Role of Fiscal Policy and Monetary Policy

In reality there is always a gap between expectation and actual achievement. For a particular nation also this is true. There always remains a gap between actual GNP and potential GNP. (GNP = Gross National Product) The GNP that is produced in a particular year and the GNP that the economy is capable of producing, had there been high employment, optimum capacity utilization or maximum utilization of the available resources, are never equal. Even under favourable conditions, actual GNP falls short of the potential GNP. There is some wastage of scarce resources. Maintaining a steady growth with full employment and price stability is very difficult.

Fiscal Policy

When the economy does not function properly under the influence of unemployment, depression or inflation, the government tries to make certain changes in its expenditure policy to bring in the desired changes, and to eliminate the forces that are destabilizing the economy.

There are two basic measures that a government can undertake to stabilize the economy.

1. Government Expenditure

Increase in government expenditure acts as an investment. It gets added to the private investment that is prevailing in the economy. Thus, more government expenditure generates more employment and income, and takes the economy to a new equilibrium position.

C = consumption Expenditure
I = Private Investment Expenditure
G = Government expenditure
C+S+T = the income line of the community

FF is the full-employment line. It shows the society's maximum output capacity. The equilibrium is at point E. The society is not utilizing its full resources. This is known as under-employment equilibrium between investment and expenditure.

If the government tries to reach full-employment equilibrium, it will spend more money. As a consequence, the C+I+G curve will shift to a new position, C+I+G'. The full-employment level is reached at point F'. The government increases the expenditure by ΔG, and the national income increases by ΔY.

2. Taxation

Government Expenditure expands the economy, whereas taxation contracts the economy. More taxation reduces the disposable income of individuals. This reduces their capacity to spend on consumer goods. A rise in taxes lowers the C+I+G schedule or curve. This reduces income and employment. This is necessary during periods of inflation, when prices are moving upwards.

A reduction in taxes will give more income in the hands of consumers. Demand will increase, and new investment and income will be generated. This is necessary during periods of depression. Cut in taxes helps the economy to recover from a depressed state.

In a full-employment situation, increase in government expenditure will increase the income. But the economy cannot produce more to meet this extra demand, as it is already in a full-employment situation. Under such circumstances, prices will rise, leading to an inflationary situation. Then it is necessary to raise the taxes to take the extra income away, so that prices may not rise.

Similarly, lowering of government expenditure will lower the income, and effective demand. This may push the economy towards depression. So, with lowering of government expenditure, a reduction in taxes is necessary to maintain the same level of income and effective demand.

Monetary Policy

Monetary policy is aimed to control the supply of money in an economy. The central bank, which acts as the agent for the government, determines and controls the money supply according to the need of the economy. Objectives of monetary policy are as follows:

1. Price Stabilization
2. Move towards full-employment
3. Rapid growth rate
4. Stabilize the capital market
5. Favourable balance of payments.

Measures adopted to control money supply

1. Changes in cash reserve ratio
2. Changes in bank rate
3. Open market operations
4. Selective credit control
5. Moral persuasive measures

These two policies may be used in combination by the government to get the desired result.

Also read: Automatic Stabilizer and Discretionary Fiscal and Monetary Policy