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Unit 14: Macro Economic Policies: Fiscal Policy

Crowding Out: Increased government spending (G) to increased AD may cause "Crowding out" Notes
Crowding out occurs when increased government spending results in decreasing the size of the
private sector.
Monetarist Critique: Monetarists argue that in the long run AS is inelastic therefore an increase
in AD will only cause inflation to increase.

Caselet RBI Must Balance Fiscal and Monetary Policy

he government must do its bit to contain inflation and shore up investment: contain
the fiscal deficit and direct investment, by itself or through clearheaded, decisive
Tpolicy, to remove the supply bottlenecks that feed inflation. This is the unambiguous
message of the RBI's first quarter review of monetary policy.
For all the brouhaha over its higher-than-expected hike in the repo rate, at which it lends
to banks, there are two reassuring aspects of the policy review. One, the baseline GDP
growth rate for the current year has been retained at 8%, the rate projected in the policy
statement of May 3. Clearly, the RBI does not expect growth to be hit by its tough love act,
raising the repo rate by 50 basis points, twice as much as anticipated, to 8%.
Two, the central bank seems far more determined than before to get inflation under
control. Unlike in 2010-11, when it failed to read the writing on the wall and maintained
its dovish assumption on year-end inflation, only to end up with egg on its face when the
final March 2011 number was way ahead of its estimate, this time round it has opted to
play safe. It has raised its inflation projection for March 2012 to 7%, up from 6% projected
in its May statement.
This is recognition (albeit belated) both of the limited options available to a central bank
in a scenario where the government refuses to play ball and of the fact that inflation has
now become a 'dominant' Macro Economic concern.
But as the Statement points out, when the government drags its feet and acts irresponsibly
by failing to keep the fiscal deficit under control, monetary policy has to overcompensate.
The net effect is that the RBI ends up carrying the can for the government and not achieving
very much for its efforts either, since, for a variety of structural reasons, the monetary
transmission mechanism or signaling system is not as efficient as it should be.

All the more reason for fiscal and monetary policy to act in tandem in order is to achieve
the twin Macro Economic goals of sustained growth with price stability. Sub-optimal
results ensue when monetary and fiscal policy pull in different directions. The RBI is
doing its job right. It is up to the government to the right thing, too.

Source: www.articles.economictimes.indiatimes.com

Self Assessment

State whether the following statements are true or false:
14. Lower future spending commitments mean that future taxes won't have to rise as much.
15. Crowding out occurs when increased government spending results in increasing the size
of the private sector.
16. Higher tax rates don't necessarily mean that there is lesser incentive to work.

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