A market economy left to it self will often produce an equilibrium which the government in a democratic society may not find acceptable. It may be characterized by high levels of unemployment or a high rate of inflation; the distribution of income may be very lopsided; balance of payments may show a large deficit and so forth. Dynamically, the economy may show undesirable features such large fluctuations in income ad employment or low rates of log term growth. Most democratic governments regard it as their duty to design and implement macroeconomic policies which will mitigate if not eliminate some of the undesirable consequences of operation of the market mechanism.
Macroeconomic policies are of two types. Fiscal policies pertain to the volume and structure of public revenue and expenditure and government borrowing. Monetary policies refer to control of money supply, credit and interest rates. In addition, exchange rate policy may also be looked upon as an instrument of macroeconomic policy.
In addition, the government attempts to influence the economy by means of other policy instruments. Tariffs and quotas on foreign trade are employed to serve a number of objectives including protection of domestic industry. Government may also directly intervene in the economy by means of administrative controls on production, prices, consumption and investment. Some sectors of economic activity may be reserved for public sector of government may be an important player in them along with the private sector.
Our discussion of economic policy here is confined to traditional fiscal and monetary policies.
Governments collect taxes and other revenues such as various fees, user changes for services provided, dividends and interest on its investments in public enterprises ad so forth. Part of the money is spent on current expenses of running the country salaries of government employees, travel, communications, etc – while the rest may be devoted to investments in physical and social infrastructure. If the expenditure exceeds the revenue, the governments must borrow either from the central bank or the market including external sources. By altering the aggregate volume and composition of its revenues and expenditure and the size and source of its borrowings the government can exercise a significant influence on the economy.
Changing the tax structure and tax rates can have important incentive distinctive effects. High levels of income and profit taxes for instance may have adverse effects on the incentives to work and invest and may also lead to widespread tax evasion and other distortions. Excise and sales taxes affect relative prices of different goods and services and hence consumption and production patterns. If the government is unable to control its current expenditure it may have to curtail investments in infrastructure or resort to excessive borrowing both of which have undesirable long term consequences.
In the past, governments have used tax expenditure policies to moderate cyclical fluctuations in economic activity. Public expenditures are increased when the economy shows signs of sliding into a recession and cut back when a boom is in the offing. Alternatively or concurrently, taxes may be lowered to encourage private spending when the economy is weak and raised when the economy is strong. The size of the budget deficit is regarded as a measure of fiscal stimulus. The so called fiscal deficit is the difference between government’s current revenues and its total expenditure – current plus capital. It indicates the amount of borrowing government must resort to. The size of the fiscal deficit in relation to GDP has become an important policy parameter with the government attempting to bring it down to about 4-4.5% of GDP.
Excessive fiscal deficits can lead to accelerating inflation and can potentially crowd out private investment by preempting a range chunk of savings. In particular, if rising fiscal deficits are on account of increases in current government expenditure, it is matter of grave concern since it implies reduction in total investment with undesirable consequences for future growth of the economy.