ARTICLE (March 07 2010): As we know that fiscal policy is the use of government spending and revenue collection to influence the economy as the governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer of payments such as welfare benefits. This expenditure is normally funded through the following:
1) Taxation
2) Seignorage (the benefit from printing money).
3) Borrowing money from the population (fiscal deficit).
4) Consumption of fiscal reserves.
5) Sale of assets (eg land, nationalised assets etc) and;
6) Issuing bonds like treasury bills.
Any fiscal deficit, funded by issuing bonds, like treasury bills etc, requires payment of interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.
We have seen in the past or even in recent past that governments have used, taxation, seignorage, fiscal deficit, sale of assets and issuance of bonds, but were unable to consume the fiscal reserve owing to our long history of deficit budget except 1957.
Fiscal policy is contrasted with monetary policy, which attempts to stabilise the economy by controlling interest rates, exchange rates and the supply of money. It uses two main instruments - government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
-- Aggregate demand and the level of economic activity;
-- The pattern of resource allocation;
-- The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity and its three possible stances are neutral (government spending = tax revenue), expansionary, and contractionary. A neutral stance of fiscal policy implies a balanced budget where the government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
An expansionary stance of fiscal policy involves a net increase in the government spending through rises in the government spending, a fall in taxation revenue, or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget.
Expansionary fiscal policy is usually associated with a budget deficit. Historically, our budget documents, containing budget deficits, are prima self-evident of expansionary stance. A contractionary fiscal policy occurs when net government spending is reduced either through higher taxation revenue, reduced the government spending, or a combination of the two.
This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus, but even during recessionary period and non-availability of surplus, our present government is following this policy.
ECONOMIC EFFECTS OF FISCAL POLICY Governments use fiscal policy to influence the level of aggregate demand in the economy in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that adjusting the government spending and tax rates are the best ways to stimulate aggregate demand.
This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies to stimulate trade due to its size and prestige. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the new deal.
Governments can use budget surplus to do two things - to slow the pace of strong economic growth and to stabilise prices when inflation is too high. Unfortunately, we never have surplus in the history except 1957. Keynesian theory posits that removing funds from the economy will reduce levels of aggregate demand and contract the economy and may stabilise prices.
MONETARY POLICY AND INFLATION Monetary policy is the process a government, central bank, or monetary authority of a country uses to control (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
Monetary policy is referred to as either being an expansionary or a contractionary policy. An expansionary policy increases the total supply of money in the economy and is traditionally used to combat unemployment in a recession by lowering interest rates. On the other hand, a contractionary policy decreases the total money supply and involves raising interest rates to combat inflation.
Monetary inflation is a term used by some economists to differentiate direct inflation in the money supply (or debasement of the means of exchange) from price inflation, which they view as a result or necessary outcome of the former. Pakistani economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply
However, there is conflict in views of local economists about the factors determining low to moderate rates of inflation in Pakistan. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.
MONETARY VS. FISCAL POLICY AND INFLATION The description of the actual mechanism and relationship between price inflation and monetary inflation varies according to each school of thought, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms.
Some classical and neo-classical economists argue that fiscal policy can have no stimulus effect and is known as the Treasury View, which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, which opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by neo-classical economists up to the present.
From their point of view, when the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When the governments fund a deficit with the release of government bonds, interest rates can increase across the market.
This is because the government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out; it is a "sister" of monetary policy.
In the classical view, fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When the government borrowing increases, interest rates attract foreign capital from foreign investors.
This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies, wanting to finance projects, must compete with their government for capital so they offer higher rates of return.
To purchase bonds, originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases.
The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.
Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle.
For instance, if a fiscal stimulus employs a worker, who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labour supply remains fixed, leading to inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.
Although the system is complex and great deal of argument on how to measure the monetary base or how much factors like the velocity of money affect the relationship, and even more disagreement on what is the best monetary policy, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation.
Inflation targeting is advised by followers of the monetarist school, while Austrian economists advocate the return to genuine free market, which would entail the abolition of the state-sponsored and protected central bank, which protects and supports and controls modern fractional reserve banking and advocate instead free banking or (more often) a return to a 100 percent gold standard.
CURRENT PROBLEM AND POLICY Everywhere, the rootcause of inflation is raising food and fuel prices. Adding the insult to injury, indirect taxes were loaded on fuels having direct nexus with food inflation. Further, poor governance in managing the crops, lack of attention to minor crops, livestock and dairy products by successive governments also contributed to the surge in the domestic price level while the government never tried to take the benefit of positive effects of inflation for mitigation of economic recessions and debt relief by reducing the real level of debt.
It is apparent from the discussion that the GDP, employment, investment spending, capacity utilisation, household incomes, business profits and inflation all fall during recessions while bankruptcies and the unemployment rate rise.
Surprisingly, owing to non-alignment of monetary and fiscal policies, the inflation increased considerably because indirect taxes were loaded on fuels having direct nexus with food inflation, electricity shortage resulting in under utilisation of capacity, corporatization of basic utilities, promotion of cartels, and profiteering due to hoarding.
Recessions are generally believed to be caused by a widespread drop in spending. The governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply, increasing government spending and decreasing taxation. In contrast, inflation increased during the recessionary period in Pakistan owing to our prudent policies of loading indirect taxation on basic utilities, including fuel, decreasing money supply through tight monetary policy, decreasing government spending and increasing taxation.
It seems that Pakistan is currently using the contractionary fiscal policy through higher taxation revenue and reduced government spending. On monetary policy front, it is using interest rate and exchange rate adjustment for macroeconomic stability.
Although, Keynesian theory posits that removing funds from the economy will reduce levels of aggregate demand and contract the economy presumably in order to achieve stabilisation of prices. The drawback of these policies includes hoardings, profiteering, low capacity utilisation and increased unemployment.
Historically, our budget documents containing budget deficits are prima self evident of expansionary stance. Contractionary fiscal policy is usually associated with a surplus but even during recessionary period and non-availability of surplus, our present government is following this policy.
We are still stuck-up with the fashionable terms like tax-to-GDP ratio, which represents the market value of all final goods and services made within the borders of a country in a year just to see how much tax was contributed by the society out of its production not profit.
It also seems that the government is currently following the crowding out effect more specifically by funding the deficit with the release of government bonds that increases interest rates as the government borrowing creates higher demand for credit in the financial markets, thereby causing a lower aggregate demand (AD), which is contrary to the objective of a budget deficit.
Lower AD results in lower capacity utilisation falls, which is liked by the bond market and monetary economists and bankers often watch capacity utilisation indicators for signs of inflation pressures. Bondholders view strong capacity utilisation as a leading indicator of higher inflation, which decreases bond prices although excess capacity means that insufficient demand exists to warrant expansion of output.
Foreign investment has been used to make the currency appreciate or at least stabilise. Pakistani monetary economists have a treasury view. Consequently, the task of keeping the rate of inflation low and stable is usually given to State Bank of Pakistan, which controls the size of the money supply through the setting of interest rates, open market operations and through the setting of banking reserve requirements.
These economists had not even tried to give benefit of positive effects of inflation, including a mitigation of economic recessions and debt relief by reducing the real level of debt.
On the contrary, even the IMF has suggested fiscal impetus plan, that is, fiscal policy should be used to influence the level of aggregate demand in the economy to achieve economic objectives of price stability, full employment, and economic growth. The IMF's fiscal impetus plan is the best alternative in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies to stimulate trade due to its size and prestige.
The description of the actual mechanism and relationship between price inflation and monetary inflation varies according to each school of thought, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms and there lies the importance of fiscal stimulus plan or the application of principles of Islamic economics.
(To be continued)
taxonomy.ashraf@gmail.com
Source: http://www.brecorder.com/index.php?id=1027950&currPageNo=1&query=&search=&term=&supDate=
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