Fiscal Policy and Inflationary Gap

The government uses the following four fiscal tools to reduce excess demand and control inflation:

1. Increase in Taxes
When the government raises tax rates, people's take-home income (disposable income) falls. With less money to spend, they buy less — reducing demand and controlling inflation.​

2. Decrease in Government Expenditure
The government is a big spender. When it cuts its own spending, less money flows into the economy — reducing total demand.
The government reduces spending on:

• Health and education projects
• Public works programmes (roads, buildings)
• Maintenance of law and order, and defence
• Subsidies

3. Decrease in Deficit Financing
Deficit Financing means the government prints more currency notes to cover the gap between its income and expenditure.​
Printing more notes puts more money in circulation → more spending → more inflation.
So during inflation, the government must restrict deficit financing.

4. Increase in Public Borrowing
When the government borrows money from the public, it takes excess purchasing power away, leaving people with less money to spend.

A Government Budget is the detailed annual account of the government's income and expenditure.
Three Types of Budget:

Taxes
Taxes directly reduce disposable income. When people have less money, they buy less — reducing inflationary pressure. The government should both raise existing rates and introduce new taxes across sectors, leaving people with less purchasing power.

Public Expenditure
During inflation, the level of effective demand is very high due to big private and public spending. This excess of expenditure over the available supply of goods causes inflation. To reduce private spending, the government should first reduce its own expenditure.

Public Borrowing
Public borrowing helps reduce Aggregate Demand and, therefore, the price level.

• Voluntary borrowing — at the free will of the public
• Compulsory borrowing — a certain percentage of wages/salaries, redeemable only after a few years
  This means purchasing power can be postponed for a definite period to control inflation.​

Deficit Financing
Deficit financing refers to financing the gap between income and expenditure through printing currency. To check inflation, the government should minimise deficit financing — it takes away spendable money from the public and hence checks inflation.

• Increase taxes to reduce people’s disposable income and purchasing power, thereby lowering aggregate demand.
• Reduce public expenditure on public works, subsidies, and non-essential spending to control excess demand.
• Reduce deficit financing to prevent further increase in money supply and inflation.
• Increase public borrowing to absorb excess purchasing power from the economy.