Let us make an in-debt study of the role of fiscal policy in controlling inflation.
The economy’s levels of output, employment, and income are influenced by the relationship between the amount that the government levies in taxes and the amount that it spends. A change in either taxes or spending may induce an expansion or contraction in the economy.
Changes in taxes and/or government spending to control unemployment or demand- pull inflation are termed fiscal policy.
Fiscal policy has evolved largely from the theories of J. M. Keynes, who focused on the relationship between aggregate spending and the level of economic activity, and suggested that the government could fill in a spending gap created by a lack of private spending.
The Mechanics of Fiscal Policy:
Very simply, increases or decreases in total spending due to changes in taxes and/or government expenditures can lead to expansions or contractions in economic activity.
If there is high unemployment, policymakers can take action to increase the level of aggregate spending and, consequently, the level of economic activity.
This increased spending could come from:
(1) Increased government purchases of goods and services, and/or
(2) Increased transfer payments, and/or
(3) Decreased taxes.
These three actions could be taken separately or in combination.
Although each of these actions can cause economic activity to grow, the expansionary impact of increasing government purchases by a particular amount is greater than the expansionary impact of increasing transfers or decreasing taxes by the same amount. All of the rupees spent on government purchases are injected directly into the spending stream, whereas increased transfers and decreased taxes provide additional income — part of which will be spent but part of which will be saved.
If the economy is experiencing demand- pull inflation, the appropriate fiscal policy action for lowering the inflation rate is to decrease aggregate spending.
Excess spending could be removed from the economy by:
(1) Decreasing government purchases of goods and services, and/or
(2) Decreasing transfer payments, and/or
(3) Increasing taxes.
Again, a more sharp decrease in spending results from a decrease in government purchases because some of the reduced transfers and increased taxes would affect saving rather than spending.