Question

Explain how fiscal policy measures can be used to reduce excess demand in an economy.

Explain the instruments of fiscal policy?

What possible fiscal policy measures can be taken with respect to expenditure and income to correct excess demand?

Answer 1

Fiscal policy can be used effectively to reduce the excess demand. Fiscal policy is the policy of the government under which it uses the instruments of taxation, public expenditure and public borrowing to achieve various objectives of economic policy.

1. Taxation: The government can utilise taxation to address excess demand. The government should levy new taxes and increase the rates of existing taxes. A rise in direct taxes, particularly on the wealthiest, reduces disposable income, resulting in a fall in consumption expenditure. Similarly, an increase in business (corporation) taxes, particularly on the business sector that invests in creating luxury, will result in a decrease in investment.
2. Public Expenditure: To eliminate surplus demand, the government should reduce its spending, particularly on unproductive and non-development activities such as defence and administration. A reduction in government spending on goods and services reduces excess demand immediately.
3. Public Borrowing: The government should also embrace a programme of large-scale public borrowing. This will absorb extra purchasing power among the public.
4. Deficit Financing: Deficit financing (the policy of creating new money to cover the difference between government expenditure and revenue) must be significantly reduced. Reducing deficit finance will limit the government’s ability to spend. As a result, aggregate demand will decline.