Fiscal Policy∗

Divya Gupta

Economics II

∗
Please note that the slides are not substitutes to classroom discussions and main
reading(s).
Divya Gupta Fiscal Policy∗ Economics II 1 / 41
References

Neva Goodwin: Chapter 25

Kalecki, M. (1943). Political aspects of full employment. New York
and London.
Patnaik, P. (2005). The Humbug of Finance

Divya Gupta Fiscal Policy∗ Economics II 2 / 41

From the last discussion..

A few concepts to be reminded of:

In a two-sector economy: AD = C + Ii
In equilibrium: Y = AD = C + Ii
In Keynesian model, consumption function is: C = C + mpcY ; and
Investment is autonomous, that is, Ii = I i .
Actual Investment may be unequal to Ii (intended investment), giving
rise to unintended inventories.
In Keynesian model, there is a multiplier effect of private investment
on GDP, which means that one unit change in Investment leads to a
change in output (Y) greater than one.
1
Multiplier = 1−mpc
1
Thus, ∆Y = 1−mpc ∆I i

Divya Gupta Fiscal Policy∗ Economics II 3 / 41

Introduction: Need for fiscal policy

During the Great Depression of 1930s, Keynes suggested government

action to stimulate output and to help the economy recover and grow
further.
Similarly, much later, during the Global Recession of 2007, the then
US government (Obama administration) introduced a stimulus
package for the US economy to recover, which included - expanded
government spending and tax cuts.
What’s common in the above two policy stances by the respective
governments?
Both actions are the Keynesian responses to an economy on the
trough part of the business cycle.

Divya Gupta Fiscal Policy∗ Economics II 4 / 41

Introduction: Need for fiscal policy (contd.)

Although classical economists would have suggested to let the

markets operate freely which will automatically enable the economy
to recover (may be in the long run).
Keynesian economists argued that in recessionary times, private firms
may not want to invest at all (recall the assumption under Keynesian
model that Investment depends only on market expectations), which
may further deepen the crisis, eventually pushing the economy into
depression - stuck in a ‘low output equilibrium trap’.
Thus, government action is required to create the necessary demand
in the economy and boost income levels as well as confidence of the
firms; and bring the economy out of this trap.
Such government actions of spending and tax cuts are called as
‘fiscal policy’ actions.

Divya Gupta Fiscal Policy∗ Economics II 5 / 41

Aggregate Demand: Three-sectors
Introducing the third sector

In a three-sector economy, aggregate demand in the economy now

looks like:
AD = C + Ii + G
where, G represents the government spending on goods and services, including
spending by central, state, and local governments.
In a two-sector model, we saw how a fall in I i led to a fall (downward
shift) in the AD curve.
Now, in a three-sector model, this can be corrected through
government spending.
G is assumed to be autonomous (that is, no direct relation with
income and fixed or constant during a period of time). Thus, G = G .
An increase in G will shift the AD curve upward and hence, can
counter the effect of fall in I i .
The effect of increase in ‘G ’ works in exactly the same way as that of
an increase in I i .
Divya Gupta Fiscal Policy∗ Economics II 6 / 41
Government Spending and shift in AD
Graphical representation

Divya Gupta Fiscal Policy∗ Economics II 7 / 41

Government Spending and shift in AD
Graphical explanation

In the diagram on slide 7, AD0 depicts the AD in two-sector economy,

where G = 0.
If G increases by 80, i.e. ∆G = 80, the new AD1 is higher than AD0
by exactly 80 units.
Thus, the economy now moves to a higher equilibrium output, from
Y0 = 400 to Y1 = 800.
Remember from discussion of two-sector model, a fall in Ii led to a fall
in income from 800 to 400 - which was an unemployment equilibrium.
With the help of increase in G , we are back to full-employment
equilibrium of 800.
Notice that an increase in G by 80 units leads to increase in Y by
more than 80 units.
That is, for ∆G = 0, ∆Y = 400. Multiplier effect?
Divya Gupta Fiscal Policy∗ Economics II 8 / 41
Government Spending Multiplier
1 The initial change in government spending by 80 (i.e. (∆G = 80)) becomes
income to individuals, i.e. ∆Y = 80
For example, under a new public works/construction program, the
government spends on goods such as concrete and steel as well as makes
wage payments to workers; all of which total to 80.
2 The first stage increase in income leads to a second round of increase in
income via increased consumer spending. That is, workers who earned wages
worth 80 in stage 1, will spend some of it on consumption of goods and
services. That is, ∆C = mpc.∆Y .
Suppose, mpc = 0.8, therefore, ∆C = 0.8(80) = 64.
Increased consumption by 64 leads to more demand for goods and
services, inducing producers to increase output (and hence income) by
64. Therefore, ∆Y = 64
3 A second round of income generated (by 64) leads to another round of

consumer spending, by ∆C = 0.8(64) = 51.2; finally leading to ∆Y = 51.2

4 And so on...

Thus, the whole process can be summarized using the same formula as that for
investment multiplier derived earlier (during our discussion of 2-sector economy).
Divya Gupta Fiscal Policy∗ Economics II 9 / 41
Government Spending Multiplier (contd.)

The total change in output owing to a one-time change in

government spending in G by 80 can be, thus, summarised as:
∆Y = 80 + 64 + 51.2 + ....
∆Y = 80 + 0.8(80) + 0.82 (80) + .....
1
∆Y = 80 1−0.8
Thus, government spending multiplier, that is, the multiplier effect of
a unit change in government spending on the output in the economy,
is given by:
1
∆Y = 1−mpc ∆G
1
where, the government spending multiplier is:
1−mpc

Divya Gupta Fiscal Policy∗ Economics II 10 / 41

Taxes and Transfer Payments
As already discussed, fiscal policy includes not just government
spending decisions but also taxes and transfer payments.
While one way of stimulating/increasing output in the economy is
through increased government spending, another policy instrument is
to reduce/cut taxes or increase transfer payments.
Taxes are assumed to be lump-sum and direct taxes - more
specifically, personal income taxes.
Transfer payments are one-sided payments (that is, not in exchange
of any production or service) made by the government to individuals
or firms, such as social security payments, unemployment allowances,
cash transfers, and subsidies etc.
These policy instruments differ from government spending (G) in one
main aspect - that, while G has a direct effect on output (Y ) because
it is a direct component of AD, taxes and transfer payments have an
indirect effect on Y , as they first affect consumption by households
(C ), which then further affects Y .
Divya Gupta Fiscal Policy∗ Economics II 11 / 41
Taxes and Transfer Payments (contd.)
Therefore, the mechanism by which changes in taxes and transfer
payments affect output differs from the process discussed for
government spending.
Taxes and transfer payments are both assumed to be fixed (or
lump-sum) and do not change with income; i.e., T = T and
TR = TR.
Households, now, pay some part of their total income (Y ) as taxes
which they can not use for consumption. Furthermore, in addition to
Y, they also receive transfer payments which they can use for
consumption.
Therefore, households now consume and/or save out of what is called
a ‘disposable income’, which is the income remaining for consumption
or saving after subtracting taxes and adding transfer payments, i.e.:
Yd = Y − T + TR
where,Yd is disposable income, T are lump-sum taxes, and TR are fixed transfer
payments.
Divya Gupta Fiscal Policy∗ Economics II 12 / 41
Taxes and Transfer Payments (contd.)

Note that taxes and transfer payments first affect the disposable
income of households, via which they affect the C component of AD.
Consumption function without taxes and transfer payments was:
C = C + mpc.Y
Consumption function with taxes and transfer payments becomes:
C = C + mpc.Yd , that is
C = C + mpc.(Y − T + TR)
Therefore, it is clear from the above equation that T and TR will first
affect Yd and then Yd affects C . The effect of changes in T and TR
on C , is thus, given by:
∆C = mpc(−∆T + ∆TR)

Divya Gupta Fiscal Policy∗ Economics II 13 / 41

Tax Multiplier
As seen previously, the effect of taxes and transfer payments on C can be
given by: ∆C = mpc(−∆T + ∆TR).
Suppose, households receive a tax cut of 80 (i.e. ∆T = −80) and no
transfer payments, i.e. TR = 0. Then, if mpc = 0.8, the first effect on
consumption is: ∆C = 0.8(−(−80)) = 64. That is, with a tax cut of 80,
consumption increases by 64 and not 80 (why? ). Subsequently,in response
to increased consumption, producers will respond by increasing output by
64, i.e. ∆Y = 64
Compare this with the first stage impact of increased G. When G increased
by the same amount of 80, the first stage effect on output was it to increase
by 80.
Hence, it is clear that the impact of a lump-sum tax cut on economic
equilibrium is less than that of G which affects the aggregate demand
directly.
The multiplier effects of changes in taxes and transfer payments are, thus,
smaller than the multiplier impacts of government spending.
To derive tax multiplier, let’s first assume that TR = 0.
Divya Gupta Fiscal Policy∗ Economics II 14 / 41
Tax Multiplier (contd.)
In equilibrium: Y = C + I i + G .
We can write: ∆Y = ∆C + ∆I i + ∆G .
Or; ∆Y = ∆C + mpc.(∆Y − ∆T + ∆TR) + ∆I i + ∆G .
Assuming nothing else changes, except for taxes, we have:
∆C = ∆TR = ∆I i = ∆G = 0.
Therefore, ∆Y = mpc(∆Y − ∆T )
Or; ∆Y = mpc(∆Y ) − mpc(∆T )
Or; ∆Y (1 − mpc) = −mpc(∆T )
Finally, we have:
−mpc
∆Y = 1−mpc (∆T )
−mpc
where, 1−mpc is the tax multiplier.
Note: the negative sign indicates the inverse relation between taxes and output.
That is, an increase in taxes reduces output and vice-versa.
Divya Gupta Fiscal Policy∗ Economics II 15 / 41
Transfer Payments Multiplier
Transfer payments, which as we noted are a kind of “negative tax”, affect
the level of output through a similar logic.
An increase in transfer payments, like a tax cut, will give people more
income that they can spend, i.e., their disposable income increases.
But just like a tax-cut, the expansionary effect of increased transfer
payments will be via increase in households’ consumption, and not via a
direct effect on AD.
The first and immediate effect will be to increase consumption (C) and
hence, output (Y) by mpc times the change in transfer payments, i.e. at
first stage: ∆Y = mpc(∆TR).
The multiplier impact of a change in transfer payments is therefore the same
as that of a change in taxes, except in the opposite direction.
mpc
Transfer Payment multiplier, thus, is given by: ∆Y = 1−mpc (∆TR)
A cut in transfer payments, like an increase in taxes, will be contractionary,
tending to lower economic equilibrium and vice-versa.
A side note: For simplicity, we may sometimes refer to taxes and transfer payments jointly
as ‘net taxes’, where net taxes are Taxes minus Transfer Payments.
Divya Gupta Fiscal Policy∗ Economics II 16 / 41
The Budget

An account of government’s outlays (expenditure) and revenues is the

government budget.
Total outlay of govt. includes spending on goods and services as well
as transfer payments, that is,
Govt. Outlay (total govt. expenditure) = G + TR
In terms of revenue, the primary source of govt.’s revenue is Taxes,
that is, Revenue = T .
In case of shortfall in revenues from taxes, the govt. borrows to cover
the outlays, which is called deficit financing.
This is facilitated through issue of govt. bonds, which are interest-bearing
govt. securities constituting a promise to pay the amount borrowed at a
specified time in the future.
These bonds can be bought by firms, individuals, or foreign governments.

Divya Gupta Fiscal Policy∗ Economics II 17 / 41

The Budget
Deficit and Surplus

The expenditures by the govt. can be of two-types:

Off-budget: govt. funded programs that are exempted from the normal
budgeting process because the taxes that fund them cannot be used for
budgetary items that are subject to parliamentary appropriations.
On-budget: all federal expenditures that rely on general tax revenue subject
to parliamentary approval each year.
Appropriation: Congressional (basically, parliamentary) approval required for
each of the on-budget spending items.
Budget Surplus (+) or Deficit (-) = T (total revenue) - (G + TR)
(total govt. outlays).
Budget Deficit or Fiscal Deficit: an excess of total government outlays
over total government tax revenues; that is, when (G + TR) − T > 0
Budget Surplus: an excess of total government tax revenues over
total government outlays; that is, when (G + TR) − T < 0

Divya Gupta Fiscal Policy∗ Economics II 18 / 41

Union Budget of India: 2023-24
Sources of Revenues

Divya Gupta Fiscal Policy∗ Economics II 19 / 41

Union Budget of India: 2023-24
Avenues of Expenditures

Divya Gupta Fiscal Policy∗ Economics II 20 / 41

Fiscal Deficit for India: 2023-24

Divya Gupta Fiscal Policy∗ Economics II 21 / 41

Sources of financing Fiscal Deficit for India: 2023-24

Divya Gupta Fiscal Policy∗ Economics II 22 / 41

Balanced Budget Multiplier
What is the meaning of “Balanced Budget”?
When the government maintains a balance in its budget, that is, expenditure
= revenue.
Now suppose, in case of an economic downturn, a fiscal policy stimulus is
required. However, the govt., which is already facing a fiscal deficit, does
not want to increase it any further. In such a situation, the govt. decides to
fund its “increased spending” through “increased taxes”, hence, maintaining
a balanced budget approach (and hence, having no effect on widening the
fiscal deficit).
What effect would it have on the output?
We know that increased spending leads to higher output, whereas increased
taxes lead to lower output. So, in case of a balanced budget, would the
effects cancel out each other?
NO! Because the effect of rise in govt. spending (+ve) is higher than the
effect of rise in taxes (-ve). (Remember, the multiplier effect of change in
taxes is smaller than the multiplier effect of change in government spending.)
Divya Gupta Fiscal Policy∗ Economics II 23 / 41
Balanced Budget Multiplier (contd.)

Thus, there is a net ‘positive (+ve) effect’ on output.

The net multiplier effect = 1, which we call ‘Balanced Budget
Multiplier (BBM)’. How?
BBM is defined as the impact on equilibrium output of simultaneous
increases of equal size in government spending and taxes.
In case of a balanced budget approach, change in govt. spending is
equal to change in taxes; that is ∆G = ∆T , in both there is an
increase, so ∆G &∆T > 0.
From our earlier discussions of govt. spending multiplier and tax
multiplier, We know:
1
Effect of ∆G is given by: ∆Y = 1−mpc ∆G
−mpc
Similarly, effect of ∆T is given by: ∆Y = 1−mpc ∆T

Divya Gupta Fiscal Policy∗ Economics II 24 / 41

Balanced Budget Multiplier (contd.)

Total effect on output is, thus, the effect on output due to increased
G + the effect on output due to increased T.
That is, ∆Ytotal = ∆YG + ∆YT .
1 −mpc
∆Ytotal = 1−mpc ∆G + 1−mpc ∆T
Since ∆G = ∆T , we can write the above equation as:
1 −mpc
∆Y = 1−mpc ∆G + 1−mpc ∆G
1 −mpc
This implies that: ∆Y = [( 1−mpc ) + ( 1−mpc )]∆G
1−mpc
Thus, ∆Y = ( 1−mpc )∆G
That is, ∆Y = (1)∆G
Therefore, the Balanced Budget Multiplier (BBM) = 1.

Divya Gupta Fiscal Policy∗ Economics II 25 / 41

Circular Flow of Income: Three sector economy
Re-imagine the circular flow of income in an economy with the govt. sector
and the role of govt. spending and taxes in it.
Analysing it from the perspectives of leakages and injections:
Net taxes (i.e., T − TR) are leakages as they reduce household’s purchasing
power and are not spent on consumption.
Using these tax revenues, the govt. spending then brings it back into the
flow and hence are injections into the system.

Notice that these leakages and injections are in addition to the existing saving and
investment, respectively.
Divya Gupta Fiscal Policy∗ Economics II 26 / 41
Types of Fiscal Policies
Expansionary - when a fiscal policy tool (govt. spending, transfer
payments, or taxes) is used to stimulate the economic activity, that is,
to increase the output of the economy, then the fiscal policy is termed
as an expansionary fiscal policy.
Policy tools under expansionary fiscal policy include:
Increase in govt. spending
Increase in transfer payments
Decrease in taxes, that is, tax-cuts
Possible side-effects of an expansionary fiscal policy
Funding higher spending through higher taxes or borrowings which may
create deficits and debt burden on govt.
Inflation - higher aggregate demand as a result of higher G can lead to
excessive inflation if this output is pushed beyond the full-employment
level of output. (Note that governments may want to increase G
despite full-employment output, for the benefit of their vote banks).
Thus, in such situations of excessive inflation, we have another policy
response.
Divya Gupta Fiscal Policy∗ Economics II 27 / 41
Types of Fiscal Policies (contd.)

Contractionary- reductions in government spending or transfer

payments or increases in taxes, leading to a lower level of economic
activity, that is, lower output, is called contractionary fiscal policy.
Must not be used at times of high unemployment.
Can prove to be powerful tools against inflation, especially when
previous policies have “overshot” the goal.
Based on the response of the govt. in relation to the business cycle, the
fiscal policy can be divided into two types:
Counter-cyclical fiscal policy - fiscal policy which aims to counter
the business cycle, that is, against the movement of the cycle.
Thus, in case of an economic downturn, taxes are lowered and
expenditure is raised under counter-cyclical policies; likewise, taxes are
raise and expenditure lowered when the economy is strong.

Divya Gupta Fiscal Policy∗ Economics II 28 / 41

Types of Fiscal Policies (contd.)

Pro-cyclical fiscal policy - fiscal policy which moves along the

direction of the business cycle.
Thus, in case of an economic downturn, taxes are raised and
expenditure is lowered under pro-cyclical policies; likewise, taxes are
lowered and expenditure raised even when the economy is already
going strong.
In this policies, both recessions and booms are reinforced rather than
counterbalanced.
These policies are adopted and implemented mostly out of voters
concerns, as voters are more inclined to support local spending on
schools, for example, when times are good.
Automatic Stabilizers - Automatic stabilisers are tax and spending
institutions that tend to increase government revenues and lower
government spending during economic expansions but lower revenues
and raise government spending during economic recessions.
Deficits and surpluses are not just a result of active fiscal policy.

Divya Gupta Fiscal Policy∗ Economics II 29 / 41

Types of Fiscal Policies (contd.)
Automatic Stabilizers (contd.) -
A significant portion of the variations in government spending and tax
revenues occurs “automatically”, due to mechanisms built into the
economic system to help stabilize it.
For example, in case of boom, tax revenues of govt. increase due to
higher incomes with households and the need for transfer payments,
such as unemployment allowance goes down due to higher employment.
This means that personal disposable income does not rise as quickly as
national income which in turn, puts a damper on increases in consumer
spending - and limits the inflationary overheating that can arise from
increased aggregate demand.
Thus, the effect of higher output is stabilised without the govt. having
to implement an active policy.
Similarly, during a recession, tax revenues decline as people have less
income and more people receive unemployment allowances. This
provides a cushion to the fall in consumer spending. These automatic
changes in spending and taxes tend to moderate the recession.
Divya Gupta Fiscal Policy∗ Economics II 30 / 41
Types of Fiscal Policies (contd.)
Discretionary fiscal policy -
Sometimes, adjustments in outputs may happen automatically on
account of movement of the business cycle.
But, sometimes the automatic stabilization effect of government
spending and taxes cannot smooth economic ups and downs as much
as is needed.
Thus, in those situations, govt. has to take deliberate policy decisions
related to its spending and taxation - these are called “discretionary
fiscal policies”.
Historically though, this ‘fine-tuning’ of the economy using fiscal policy
was largely discredited in the 1970s and 1980s.
The problem was that ‘time-lags’, that is, the time that elapses
between the formulation of an economic policy and its actual effects on
the economy, made fiscal policy unwieldy and often counterproductive.
There are two types of lags: inside and outside lags.
Inside lags refer to delays that occur within the government, such as data
lags, recognition lags, legislative lags and transmission lags.
Outside lags refer to the delayed effects of government policies.
Divya Gupta Fiscal Policy∗ Economics II 31 / 41
Types of Fiscal Deficit (Surplus)
Cyclical deficit - In the context of automatic adjustments, the
portion of the deficit (surplus) that is the result of automatic
stabilizers are called the cyclical deficit (or surplus).
For example, a situation of automatic surplus generated in boom periods due
to higher tax collections and lower spending on transfer payments.
Similarly, during recession, tax revenues fall due to lower income with
households and higher unemployment necessitates the need for more
unemployment allowances putting an upward pressure on govt. spending.
This leads to a situation of budget deficit.
Structural deficit - Just like automatic stabilisers led to creation of
cyclical deficit/ surplus situation, discretionary fiscal policies create
structural deficit or surplus.
Structural fiscal deficit or surplus is that portion of the deficit (surplus) that
is the result of tax and spending policy dictated by the Parliament/ Ministry
of Finance at their discretion.
Only changes in the structural budget balance truly reflect the direction of
fiscal policy—that is, whether it is expansionary or contractionary.
This is because other changes in the budget are related to the automatic
stabilizers.
Divya Gupta Fiscal Policy∗ Economics II 32 / 41
Crowding Out
A common issue with using fiscal policy for stimulating economy is that
govt. spending may get in the way of consumption and private investment.
For financing a higher govt. spending, we know that the primary source of
revenue is raising taxes. However, this is not the only means.
In addition to using tax revenues, govt. has to often borrow from the market
for loanable funds (or capital markets).
This leaves lesser funds available for private investment.
Further, the reduced availability of loanable funds can have the effect of
raising interest rates, which, by making borrowing more expensive, makes
investment less likely, ceteris paribus.
Thus, borrowing by the govt. to help cover budget deficits may have the
effect of “crowding out” of private investment.
Economists who favor the classical approach often claim that replacing
dynamic private investment with “clumsy” government spending is wasteful
and inefficient.
The implication of this analysis is that government deficit spending is
counterproductive to the aim of promoting private investment.
Divya Gupta Fiscal Policy∗ Economics II 33 / 41
Crowding Out (contd.)
As shown in figure, govt.’s borrowing to finance its budget deficit leads to a higher
demand for total funds, which shifts the demand curve upwards, from D1 to D2 .
Here D1 indicates demand for funds by firms (i.e. Ii ) and D2 includes demand by
firms plus govt. (i.e. Ii + G ).
As a result of upward shift in demand curve, the new equilibrium is now attained
at a higher interest rate, i2 .
At i2 , the corresponding demand for funds by private firms is only Q3 .
This fall in private investment from Q1 (before govt. intervention) to Q3 (due to
govt. borrowings) is called ‘crowding out’ of private investment.
Although, the equilibrium quantity increases from Q1 to Q2 .

Divya Gupta Fiscal Policy∗ Economics II 34 / 41

Crowding In
While the classical economists argued about the crowding out effect of
fiscal policy, Keynes acknowledged these issues but did not consider them
to be of significant degree. Further, various arguments in favour of the
need for the government to maintain higher fiscal deficits (especially so in
the context of developing economies) have also been put forth by Prabhat
Patnaik in “The Humbug of Finance” and by M. Kalecki in “Political
Aspects of Full Employment”. All these arguments can be summarised as
follows∗ :
1 Private Investment depends on Market expectations.

Recall, Keynes believed that private investment depends on future

expectations (animal spirits) and not only on the interest rates.
Therefore, he argued that in good economic times, investors purchase
more capital goods because their growing profits reinforce an optimistic
outlook about the future. Thus, are likely to do so even if the interest
rates rise during boom.
∗
Please go through the readings for a detailed discussion of each of these points.
Divya Gupta Fiscal Policy∗ Economics II 35 / 41
Crowding In (contd.)
1 Private Investment depends on Market expectations (contd.).
Due to higher fiscal spending, when the economy recovers or grows,
market sentiments improve, hence leading to an increase in private
investment, despite increasing interest rates.
Lastly, government borrowing to finance deficits may not necessarily
raise interest rates during a recession and even if it does, this might
not have any significant effect on investment, since investors will not
want to invest anyway.
2 Public and Private investments are complementary to each
other.
The nature of investments by the government and private sector (firms)
are such that there is a scope for complementarity between them.
For example, certain government expenditures on, say, transportation,
energy, or communications networks enhance the potential profits of
private investment by providing critical infrastructure.
Thus, Keynes concluded that there is, in fact, crowding in: the process
in which government spending leads to more favorable expectations for
the economy, thereby inducing private investment.
Divya Gupta Fiscal Policy∗ Economics II 36 / 41
Crowding In (contd.)

3 The pool of savings is not fixed.

The classical argument of crowing out implicitly assumes the pool of
savings (that is, the supply of loanable funds) to be constant. Hence,
the supply curve does not shift.
However, when govt. spending increases, through multiplier effect,
income increases; and because the keynesian model assumes savings to
be a function of income, savings also increase.
This argument was advanced by Richard Kahn (Keynes’ student).
This increase in savings will increase supply of loanable funds as well.
Hence, the interest rates will either not increase at all, or may actually
decrease; or even if they increase, they may not increase a lot - because
both demand and supply curves will shift.
Thus, in other words, a fiscal deficit finances itself.

Divya Gupta Fiscal Policy∗ Economics II 37 / 41

Crowding In (contd.)
4 Government’s net indebtedness remains same.
It is acknowledged that a large amount of fiscal deficit is often financed
by the borrowings.
If in an economy, there are public sector enterprises, then What appears
as an increase in the fiscal deficit is counterbalanced by a surplus in the
rest of the government sector, which is not reflected in the budget.
Therefore, this appearance of a fiscal deficit is entirely on account of
the convention of making the budget reflect only a part of the
government sector’s transactions.
For example, in India, the govt. maintains millions of tonnes of
foodgrains via the Food Corporation of India. Now, suppose the govt.
spends Rs. 100 on an employment generation programme (leading to a
deficit/borrowing of Rs 100).
Suppose, that employment generation programme requires only labour
and that labour spends its wages only on foodgrains.
This implies, that Rs.100 would be spent on foodgrains and hence
(ignoring minor complications like transport costs) the FCI’s stocks
would go down by Rs.100.
Divya Gupta Fiscal Policy∗ Economics II 38 / 41
Crowding In (contd.)
4 Government’s net indebtedness remains same. (contd.)
The FCI can then repay Rs.100 to the banks from whom it has taken
credit for stock-holding.
Therefore, what appears as an increase in the fiscal deficit in this case
is no actual increase.
It is only a consequence of the fact that FCI transactions do not figure
in the budget as a matter of convention (indeed they used to figure in
the budget until the early seventies).
5 Political problems with achievement of full-employment via
higher fiscal deficit/ higher govt. spending
There are three major oppositions by the free market proponents to a
higher govt. spending leading to full-employment level of output.
i the dislike of Government interference in the problem of employment as
such;
ii the dislike of the direction of Government spending (public investment
and subsidising consumption) ;
iii dislike of the social and political changes resulting from the
maintenance of full employment.
Note: Please refer to Kalecki for detailed explanation of each of these points of oppositions.
Divya Gupta Fiscal Policy∗ Economics II 39 / 41
Policy issue: Different multiplier effects
An issue of considerable policy controversy is which items in the budget
deserve priority.
While we have seen that the govt. spending has a multiplier effect of greater
than 1, much of this effect can be offset by increased taxes.
Also, it is unrealistic to assume that different types of govt. expenditures
would have a similar multiplier effect.
Lastly, all this while, we assumed mpc to be constant, which drives the
multiplier in motion. However, in reality, this mpc differs across types of
individuals.
For example, mpc might be much higher among lower income groups,
compared to higher income groups.
Thus, based on the above two facts, the total multiplier effect would depend
on the target population of the fiscal policy.
The multiplier is largest when government spending is directed toward those
who have the highest mpc. Hence, govt. spending that benefits the poor or
unemployed is likely to have larger multiplier effects.
Similarly, the smallest multiplier effects tend to be associated with tax cuts,
whether for wealthy individuals or corporations.
Divya Gupta Fiscal Policy∗ Economics II 40 / 41
 All the best!

Divya Gupta Fiscal Policy∗ Economics II 41 / 41