IMPACT OF FISCAL POLICY IN RESOLVING UNEMPLOYMENT IN INDIA

 

Abstract

Through this assignment of mine, some impacts of fiscal policy on unemployment in India have been explained. Unemployment is now one of the major macroeconomic concerns of the country. Government is trying its best to solve this issue but don’t seem to find the right remedy. It has tried both fiscal and monetary policies for this concern among which I would like to look upon the impact of fiscal policies only here in this assignment. After all, I would like to relate this issue with the popular IS-LM framework in both supporting and contradicting ways.

We will have to remember one important and a very basic point. Fiscal policy (cutting down taxes/ increasing spending) can lead to increase in aggregate demand (AD) and rise in real GDP. Thus the economic growth will lead to increase the demand for workers. This leads to rise in employment and reduces unemployment. This basic idea gives us an insight that the fiscal policy has a positive impact on solving unemployment. (Pettinger, 2020)

However, we shall consider some of the economist’s theory as well.

Here I would like to compare Keynesian economists and classical economist’s theories where both of them have contradicting ideas.

·       Keynesian economists say that an expansionary fiscal policy will be able to reduce unemployment. An expansionary fiscal policy would raise aggregate demand creating higher output (also equals income) and thus creating job opportunities.

·       On the other hand the Classical economists don’t feel that expansionary fiscal policy to be that very effective especially when the long run factor comes into the picture. In the long run the fiscal policy only leads to inflation and doesn’t really increase the all important GDP. Also Monetarists argue that, in order to reduce unemployment supply side factors which affect labor market must be taken into consideration.

Let’s look at this graphically,

REAL GDP

Here in this diagram, due to fiscal policy aggregate demand curve shifts to its right with the long run aggregate supply curve remaining idle. As a result, price and real GDP/output increases. As output increases, there is a sudden rise in the demand for workers which increases employment. That is how a decline in unemployment is shown graphically.

Let us consider a case of Recession.

During recession, an increase in personal savings can be found.

 Reasons could be,

1)     All the firms cut back from any further investment during this period.

2)     Similarly, all the households hold back their consumer spending as they don’t want to risk their income.

This decline in spending will certainly cause a negative multiplier and magnify the initial fall in unemployment. This is the time where the government usually borrows from the private sector at a low cost of borrowing.

When the economy is at full employment, effect on unemployment remains pretty much the same as before but the quantity of change differs because of elasticity. The long run aggregate supply curve was a little steeper but here at full employment the long run aggregate supply curve is going to be a lot more vertical. (Fiscal Policy,2020)

As we can see in this diagram, the change in Real GDP is comparatively less than that of the previous case. However, it has a positive impact as far as employment is concerned.

Fiscal policy has its own limitations on employment as well. Tax cuts might be saved not spent. During the period intense regression consumers might be mighty reluctant to spend even once the tax is cut. Fiscal policy can take time to implement. The government has to decide which projects to follow, and there will be time before the project gets off the ground.

Now how do we relate this to IS-LM framework?

If the government is successful in reducing savings in both firms and households, it can reduce unemployment. Here, if the labors leave their current job they will not be able to reenter the market. If money demand doesn’t depend on income, then there is only one level of interest that clears the goods market, and it clears the market for any value of output.

This can be understood better through the diagram given below.

A crowding out effect on investment makes this specification on fiscal policy a lot more effective than never before in my understanding. Here in this model, government spending and taxation multiplier remains the same throughout. An increase in government spending increases the output. In the money market this doesn’t cause a change in the interest rate.  Thus rate of interest doesn’t change and investment is not crowded out.

In the above seen diagram, the difference between Ybar2 and Ybar is G/MPS and the denominator is the difference between 1 and MPC. The same is not true for monetary policy. It has totally contrasting effect on unemployment. If the Price level if higher, changing money supply is related to a smaller change in r. We can think of this as a country with a high price level having a high money supply already, thus larger changes in the money supply are required to adjust the interest level. (NA, 2020)

CONCLUSION

Good fiscal policy can positively affect the Indian economy on a very large scale in my understanding. There are many cases in which these policies can be worked out. There are similar cases like where the central bank keeps the interest rate constant, effects of a shock in the economy and so on. These many aspects need to be considered before framing out a policy. I provided IS-LM framework as a supporting role for the fiscal policy I had explained. Similarly it might have some negative impacts too.

 

REFERENCES

1)   1)   Www2.harpercollege.edu. 2020. Fiscal Policy. [online] Available at: <http://www2.harpercollege.edu/mhealy/eco212i/lectures/fiscpol/fp.htm> [Accessed 2 August 2020].

2)   2)  Pettinger, T., 2020. Does Fiscal Policy Solve Unemployment? - Economics Help. [online] Economics Help. Available at: <https://www.economicshelp.org/blog/226/unemployment/does-fiscal-policy-solve-3)unemployment/#:~:text=Fiscal%20policy%20(cutting%20taxes%20and,providing%20employment%20and%20reducing%20unemployment.> [Accessed 2 August 2020].

3)     4) Www2.harpercollege.edu. 2020. Fiscal Policy. [online] Available at: <http://www2.harpercollege.edu/mhealy/eco212i/lectures/fiscpol/fp.htm> [Accessed 2 August 2020].