxes are increased

then the purchasing power of the people reduces.

~ 30 ~

Reduce the Regional Disparity: In the less-developing countries, the regional disparity is

found. Some areas are more developed while the others are less developed. Government

provides the infrastructure facilities in less developed areas. The tax holiday incentive is also

provided in these areas which is very useful in increasing the per capita income.

Check Rapid Increase in Consumption: Fiscal policy is also used to check the rapid

increase in the consumption will be high then the rate of saving will be low and consequently

rate of investment will be low. So one country cannot improve its economic condition

without increasing the investment.

ALTERNATIVE FISCAL POLICIES

a. Fiscal policy during the contraction

increase in government spending

reduction in personal income taxes

reduction in business taxes

increase in transfer payments

practicing deficit budget

b. Fiscal policy during the expansion

decrease in government spending

increase in personal income taxes

increase in business taxes

reduction in transfer payments

practicing surplus budget

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NATURE AND TECHNIQUES

The nature of fiscal policy may be either expansionary or contractionary.

Expansionary fiscal policy

Expansionary fiscal policy increases the AD of the economy. It increases the level of

production, and hence the level of employment. It eliminates the recessionary gap existing in

the economy. It should be noted that recessionary gap occurs when the equilibrium real GDP

is less than the potential real GDP of the country. In this situation, unemployment is greater

than natural rate of unemployment. It can be explained with the help of following diagram:

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CHAPTER 5

APPROACHES TO FISCAL POLICY

The role of fiscal policy the national government’s planned, discretionary balance

between its outlays and recurrent revenues (broadly, spending and taxes) has long been a

subject of debate and controversy in modern times. During the 20th century, for a time at

least, a ‘Keynesian’ view of the role of fiscal policy supplanted the more traditional

conservative view. The latter view took as its benchmark a rather thorough-going

commitment to the maintenance of a balanced budget aggregate spending being restricted to

the size of aggregate recurrent revenue with a view to the objective of sound management of

the government sector’s ‘balance sheet’. Or to put the same point differently, budgets were to

be framed with a view to prudent management of the State’s assets, financial liabilities and

net worth—generally with a presumption in favour of ‘small government’.

This approach does not inexorably lead to the policy conclusion that there ought to

be continuous annual balancing of outlays and recurrent revenue: it is consistent, for

example, with balancing the ‘current’ budget (recurrent expenditures equal to recurrent

revenues), while funding capital expenditure with issue of financial liabilities (government

debt). For in this way, at least if sensibly done, the value of assets would increase with the

extent of financial liabilities, with no deterioration in the public sector’s net worth.

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Nevertheless, in practice the credo of the balanced budget was the common mantra.

And in truth, the illiquidity of government assets, and their commonly non-revenue-

generating character, means that funding assets with debt is not a straightforwardly viable

financial exercise.

Against this traditional view, in the aftermath of the Great Depression,

following the lead provided by the British economist and public intellectual, John Maynard

Keynes, many within and without the economics profession took the view that the primary

purpose of the annual fiscal balance was not so much to ‘balance the books’ of the public

sector, but rather, to ‘balance’ the economy as a whole; that is to say, to set expenditure in

excess of revenues to offset unemployment and insufficiency of demand in the private sector,

or to set revenues in excess of expenditure to offset excess demand pressures in the private

sector.

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ROLE O FISCAL POLICIES

A free market economy was once believed to be capable of functioning without

interference by government; however, it does not automatically establish optimum demand

for goods and services. During the 1920's the quantity theory of money became widely

accepted, and the Federal Reserve was believed to be capable of preventing future "booms"

and "busts." The great depression shattered those hopes, resulting in increased emphasis on

fiscal policy. In 1946 Congress passed the Full Employment Act, which in effect made the

government responsible for maintaining high levels of employment without inflation.

The essential idea is that the go vernment, through monetary-fiscal policies, should

augment or offset private demand in such a wav as to maintain high levels of employment

and stable prices. Recently emphasis has been given to two additional objectives, promoting

economic growth and protecting the balance of pavments. Presently economists generally

agree that monetary-fiscal policies should and can be used to prevent extreme economic

fluctuations. Almost all economists agree that monetary policy should be "tighter" in a period

of full employment and inflation than during a period of under-utilization of economic

resources. They also agree that government revenues relative to receipts should be higher

during inflation periods and lower during recessions.

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Unfortunately this still leaves much room for disagreement on which of these tools

represents the more potent force, on how tight or how easy money should be in particular

circumstances, and on the most desirable size of the budget deficit or surplus. Also, opinion

differs considerably about length of lags, for both monetary and fiscal policy, between: (1)

recognition of a need for action, (2) taking of action, and (3) eventual impact upon the

economy.

These issues cannot be settled by logical analysis alone. Empirical evidence must be

brought to bear upon these areas of conflict. In this discussion I will present the basic theory

underlying the fiscal policy approach and the monetary policy approach, cite what I consider

to be the relevant evidence and then apply my conclusions to the current debate concerning

the desirability of a tax cut as well as the dispute concerning use of monetary policy for

reducing a

balance-of-payments deficit.

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CHAPTER 6

SUMMARY

We may conclude that the primary role of monetary-fiscal policies is to influence

final demand for goods and services. Unfortunately the free enterprise system has nothing in

it which will properly regulate total spending automatically. Therefore, conscious

governmental actions are required. Although monetary-fiscal policies can prevent severe

swings in economic activity, little evidence is available to indicate that our knowledge is

sufficient to permit

perfection. Inadequate knowledge concerning the variability and length of lags will continue

to encourage actions which in hindsight prove to have been wrong. The evidence would

suggest that without a proper monetary policy, fiscal policies exert only limited effects upon

final demand. Furthermore, little evidence is available to show that monetary policy is well

adapted to alleviating balance of- payments difficuties. Although our knowledge concerning

the impact of monetary-fiscal policies continues to grow, further refinement based upon

careful economic research is urgently needed.

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REFERENCES

1. Milton Friedman and David Meiselman, "The Relative Stability of Monetary

Velocity and the Investment Multiplier in the United States, 1897-1958"

BIBLIOGRAPHY

Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking

(10th ed). Prentice Hall.

Larch, M. and J. Nogueira Martins (2009): Fiscal Policy Making in the European Union –

An Assessment of Current Practice and Challenges. Routledge.

Hansen, Bent (2003): The Economic Theory of Fiscal Policy, Volume 3. Routledge.