Budgetary policy has its own bearing on the performance of a national economy. That is on targets such as high employment, a reasonable degree of price stability, soundness of foreign accounts and an acceptable rate of economic growth. These macro targets cannot be materialized automatically. But it requires deliberate and well planned policy guidance and packages.
In the absence of this, the economy becomes vulnerable to substantial fluctuations and may slip into sustained periods of unemployment or inflation. There may occur the co-existence of unemployment and inflation as happened in 1970’s or a painful depression of the 1930’s dimensions.
In the present world of globalization and growing international dependence, the possibility of instability getting transmitted, globally across the country, is higher.
A free market economy is vulnerable to fluctuations in prices and employment. The price and employment situation in an economy in turn depend upon the level of aggregate demand and the realized output in the economy.
The level of demand is influenced by the spending decisions of millions of consumers, corporate managers, investors etc. These decisions are again conditioned by many factors, such as past and present income, wealth composition, availability of credit, and business expectations.
The level of expenditure may sometimes be insufficient to secure full employment of labour and other resources. This deficiency will not be corrected automatically and this may necessitate expansionary measures to raise aggregate demand to ensure full employment.
Likewise, sometimes level of expenditure may exceed the available output, under situation of high employment, and this may result in inflation. In such a situation restrictive measures are needed to reduce demand.
The changing business expectations will introduce the element of dynamism in economic activity and promote economic growth and the same time act as resource of instability in the system. In these cases, the automatic adjustment process does not function properly to ensure stability in the economy. The hard realities of 1930’s and 1970’s teach us this lesson.
Therefore public policy must device some measures to counteract these fluctuations and to ensure economic stability. The stabilization branch of the budget take care of this situation and device some compensatory measures to revive the economy from unemployment or inflation.
Instruments of Stabilization Policy:
Instruments of stabilization policy are broadly divided into two:
(1) Monetary measures.
(2) Fiscal measures.
The interaction between fiscal and monetary measures determines the efficiency of the stabilization branch:
1. Monetary Measures:
Economists often argue that market mechanism cannot regulate the money supply of an economy, even though it can allocate resources.
Therefore the monetary and debt policies offer the major alternative to stabilization by budget policy, if the banking system is left uncontrolled; it is incapable of generating the money supply which is compatible with economic stability.
Expansions and contraction in money supply resulting from unregulated credit system is a major cause of instability in modern economies.
Therefore money supply must controlled by the central banking system and fine-tuned to the reds of the economy in terms of growth and stability.
The major instrument of monetary policy which includes the devices like cash reserve requirements, open market operation, bank rate, is an indispensable component of stabilization policy. Expansion and contraction of money as required, depending on the prevailing situation can be effected through a well-structured money and credit policy.
2. Fiscal Instruments:
Fiscal policy exerts a direct influence on the level and structure of demand. Changes in budget policy may be used as positive means of obtaining or offsetting changes in demand.
The fiscal tools of expenditure and taxation can be adjusted in the required direction to bring stability in the economy. The principle of compensatory finance is usually adopted to do away with the evils of inflation and deflation.
When the economy suffers from involuntary unemployment, the level of demand has to be increased through an expansionary expenditure policy. When the economy suffers from inflation, level of demand has to be reduced, and this is achieved through contraction of public expenditure.
Likewise tax policy will be designed to achieve the required results in the economy. The fiscal tool of deficit financing and pump priming is also used to fight instability caused by depression.
Although monetary and fiscal measures supplement each other, they differ in their impact by using them in proper combination.
Therefore monetary and fiscal policies are linked by the need for obtaining a policy which will permit the pursuit of multiple policy objectives.