Managerial economics

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Name- arisha sarkar

Section- g sem- 3rd

Roll no. - 30905019056

1. Define Fiscal policy. What are the major goals of Fiscal policy?

Ans: Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a
central bank influences a nation's money supply. These two policies are used in various combinations to
direct a country's economic goals. Here's a look at how fiscal policy works, how it must be monitored,
and how its implementation may affect different people in an economy.

The usual goals of both fiscal and monetary policy are to achieve or maintain full employment, to
achieve or maintain a high rate of economic growth, and to stabilize prices and wages. The
establishment of these ends as proper goals of governmental economic policy and the development of
tools with which to achieve them are products of the 20th century.In taxes and expenditures, fiscal
policy has for its field of action matters that are within government’s immediate control. The
consequences of such actions are generally predictable: a decrease in personal taxation, for example,
will lead to an increase in consumption, which will in turn have a stimulating effect on the economy.
Similarly, a reduction in the tax burden on the corporate sector will stimulate investment. Steps taken to
increase government spending by public works have a similar expansionary effect. Conversely, a
reduction in government expenditure or an increase in tax revenues, without compensatory action, has
the effect of contracting the economy. Fiscal policy relates to decisions that determine whether a
government will spend more or less than it receives. Until Great Britain’s unemployment crisis of the
1920s and the Great Depression of the 1930s, it was generally held that the appropriate fiscal policy for
the government was to maintain a balanced budget. The severity of these disturbances gave rise to a
new set of ideas, first given formal treatment by the economist John Maynard Keynes, revolving around
the notion that fiscal policy should be used “countercyclically,” that is, that the government should
exercise its economic influence to offset the cycle of expansion and contraction in the economy.
Keynes’s rule, briefly, was that the budget should be in deficit when the economy was experiencing low
levels of activity and in surplus when boom conditions (often accompanied by high inflation) were in
force.

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2. Explain the role of Fiscal policy to cure recession.

Ans: Fiscal policy is the use of government spending and tax policy to influence the path of the economy
over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the
aggregate demand outward in the case of expansionary fiscal policy and inward in the case of
contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity
and quality of our resources grow as the population and thus the labor force get larger, as businesses
invest in new capital, and as technology improves. The result of this is regular shifts to the right of the
aggregate supply curves, as (Figure) illustrates.The original equilibrium occurs at E0, the intersection of
aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price
level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term
economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy
operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a
price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and
aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and
a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing
at its potential GDP each year, with only small inflationary increases in the price level.

A Healthy, Growing Economy in this well-functioning economy, each year aggregate supply and
aggregate demand shift to the right so that the economy proceeds from equilibrium E0 to E1 to E2. Each
year, the economy produces at potential GDP with only a small inflationary increase in the price level.
However, if aggregate demand does not smoothly shift to the right and match increases in aggregate
supply, growth with deflation can develop.

Aggregate demand and aggregate supply do not always move neatly together. Think about what causes
shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends
to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in
any given period it may not shift the same amount as aggregate supply. What happens to government
spending and taxes? Government spends to pay for the ordinary business of government- items such as

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national defense, social security, and healthcare, as (Figure) shows. Tax revenues, in part, pay for these
expenditures. The result may be an increase in aggregate demand more than or less than the increase in
aggregate supply.

Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even
shift left, for a number of possible reasons: households become hesitant about consuming; firms decide
against investing as much; or perhaps the demand from other countries for exports diminishes.

For example, investment by private firms in physical capital in the U.S. economy boomed during the late
1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002.
Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary
increases in the price level will result. Business cycles of recession and recovery are the consequence of
shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use
fiscal policy to address the difference.

Expansionary fiscal policy increases the level of aggregate demand, through either increases in
government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing
consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2)
increasing investment spending by raising after-tax profits through cuts in business taxes; and (3)
increasing government purchases through increased federal government spending on final goods and
services and raising federal grants to state and local governments to increase their expenditures on final
goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate
demand by decreasing consumption, decreasing investment, and decreasing government spending,
either through cuts in government spending or increases in taxes. The aggregate demand/aggregate
supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in (Figure), which is similar to the U.S. economy during the 2008-2009
recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below
the level of potential GDP as the LRAS curve indicates. At the equilibrium (E0), a recession occurs and
unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government
spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition,
the price level would rise back to the level P1 associated with potential GDP.

Expansionary Fiscal Policy

The original equilibrium (E0) represents a recession, occurring at a quantity of output (Y0) below
potential GDP. However, a shift of aggregate demand from AD0 to AD1, enacted through an
expansionary fiscal policy, can move the economy to a new equilibrium output of E1 at the level of
potential GDP which the LRAS curve shows. Since the economy was originally producing below potential
GDP, any inflationary increase in the price level from P0 to P1 that results should be relatively small.

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3) Explain the crowding out effect of fiscal policy.

Ans: Crowding out effect

In economics, crowding out is a phenomenon that occurs when increased government involvement in a
sector of the market economy substantially affects the remainder of the market, either on the supply or
demand side of the market.

One type frequently discussed is when expansionary fiscal policy reduces investment spending by the
private sector. The government spending is "crowding out" investment because it is demanding more
loanable funds and thus causing increased interest rates and therefore reducing investment spending.
This basic analysis has been broadened to multiple channels that might leave total output little changed
or even smaller.

Other economists use "crowding out" to refer to government providing a service or good that would
otherwise be a business opportunity for private industry, and be subject only to the economic forces
seen in voluntary exchange.Crowding out from government borrowing One channel of crowding out is a
reduction in private investment that occurs because of an increase in government borrowing. If an
increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by
increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private
investment. There is some controversy in modern macroeconomics on the subject, as different schools
of economic thought differ on how households and financial markets would react to more government
borrowing under various circumstances.The macroeconomic theory behind crowding out provides some
useful intuition. What happens is that an increase in the demand for loanable funds by the government
(e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the
real interest rate. A higher real interest rate increases the opportunity cost of borrowing money,
decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus,
the government has "crowded out" investment.

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What factors determine how much crowding out takes place?

The extent to which interest rate adjustments dampen the output expansion induced by increased
government spending is determined by:

● Income increases more than interest rates increase if the LM (Liquidity preference—Money supply)
curve is flatter.

● Income increases less than interest rates increase if the IS (Investment—Saving) curve is flatter.

● Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift
in the IS curve.

In each case, the extent of crowding out is greater the more interest rate increases when government
spending rises.

The Classical Case and crowding out

If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium
income and only increases the interest rates. If the demand for money is not related to the interest rate,
as the vertical LM curve implies, then there is a unique level of income at which the money market is in
equilibrium.

Thus, with a vertical LM curve, an increase in government spending cannot change the equilibrium
income and only raises the equilibrium interest rates. But if government spending is higher and the
output is unchanged, there must be an offsetting reduction in private spending. In this case, the increase
in interest rates crowds out an amount of private spending equal to increase in government spending.
Thus, there is full crowding out if LM is vertical.

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