What fiscal policy is
Fiscal policy is the set of government measures dealing with its revenues and expenses. Revenue comes primarily from taxation. Expenditure covers education, healthcare, police, the military, interest on borrowing, the administrative machinery, welfare benefits and more. When the government changes either side, it influences aggregate demand, supply, savings, investment and overall economic activity.
The fiscal deficit
The budgeted excess of the government's expenditure over its revenues in a year is the fiscal deficit, generally expressed as a percentage of GDP. It is bridged through market borrowings, both short-term and long-term. The consequence follows in one chain: a large deficit means more government borrowing, more borrowing pushes up interest rates in the economy, and high rates make it hard for corporate borrowers to access funds. A high interest rate environment is detrimental to growth.
"The fiscal deficit is bridged by the government through market borrowings, both short-term and long-term." True. Treasury bills cover the short end and dated government securities the long end (chapter 2).
The balance of payments and the current account
A country's trade and other contracts with entities abroad produce receipts and payments, captured in an aggregate countrywide statement, the balance of payments (BOP). It includes payments for imports and receipts from exports, interest and dividends received and paid, and other transfers from abroad. The current account balance is the difference between these recurring revenue receipts and payments: a surplus when receipts exceed payments, a deficit when they fall short.
The syllabus treats a high deficit relative to GDP, caused by uncompetitive trade or excessive consumption, as a negative commentary on the economy. A high current account deficit weakens the nation's currency against others. That makes imports more expensive and hurts productivity, since capital goods and commodities cost more; it reduces the nation's creditworthiness and makes foreign currency borrowing dearer. The one relief: a depreciating currency makes exports more competitive and may help narrow the deficit. And if the country is seen as an attractive destination, FDI and portfolio inflows can offset the deficit and protect the currency from devaluation.
A country imports far more than it exports. Its currency slides. The machinery its factories import costs more (productivity hit), lenders abroad demand a higher rate (creditworthiness hit), but its garment exporters find their prices suddenly competitive (the narrowing effect), and a wave of foreign investment into its start-ups steadies the currency (the offset).
How spending is funded
Three fiscal stances
| When used | What the government does and the result | |
|---|---|---|
| Neutral | Income and expenditure are in equilibrium | No major change needed |
| Expansionary | Recessions or a slow-moving economy | Spends more and taxes less, leaving more money with citizens and companies to spend and expand the economy; results in fiscal deficits |
| Contractionary | Inflationary conditions and debt burdens that have overheated the economy to unsustainable levels | Spends less and taxes more, leaving less money to spend and cooling the economy; results in a fiscal surplus |
- Fiscal policy is the government's revenue (mainly taxation) and expenditure (education, healthcare, police, military, interest, administration, welfare). Changing either moves aggregate demand, supply, savings, investment and overall activity.
- The fiscal deficit is the budgeted excess of expenditure over revenue, stated as a percentage of GDP, and is bridged by short-term and long-term market borrowing. A large deficit pushes up interest rates, crowds out corporate borrowers and hurts growth.
- The balance of payments records receipts and payments with abroad; the current account balance is recurring receipts minus payments. A high current account deficit weakens the currency, raises import costs, cuts creditworthiness and makes foreign borrowing dearer, though a weaker currency makes exports more competitive and FDI or portfolio inflows can offset the deficit.
- Spending is funded by recurring revenue (direct and indirect taxes, interest on debt investments, PSU dividends) and capital transactions (foreign and domestic borrowing, disinvestment). Neutral policy balances income and spending; expansionary spends more and taxes less in a slowdown, causing a deficit; contractionary spends less and taxes more in an overheated economy, producing a surplus.