FISCAL POLICY

The policy of government pertaining to public revenue, public expenditure and public debt is known as Fiscal Policy. Fiscal policy can play an important role in stimulating the rate of growth of an economy. Fiscal policy operates through the budget. In fact, fiscal policy is also known as budgetary policy. According to Arther Simithies fiscal policy is a policy under which government uses its expenditure and revenue programme. The appropriate design of fiscal policy is important for all countries. Since tax and expenditure policies are geared towards encouraging savings and investment and the efficient use of policy can help stimulate economic growth. Introduction The most important instrument of government intervention in the country is that of Fiscal or Budgetary policy. Fiscal policy refers to the taxation, expenditure and borrowing by the government. The economists now hold the government intervention through Fiscal policy is essential in the matter Of overcoming recession or inflation as well as of promoting and accelerating economic growth, Which monetary policy will not hold alone. There is no doubt that the government budgetary or fiscal Policy must be sound, keeping in view the needs and requirements of a developing economy. In short we can say that, it is a part of government policy, which is concerned with raising revenue through taxation and other means and deciding on the level and pattern of expenditure. The main problem faced by the capitalist economies instability prevailing in them. This instability Is reflected in the periodic occurrence of trade cycles, which are a general phenomenon in the free market capitalist economies. During a recession or depression fiscal policy should help in increasing demand. Overview of Fiscal Policy Economic Reforms have yielded credible gains in the external and monetary sector. Since the early 1990s. Inflation has climbed down from a peak of 17 per cent in August 1991 to about 5 per cent now. The economy has grown at an average of over 6 per cent p.a. In a major structural change in the economy, the share of the services sector continues to grow steadily. Tax reforms during this period have laid the foundation of a robust, expanding tax base. Out of our total external debt of nearly US $ 112 billion, only about 5 per cent is short-term debt. Gradual and cautious liberalization of the capital account has sought to control short-term capital inflows and keep the maturity profile, end-use etc. within prudential norms. These are very impressive achievements. Stability has been achieved in the external sector and the central bank can now conduct autonomous monetary policy. However, continued fiscal deficits are restraining the economy from realizing its full potential to grow and in providing quality
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infrastructure, both physical and social, that can meet the growing needs of a resurgent economy. Objectives of Fiscal Policy 1. To strike a balance between government revenue ,expenditure and borrowings. 2. To attain best possible level of economic development. 3. To achieve full employment. 4. To reduce inequality of income and wealth. 5. To achieve desirable price level. 6. To achieve desirable consumption level. 7. To achieve desirable income distribution. 8. Increase in capital formation. 9. Degree of inflation. Objectives of Fiscal Policy in Developing Countries In developing countries, taxation, the government expenditure, taxation and borrowing have to play a very important role in accelerating economic development. Fiscal policy is a powerful instrument in the hands of the government by means of which it can achieve the objectives of development. There are several peculiar characteristics of a developing country, which necessitate the adoption of a specific fiscal policy, which ensures a rapid economic growth. There are vast and diverse resources human and Material, which are lying underutilized. Such countries have weak infrastructure, i.e. they lack adequate means of transport and communications, road ports, highway, irrigation and power and technical know-how. Their population increasing at an explosive rate, which necessitates rapid economic development to, met the requirements of the rapidly- growing population. In order to overcome these handicaps, a suitable fiscal and taxation policy is called. The principal objectives of fiscal policy in a developing economy are : To mobilize resources for economic growth, especially for the public sector. To promote economic growth in the private sector by providing incentives to save and invest. To restrain inflationary forces in the economic in order to ensure price stability. To ensure equitable distribution of income and wealth so that fruits of economic growth are fairly distributed.

ROLE OF FISCAL POLICY In recent weeks, a number of signs have appeared suggesting that the recovery of the U.S. Economy from the recent recession is on a bumpy
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path. During the second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%, well below market expectations. Unemployment, after rising throughout 2001, has leveled off but has yet to show signs of declining. Adding some gloom to the general outlook, the stock market continued to drop through most of July and has remained volatile. This sluggish economic performance comes despite substantial stimulus from both monetary and fiscal policy. Since January 2001, the Federal Reserve has reduced its benchmark policy interest rate, the federal funds rate, from 6.52% in September 2000 to a current level of 1.75%. Fiscal policy also has become more expansionary. The federal government budget has swung from a surplus of $236 billion in 2000 (2.5% of GDP) to a projected 2002 deficit of $157 billion (1.5% of GDP) as the government has increased expenditures and reduced taxes. This active use of fiscal policy during a recession is somewhat unusual. During the last U.S. recession, in 1990, then President George H.W. Bush resisted attempts to use fiscal policy to stimulate the economy. In fact, his Council of Economic Advisers, in their February 1992 report, argued that increases in fiscal expenditures or reductions in taxes might hamper the economys recovery. In contrast, during the current recession, both Congress and the President have supported increases in expenditures and tax cuts as ways to stimulate economic growth, culminating in the passage of the Economic Recovery Act in March 2002.The current recession and the 19901991 recession offer contrasting examples of the use of fiscal policy, and they also highlight some elements of the longstanding debate in economics over whether fiscal policy can play a useful role in combating business cycle downturns. This Economic Letter discusses some of the issues involved in using fiscal policy to help stabilize short-run fluctuations in the economy. In developing economies, the government has to play a very active role in promoting economic development and fiscal policy is the instrument that the state must see. Hence the great importance of public finance in underdeveloped countries desirous of rapid economic development. In a democratic Society, there is an inherent dislike for direct control regulation by the state. The entrepreneur would not like to be ordered about to produce this or that, how much to produce or where to produce. Fiscal incentives in the form of tax concessions, rebates or subside are, therefore, preferable. Similarly, the consumers would not like to be told directly to curtail their consumptions or to consume this and not to consume that. Taxation of articles whose consumptions is to be discouraged is therefore preferable. Hence, a democratic state must rely on indirect methods of control and regulation and this is doing through fiscal and monetary policies. Thus in democratic countries, fiscal policy is a powerful and least undesirable weapon on which the states can rely for promoting economic development. INSTRUMENTS OF FISCAL POLICY I. BUDGET:Keeping budget in balance, in surplus or deficit, is in itself a fiscal instrument. When the government keeps its total expenditure equal to its revenue, as a matter of policy, it means it has adopted a balanced budget
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policy. When the government spends more than its expected revenue, as a matter of policy, it is pursuing a deficit budget policy. And when the government follows a policy of keeping its expenditure substantially below its current revenue, it is following a surplus budget policy. II.TAXATION A tax is a non quid pro quo payment by the people to the government. By this definition, taxation means non quid pro quo transfer of private income to public coffers by means of taxes. Taxation takes many forms in the developed countries including taxation of personal and corporate income, so-called value added taxation and the collection of royalties or taxes on specific sets of goods. Government may want to smooth out the nation's income in order to minimize the pejorative effects of the business cycle or they may want to take steps designed to increase the national income. They may also want to take steps intended to achieve specific social objectives deemed to be appropriate by the political or legal process. Sound tax system, with moderate rates and a broad base, is an integral part of the prudent fiscal policy. The expansion in the tax base is sought to be achieved through expansion in the scope of taxes, specifically service tax, removal of exemptions and improvement in tax administration. With a decline in non-tax revenue receipts as a proportion of overall revenue receipts, the burden of fiscal corrections is expected to be mainly on tax revenues. However, the measures to increase the tax-GDP ratio must be harmonized with the overall growth objective. The strategy seeks to increase tax compliance, improve the efficiency of tax administration and with intense focus on recovery of arrears of tax revenues and prevent further build-up of such arrears. Agricultural taxation: This economic surplus mainly goes to rich farmers, landlords, intermediaries in the absence of suitable taxation on agriculture. It has potential surplus & to achieve maximum utilization of land through devising a system of land taxation which would penalize poor use of good land. III.PUBLIC EXPENDITURE Suppose the government spends more on an electricity project for which the contract is given to a PSU like BHEL. Then the money that the government spends comes back to it in the form of BHEL's earnings. Similarly, suppose that the government spends on food-for-work programmers, and then a significant part of the expenditure allocation would consist of food grain from the Public Distribution System which would account for part of the wages of workers employed in such schemes. This in turn means that the losses of the Food Corporation of India (which also includes the cost of holding stocks) would go down and hence the money would find its way back to the government. In both cases, the increased expenditure has further multiplier effects because of the subsequent spending of those whose incomes go up because of the initial expenditure. The overall rise in economic activity in turn means that the governments tax revenues also increase. Therefore there is no increase in the fiscal deficit in such cases.
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IV. GOVERNMENT BORROWING: Government borrowing is another fiscal Method by which savings of the community may be mobilized for economic development. In developing economies, the government resort to borrowing in order to finances schemes of economic development. Government or what is also called public borrowing becomes necessary because taxation alone cannot provide sufficient funds for economic development. Besides, too heavy taxation has an adverse effect on private saving and investment. V.DEFICIT FINANCING Deficit financing refers to created money, i.e., creation of additions purchasing power in the form of currency notes. According to the Indian planning commission, deficit financing is equal to the net increase in the purchasing power of the economy arising out of the operations of the government. Deficit financing is said to have been practiced whenever government expenditure exceeds the government receipts from the public, etc. such an excess of expenditure is financed by borrowing from the Central Bank. When Government borrows from central bank which is a noteissuing authority, the Central bank simply issues more notes and gives them to the Government against Government securities. Thus in the last analysis deficit financing means the creation of new currency. It may be noted that in India Net Bank Credit from RBI by the central Government is called Deficit Financing. In fact when central government borrows from RBI and the latter issues new currency it is called monetization of government debt. It is the monetization of debt that lead to the expansion in money supply due to Governments fiscal deficit that was earlier called deficit financing. However, in the modern terminology it is now called monetization of fiscal deficit.

NEED FOR DEFICIT FINANCING:

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The developing countries keen to promote rapid economic growth, the resources required for development far exceeds the amount which can be raised by normal means of resource mobilization, viz., taxation, borrowing, surpluses from public enterprises, etc. the uncovered gap is made up by deficit financing. Rapid economic development can be achieved only by setting up the rats of investment. But wherefrom are the developing countries to raise the additional resources? In the absence of sufficient foreign aid forthcoming from friendly countries and international organizations, the additional funds must come from domestic resources. For this purpose voluntary savings must be stepped up. These savings are then mopped up through national small savings schemes to add to resources available to the government. Fiscal Policy Can Be Divided Two types

I) DISCRETIONARY FISCAL POLICY FOR STABILISATION Fiscal policy is an important instrument to stabilize the economy, that is, to overcome recession and control inflation in the economy. By discretionary policy we mean deliberate change in the Government expenditure and taxes to influence the level of national output and prices. Fiscal policy generally aims at managing aggregate demand for goods and services. A) Fiscal Policy to cure recession: The recession occurs when aggregate demand decreases due to fall in private investment. Private investment may fall when businessmen become highly pessimistic about making profits in future, resulting in
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decline in marginal efficiency of investment. A fall in private investment expenditure, aggregate demand curve shifts down creating a deflationary or recessionary gap. There 2 fiscal methods to get the economy out of recession. Increase in Government Expenditure. Reduction of taxes. i) Increase in Government Expenditure to Cure Recession: This is the important tool to cure depression. Government may increases expenditure by starting public works, such as buildings roads, dams, ports telecommunication links, irrigation works electrification of new areas etc. Government buys various types of goods and materials and employs workers. The effect of this increase in expenditure is both direct and indirect. The direct effect is the increase in incomes of those who sell materials and supply labor for these projects. The output of these public works also goes up together with the increase in incomes, and for those who get more income they spend further on consumer goods depending on their marginal propensity to consumer. This creates the multiplier. As during the period of recession there exists excess capacity in the consumer goods industries, the increase in demand for them bring about expansion in their output which further generates employment and incomes for the unemployed workers and so the new income are spent and serpent further and the process of multiplier goes on working till it exhausts itself.

ii) Reduction in Taxes to Overcome Recession: The reduction in taxes increases the disposable income of the society and causes the increase in consumption spending by the people. If tax reduction of Rs.200 crores is made by the Finance Minister, it will lead to Rs.1520 crores in consumption, assuming marginal propensity t6o consume is 0.75 or . Thus reduction in taxes will cause an upward shift in the consumption function. It is worth nothing that reduction in taxes has only an indirect effect on expansion and output through causing a rise in consumption function. Like the increase in government expenditure, the increase in the consumption achieved
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through reduction in tax will have a multiple effect on increasing income, output and employment. B) Fiscal Policy to Control inflation: When due to large increases in consumption demand by the households or investment expenditure by the entrepreneurs, or biggest budget deficit caused by too large an increase in Government Expenditure, aggregate demand increases beyond what the economy can potentially produce by fully employing its given resources, it gives rise to the situation of excess demand which results in inflationary pressures in the economy. i) Raising Taxes to Control Inflation: As an alternative to reduction in Government expenditure, The taxes can be increased to reduce aggregate demand .For these purpose especially personal direct taxes such as income tax, wealth tax, corporate tax can be raised. The hike in taxes reduces the disposable in the comes of the people and thereby force them to reduce their consumption demand. ii) Disposal of Budget Surplus: the government either reduces its expenditure or raises taxes to lower aggregate demand for goods and services. Reduction in expenditure or hike in taxes results in decrease in budget deficits {if occurring before such step} or in the emergency of the budge serapes if the government was having balances budget prior to the adoption of anti-inflationary fiscal policy measures. Assume that antiinflationary fiscal policy results in budget surplus. Anti-inflationary impact of budget surplus depends to a good extent on hoe the government disposes of this budget surplus. II) NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILIZERS There is an alternative to use of discretionary fiscal policy, which generally involves the problem of, large in recognizing the problem of recession or inflation and large of the taking appropriate action to tackle the problem. In this Non-discretionary fiscal policy, the tax structure and expenditure are so designed that taxes and government spending vary automatically inappropriate direction with the changes in National Income. That is, these taxes and expenditure pattern without any special deliberate action by the government and parliament automatically raise aggregate demand in times of recession and reduce aggregate demand in times of boom and inflation and there by help in insuring economic stability. These fiscal measures are therefore called automatic stabilizers or built-in stabilizers. Since these automatic stabilizers do not require any fresh deliberate policy action or legislation by the government, they represent non-discretionary fiscal policy. Built-in-stability of tax revenue and government expenditure of transfer payment of subsidies is created because they vary with national income. These taxes and expenditure automatically bring about appropriate change in aggregate demand and reduce the impact to recession and inflation that might occur in an economy at sometimes. This means that because of existence of this automatic or built-in stabilizers recession and inflation will be shorter and less intense than otherwise is the case.
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Important automatic fiscal stabilizes compensation, welfare benefits corporate dividends. Below are some taxes and revenue from which varies directly with the change in National income: 1) Personal Income Taxes: -The tax rate structure is so designed that revenue from these taxes directly varies with income. Moreover, personal income taxes have progressive rates: The higher rates are changed are from the upper income brackets. As a result, when national income increases during expansion and inflation, increasing percentage op the peoples income is paid to the government. Thus, through causing a decline in their disposable income this taxes automatically reduce peoples consumption and therefore aggregate demand. This decline n aggregate demand because of imposition of progressive personal income tax tenders to check inflation from becoming more severe. On the other hand, when national income declines at times of recession, the tax revenue declines as well which prevent aggregate demand from falling by same proportion as the decline in income. 2) Corporate Income Taxes: -Companies, or corporations as they are called now, also pay a Percentage of their profits as tax to the Government. Like personal income taxes, corporate income tax rate is also generally higher at higher levels of corporate profits. As recession and inflation affect corporate taxes greatly, they have a powerful stabilizing effect on aggregate demand; the revenue from them rises greatly during inflation and boom which tends to reduce aggregate demand, and revenue from them falls greatly during recession which tends to offset the decline in aggregate. 3) Transfer payments: Unemployment compensation and welfare benefits: When there is recession and as a result unemployment increases, the Government has to spend more on compensation for unemployment and other welfare programmes such as food stamps, rent-subsidies to farmers. This hike in Government expenditures tends to make recession short-lived and less intense. On the other hand, when at times of boom and inflation national income increases and therefore unemployment falls, the government curtails its programme of social benefit, which result in lowering government expenditure. The smaller spending by the government help to control inflation. 4 ) Corporate Dividend Policy: With economic fluctuation, corporate profits also rise and fall. However, corporations do not so quickly increase or reduce dividend in turn with fluctuation in profits and follow a fairly stable dividend policy. This permit the individuals to spend more during recession and spend less then would have the case if dividends were lowered in time of recession and raised in condition of boom and inflation. Thus, fairly stable dividends tend to cushion recession and curb inflation by sabilising consumption.
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Limitations of fiscal policy Formulation of an appropriate fiscal policy requires reliable forecasting of the target variables, like GNP, consumption, investment and its determinants, technological changes, and so on. But no one has yet discovered a foolproof method of economic forecasting. The Overall effect of changes in the policy instruments, like, changes in government spending and taxation is determined by the rate of dynamic multiplier. Forecasting the multiplier is in itself an extremely difficult task and a time consuming process. Therefore, by the time the full impact of one policy change is realized, economic conditions change necessitating another change in the fiscal policy. A decision and execution lag in case of discretionary fiscal policy makes both working and efficacy of fiscal policy shrouded with uncertainty. Working and effectiveness of fiscal policy in underdeveloped countries is severely limited by a) low levels of income, b) small proportion of population in taxable income groups, c) existence of large non - monetized sector, d) all pervasive corruption and inefficiency in administration, especially in tax collection machinery. Countries which are excessively dependent on fiscal policy for their economic management, the governments are often forced to have recourse to internal and external borrowings and deficit financing. Excessive borrowings take such countries close to debt trap and deficit financing beyond the absorption capacity of the economy accelerates the pace of inflation, which further creates other control problems.

Fiscal Policy Effects Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses hence in this note we consider some of the microeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives. The microeconomic effects of fiscal policy 1. Taxation and work incentives Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to
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work a certain number of hours, and changes in direct tax rates will not alter that. The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn. Changes to the tax and benefit system also seek to reduce the risk of the poverty trap where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and thereby increase the economys non-inflationary growth rate. 2. Taxation and the Pattern of Demand Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as demerit goods. In contrast, a government financial subsidy to producers has the effect of reducing their costs of production, lowering the market price and encouraging an expansion of demand. The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources e.g. providing basic state health care free at the point of use. 3. Taxation and labour productivity Some economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult. 4. Taxation and business investment decisions Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nations capital stock can rise and the capital stock per worker employed can rise. The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the Irish economy over the last fifteen years. Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas of government spending might also be used to stimulate investment in
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technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy. Measuring the fiscal stance The fiscal stance is a term that is used to describe whether fiscal policy is being used to actively expand demand and output in the economy (a reflationary or expansionary fiscal stance) or conversely to take demand out of the circular flow (a deflationary fiscal stance). A neutral fiscal stance might be shown if the government runs with a balanced budget where government spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal stance means that policy has no impact on the level of economic activity A reflationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity. A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The government is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand and economic activity falls.when some components of AD (notably export demand and investment) have been weak. The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demandstimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand.

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Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand management. We will consider below some of the criticisms of using fiscal policy as a tool of stabilising demand and output in the economy. The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates.

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Problems with Fiscal Policy as an Instrument of Demand Management In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilizing demand and output. Recognition lags and policy time lags Inevitably, it takes time to for government policy-makers to recognise that AD is growing either too quickly or too slowly and a need for some active discretionary changes in spending or taxation. It then takes time to implement an appropriate policy response government spending plans are subject to a three year spending review and cannot be changed immediately. Likewise the tax system is highly complex for example income tax can only normally be changed once a year at the time of the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of aggregate demand. It then takes time for the change in fiscal policy to work, as the multiplier process on national income, output and employment is not instantaneous. EFFECTIVENESS OF FISCAL POLICY The critics of Keynesians theory has pointed out that expansionary effect of fiscal policy is not as larger as Keynesians economists suggest. In Keynesians theory it is asserted that the Government increases its expenditure, without raising its taxes or when it reduces taxes without changing expenditure it will have a large expansionary effect of national income. In other words deficit budget would lead to the large increase in aggregate demand and thereby help to expand national output and income. However it has been pointed that the above analysis of the effect expansionary fiscal policy of budget deficit ignores the effect of increase in government expenditure or budget deficit on private investment. It has been argued that the increase in government expenditure or creation of budget deficit adversely affects private investment which offsets to a good extent the expansionary affects of budget deficit. This adverse effect comes about as increase in Government expenditure or reduction in taxes causes rate of interest to go up. There are two ways in which rise in rate of interest is explained. First, within the framework of Keynesian theory increase in government expenditure leads to the rise in the national output which raises the transaction demand for money. Given the supply of money in the economy, the increase in transactions demand for money will cause the rate of interest to go up. Secondly, in order to finance its budget deficit the government will borrow funds from the market. This will raise the demand
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for the loanable funds which will bring about rise in the rate of interest. Whatever the mechanism the budget deficit or increase in Government expenditure to achieve expansion in national income and output will cause the rate of interest to go up. The rise in the rate of interest will discourage private investment. As we know from the theory of investment, at a higher rate of interest, private investment declines. Thus, increase in government expenditure or fiscal policy of budget deficit crowds out private investment. This fall in private investment as a result of the rise in rate of interest will be quiet substantial and will greatly offset the expansionary effect of the increase in the government expenditure. On the contrary, if investment demand is relatively inelastic, the rise in rate of interest will lead to only a small decline in private investment and therefore crowding out effect will be relatively small.

Differences in the Effectiveness of Monetary and Fiscal Policies When the economy is in a recession (when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree they argue that short term changes in monetary policy do impact quite quickly and strongly on consumer and business behavior. Consider the way in which domestic demand in both the United States and the UK has responded to the interest rate cuts introduced in the wake of the terror attacks on the USA in the autumn of 2001 However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal policy through changes in their own behavior for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this.

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