Automatic and Discretionary Changes in Fiscal Position during Recession
Unhealthy food habit of people increases government cost of health service. In order to change people’s habit from unhealthy food to healthy ones government in many countries has imposed tax on sugar and other unhealthy products. Australia imposes tax on cigarettes and alcohol and get a positive result in terms of reduced smoking and alcohol (theconversation.com 2017). Along with taxing unhealthy food product, a subsidy on healthy product can be proved beneficial. The extent of effectiveness on either policy depends on the demand elasticity of the food items.
Figure 1: Effect of subsidy on healthy food item
(Source: As created by Author)
D0D0 and S0S0 are the demand and supply curve for unhealthy food items. A subsidy on healthy food products reduces the cost to the producer an increases supply as reflected from a shift of the supply curve from S0S0 to SS. The price to the consumer is PB and price to producer is PA. The lower price induces consumers demand more than the price change for products having elastic demand. Elasticity for high calorie fruits, vegetables, and dairy product of low calorie is greater one. Therefore, subsidy on these items are more beneficial.
Figure 2: Effect of tax on unhealthy food product
(Source: as created by Author)
A tax on unhealthy food items shifts the supply curve leftward from S0S0 to St. The burden of tax however depends on the elasticity of supply and demand. Unhealthy food items with inelastic demand means buyers bear a greater burden of taxation and hence gradually reduces demand for these items moving towards a healthy diet.
In times of recession, the economy faces a downturn in economic activities. The aggregate demand needs to be pushed up to rescue the economy. Government expenditure is an important component of aggregate demand. Increase in government expenditure increases demand. It also affects private spending by raising disposable income. This is the simple idea as proposed by J.M. Keynes (cis.org.au 2017).. The idea was to give fiscal stimulus in times of economic contraction. Keynes gave the simple idea of the need for government support in contrast to classical concept of a completely free market economy. Monetary policy for influencing economic activity was not introduced then.
Recession causes a decline in growth rate. People face a decline in the income. They pay lower taxes reducing the tax revenue. Because of economic contraction unemployment increases and government needs to give more transfer payments. This affect government budget. These sort of changes that occur in budget without direct intervention is called automatic changes in the fiscal position (cis.org.au 2017).
In contrast to automated fiscal policy, discretionary fiscal policy is implemented by altering government expenditure and taxes. In recession, government increases their expenditure to increases demand and productivity. Tax rate are reduced to freed up more spendable income and boost demand. The additional burden on government budget results in a budget deficit.
Fiscal contraction refers to reduction of government expenditure or increase in the tax rate. Generally, tight fiscal policy leads to economic contraction. However, fiscal contraction is can be beneficial for the economy when the policy is implemented in form of cutting expenditure in wasteful areas. The parallel activity in the money market reduces the interest rate and induce investment with crowd in effect. Reduction in interest rate means reduction in the cost of real investment and increases productivity by stimulating investment (cis.org.au 2017).. A related effect on reduced interest rate is the strong exchange rate and improves net export balance that increase national income.
Monetary policy works with different instruments of the money market. The common monetary tool is the interest rate of the economy. An effective monetary policy can be implemented in the form of reducing interest rate. When interest rate reduced then borrowing cost becomes lower and hence, encourage investment. The increased investment gives stimulus to the economy and bring economic growth. Associated with a declined interest rate, there is a depreciation of the exchange rate. The depreciated currency positively affects national income.
The expansionary monetary policy is more effective to give stimulus to a financial economy. Australia has a strong financial sector and the economy is relied borrowing from external sector (cis.org.au 2017).. Therefore, monetary policy is more effective than fiscal expansion.
References
Cis.org.au. (2017). Fiscal Fallacies : The Failure of Activist Fiscal Policy. [online] Available at: https://www.cis.org.au/publications/policy-forum/fiscal-fallacies-the-failure-of-activist-fiscal-policy/ [Accessed 26 Oct. 2017].
The Conversation. (2017). Why the government should tax unhealthy foods and subsidise nutritious ones. [online] Available at: https://theconversation.com/why-the-government-should-tax-unhealthy-foods-and-subsidise-nutritious-ones-72790 [Accessed 26 Oct. 2017].
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