IMPACT OF FISCAL AND MONETARY POLICIES

A central government other than maintaining law and order in the country is burdened with crucial duty to keep the country running smoothly in matters of money. One of the primary objectives of any country is to have enough money to keep its citizen happy to keep its economy running and keep its growth intact. I had come across a quote on one of the financial papers that said “Balancing your money is the key to have enough money”. This statement describes to me exactly what The government does. It balances its books today to have money tomorrow. In simple words, it plays with its fiscal policy. 

For those who have heard about fiscal policy for the first time, It is a financial tool handy with the government just like a glass ball is for a witch. Essentially it is a gauging force that predicts the future for the government. It tells the government exactly how much to spend each financial cycle and how much it should aim to earn from the system in the form of tax revenue to keep us on the right track towards growth. 

FISCAL POLICY 

          In the eyes of commoners, Fiscal Policy should help the government achieve 3 basic Things. First economic growth, helping in maintaining a growth rate each financial cycle so that we reach on top of the ladder as planned. Second, to avoid inflation or deflation it should achieve price stability. Third, it should help achieve full employment. 

What is the importance of a Fiscal policy in India? Well for a country like ours we need to make sure the government can and should be able to finance multiple projects which could be filled with shortcomings. In India, people lack access to numerous resources because of many different factors that are not worth discussing in this post because of its political side. With the help of fiscal policies, the government can fund numerous projects in India which boosts the income increase employment and also keep a steady growth rate. For this to happen we need to understand how much to generate revenue in the form of taxes. We have numerous taxes such as income tax, cooperate tax, GST, etc. 

WHAT IS IS-LM MODEL

          To further explain the impact of fiscal policy in our economy lets understand more about the IS-LM framework. IS-LM framework based on the General Theory by Keynes and developed by John R. Hicks. It establishes a relationship between the real output and interest rates. The word IS stands for investment- saving and LM stands for liquidity preference- money supply. The IS-LM describes the behavior of the aggregate market for real goods and financial markets. This interaction helps us to figure out the equilibrium interest rates and output for our economy. 

DERIVATION OF THE IS-LM CURVES

          We first derive the IS curve. For any given economy the Supply (Y) is the Consumption ©, Investment expenditure (I), and the government expenditure (G).

                                                     

                                                       Y=C+I+G                                                                   (1.1)

According to Keynesian Model demand is equal to out put therefore 

                                                         Y=E                                                                                      (1.2)

here;   E= equilibrium and Y is the nominal GDP

                                          E= C+Iᴾ+G           Where Iᴾ= planned investment                               (1.3)

                                          Y= C+Iʳ+G           Where Iʳ= Realised Investment                              (1.4)

                          ∴ C+Iᴾ+G= C+Iʳ+G      →     Iᴾ=Iʳ                                                                      (1.5)

Assume that in (1.3) C is the function of (Y-T) hence we get 

                                          E=C(Y-T)+ Iᴾ+ G                                                                                 (1.6)        

                                          E=a+b(Y-T) + Iᴾ+G           [a= autonomous consumption 

                                                                                      b= Marginal propensity to consume]       (1.7)

Now at a given point ofttimes assume Tax, Government expenditure and investment is given and hence assume the constants to be as 

                                         𝛼=a-bT+Iᴾ+G                                                                                       (1.8) 

writing E=Y 

                                        Y=by+𝛼

                                                                                                     (1.9)

There in the Fig1.1 we see that once we plot the constants I,G,T which we add to derive 𝛼 on the y Axis. from here we draw a line whose slope is determined by the MPC of the economy. This line (PE) we derive is the demand of the market for real goods. Then in Fig1.2 we draw the same line and add the aggregate supply line AE which is at 45° ( it is always 45° because Y=E always).  Where they intersect is the equilibrium demand. This is the Keynesian cross.  

  

We know that the Investment curve is downward sloping because with a fall in Interest rates (r ) investment rises. So drawing the investment function in Fig1.3 (a) and Keynesian cross in Fig 1.3 (b) let's derive the IS curve.  

Assume the Central Bank of India dropped the Interest rates reducing Them From r to r’. this increases Investment from I to I’ . In the Keynesian cross with an increase of the Investment the PE, curve shifts upward by the same amount by which investment increases. making a new line PE’ and giving new equilibrium E to E’. This shift causes the output of the economy to increase from Y to Y’ 

Let us plot the shift of the equilibrium in the Keynesian cross to the Graph in Fig1.3 (c) and plot the change in interest rates from the investment function to the same graph. The two points where they intersect let us join the two points. The line we derive is the IS curve. 

Now, let's derive the LM curve. We know the Liquidity Preference theory says that 

                                                   Mˢ/P= M/P                                                                             (1.10)

Here Mˢ is exogenously decided and M and P are constant. We also know that money demand is a function of interest rates. Hence with rise in interest rates money demanded shall rise. Plotting the graph below for money demanded and supplied in Fig 1.4 Money supply is vertical because in the short run the Money supply is Fixed.

                                                                                              (M/P) ᵈ= L(r,Y)

therefore, Increase in Y will also increase the (M/P)ᵈ

Now with Central bank increasing the money supply in the economy The Mᵈ shifts to Mᵈ₁ (Fig1.6 (a) ) to the right. This increases the Interest rate in the market since the money supply if fixed in the short run. Interest rates shift from r₁ to r₂. Lets now draw a line to the right on the graph in Fig1.6 (b). Then on the X-axis plot, the change in the output shifted from Y₁ to Y₂. Connecting the lines we derive 2 Points which on joining we get the LM curve.  

MONETARY POLICY 

          This is the tool where the central bank in compliance with the central bank controls the supply of money in the economy. It can use various tricks and techniques to reduce or increase the money supply. For example, the Government can issue a 6-month bond at X% and reduce the money available in the economy to curtail the money available in the economy. 

MACROECONOMIC ISSUE

          Further to explain the impact of the Fiscal policy and Monetary policy lets take a macroeconomic problem which we will discuss by implying the policies. We shall take the issue to be the current COVID-19 pandemic. 

FISCAL POLICY IMPACT 

          In this pandemic, we see that growth has been tanked. with many projections of negative growth. According to Statista India should have grown at 7.43% in 2021 but According to the World Bank data India is to grow at 1.5%-2.2% if the current situation prevails. This is majorly happening to a sharp fall of output in our economy. Due to the lockdown lack of income and running business, the output of the economy has fallen. In 2019 the GDP at current prices was $2.875 trillion and in 2020 it has fallen down. We have no data available for 2020 but it is definitely lower than last year. 

Now how would we find a way to in 2021 get the economy back on track? We need to find a way to improve the GDP and get the growth rate restored. For this let us assume to imply a fiscal policy. The Government of India can not imply taxes at such times since with lack of income and reduced incomes people would not be able to pay taxes or even be able to pay taxes. This can also result in increased tax evasions. This further means that the government can not fund its projects by increasing taxes. 

The government needs to keep the money supply constant hence should fund its projects through selling bonds. Further, the government has 2 options, either it can reduce the taxes of the public which in turn should increase investment in the economy in normal times. But which layoffs on the rise and the stock market crash. On 16th January 2020, the SENSEX was 41,933 points and crashed down to 33,524 on 23rd march, 2020. The lowest in years. The other option is for the government to increase its investment to bring the demand back to its original status. This could be done by increasing its own expenditure mixed with allowing increased FDI keeping China out of the loop due to the risk of a hostile take over that their government has taken up in many countries.

Now with an increase in the government expenditure the IS curve shifts to the right because when the expenditure rises the output in the economy shall also rise. Therefore as seen in Fig 2.1 the shift to the right from IS₁ ti IS₂ due to the government expenditure keeping the money supply constant will also affect the interest rates. Causing them to rise. With demand shifting back to normal people would find the market more worthy to invest in. To invest people normally borrow funds. During a pandemic, people would be restricted by rising interest rates to borrow funds to invest. This comes as a shortfall because even tho the market is back to the original demand level there would be no growth because of lack of public investment.

 

IMPACT OF MONETARY POLICY 

          Having explained the current government scenario let us use the monetary tool in the same situation keeping the fiscal items constant. The government needs to improve the long term investment condition of the economy. Hence the government shall increase the money supply which would cause a decrease in the intreats rates of the loanable funds. As seen in Fig 2.2 the increase of money supply by the government will cause the LM curve to shift to the right showing a drop in the interest rates. This would cause people to take loans to invest. Majorly the investment would be in the housing sector. But according to the Times Of India Business, the housing prices are to slump by 5% this year demotivating people to pick up loans to invest. Hence showing a downside to this plan since the IS curve in times like this would be very steep. 

 

CONCLUSION

          Hence, we can not have the government use only one of its tools at a time to revive the economy in a pandemic we face today. The government will need to first apply its fiscal tool by increasing the government expenditure and invite FDI like Googles and Facebook's investment in Jio, shifting the IS curve to the right to IS₁. This would revive the demand in the economy pushing the supply from Y to Y₁ to serve the demand. When this causes the interest rates to rise to restrict further investment like mentioned earlier. The government should increase the money supply in the economy to reduce the interest rates to motivate investment by individuals. 

As seen in Fig 2.3 with a rise in government expenditure the rates rise from r to r ₁. To reduce the interest rate we see the government increase the money supply pushing LM curve to the right to LM₁ bringing the interest rates down from r₁ to r₂. With this, we see even tho interest rate falls a little above the original interest rate the output of the economy is on the rise as Y increases as output shifts from Y₁ to Y₂. Showing how essential it is to use both policies together. 

This would bring an increase in the economy by increasing the GDP. This would not bring the originally predicted growth rate of 6.2% according to the IMF but would definitely help the economy revive and not stoop further down.

References 

• https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=IN
• https://tradingeconomics.com/india/gdp
• https://tradingeconomics.com/india/stock-market
• Mankiw, N. G. (2015). Aggregate Demand I: Building the IS-LM Model. In Macroeconomics + launchpad for mankiw's macroeconomics, us version 9th ed., six month ... access: Canadian edition. Place of publication not identified: Worth Pub.

• Mankiw, N. G. (2015). Aggregate Demand II: Applying the IS-LM Model. In Macroeconomics + launchpad for mankiw's macroeconomics, us version 9th ed., six month ... access: Canadian edition. Place of publication not identified: Worth Pub.

• https://www.worldbank.org/en/country/india/overview

• https://www.indiabudget.gov.in/mtfpcfpss.php

• https://timesofindia.indiatimes.com/business/india-business/house-prices-to-fall-this-year-for-first-time-in-at-least-a-decade-poll/articleshow/76460293.cms