How monetary policy helps to control inflation?

What are the objectives/goals of fiscal policy of underdeveloped countries?

Fiscal policy plays a dynamic role in developing countries. The monetary policy alone ineffective due to the existence of underdeveloped money and capital markets, fiscal policy can be used as an important adjust to monetary policy in accelerating the rate of capital formation.

The importance/significance of fiscal policy in development countries are below:

i) Increase in rate of capital formation: One of the main objectives of fiscal policy is to increase the rate of capital formation. Capital formation is an important determinant of economic development. Saving and investment are the two components of capital formation. In the economy as the saving flow is the formal investment in the productive sector, the rate of capital formation increases. Economic development takes place rapidly when the rate of capital formation increases. The fiscal policy should be formulated in such a manner as to increase the rate of investment both in public and private sectors. This needs large amounts of financial resources which can be obtained by raising the incremental saving ratio and curtailing conspicuous consumption and unproductive investment. Fiscal policy helps in the formation of capital in two ways:
  1. Fiscal policy expands investment in private and public sector through planning wise development. Specially, government invests in the economic sector. It helps to provide necessary means to invest in such sectors. It collects necessary amount for the progress of the physical capital formation and human capital formation.
  2. Fiscal policy encourages unproductive investment to mobilize it in productive sector. This is done by making the tax free, low tax rate, subsidy, reduction policies etc. It helps in reducing unnecessary consumption and will increase capital formation rate, from unproductive sector to productive sector through the mobilization of resources.
ii) Resource mobilization: Resources are limited in developing countries. The aim of economic development can be obtained only if the limited resources are utilized optimally. The available resources should be mobilized rationally and effectively. Fiscal policy plays a central role for resource mobilization in the economy. The fiscal policy is more effective means for resource allocation and mobilization than any other means. In this context, according to OKun and Richardson, “The main task of fiscal policy in underdeveloped countries is to make available adequate saving for financing economic development from excessive low production and prepare the environment for increasing significantly the private investment activities.”
  1. Fiscal policy provides tax facilities in order to increase saving and in investment. Government may increase the tax rate and give priority for the public sector for investment.
  2. Fiscal policy can be the means for mobilizing the investment and resources of agriculture to the productive sector such as trade industry, tourism etc. then after the available saving from agriculture should be maintained in the form of tax to the economic development.
iii) Promotion in employment opportunity: Fiscal policy plays a crucial role to create conditions of full employment and provide with higher living standards. Fiscal policy therefore should aim at increasing employment opportunities and reducing unemployment. For this, government expenditure on economic and social overheads should be incurred to generate employment. Government should increase productive efficiency in the economy. Government can encourage labor based small industries by reducing tax or by providing subsidies. Likewise, government can increase local community development programs involving more labor and requiring less capital per head. Government should give greater emphasis to the family planning performance to control the high growth of population which is the major reason of population growth. For this reasons, above mentioned fiscal measures can help to increase employment.

iv) Effective role in counteracting inflation: In the initial stage of economic development creeping inflation is not bad but higher inflation is dangerous in the economy. Inflation creates uncertainties which are the barrier for investment and economic growth. That is why fiscal policy can play an effective role in counteracting inflation. In this context, according to Henry C. Murphy, fiscal policy is an effective in counteracting inflation in developing countries as it is in industrial countries. The following are the effective roles in counteracting inflation:
  1. Curtail government expenditure without changing tax rate: This increases the saving of government budget and reduces the purchasing power of public. These are the forces which influence or increase the inflation will be declined.
  2. Curtail government expenditure with the increase in tax rate: This helps to increase the rate of saving and reduce the purchasing power of public. In this, aggregate demand will be decreased which help in controlling inflation.
  3. Fixed in government expenditure with the increase in tax rate: Sometimes, government expenditure cannot be controlled. In such situation, inflation can be controlled by increasing tax rates with the help of reducing purchasing of public.
  4. Curtail in government and reduce tax rates in equality: If the government expenditure and tax rate is inequality is reduced, the income between the beneficiaries of government expenditure and the class of tax payers will be redistributed. This process reduces the net propensity to consume and reduces more in the national income than government expenditure. Through this, the multiplier value of balanced budget will be greater than the unity and the effects occur against inflation.
  5. Increase in government debt: Government may increase public debt and pull public saving which reduce purchasing and demand. This helps in controlling inflation.
v) Reduction of income inequality and wealth distribution: In underdeveloped countries, inequality of income and wealth distribution widely spread. This inequality is socially injustice and economically helpful. Until the problem of such inequalities exists in the economy. There will be hardly developed of economy and social welfare. That’s why inequality of income exists and wealth distribution should be reduced. For this, fiscal policy plays very important role.
  1. Implementation of progressive tax system. To achieve this, government has to impose high tax rate to the rich people and low tax rate or free tax to the poor people.
  2. Levy tax on the basis of class of consumption patter: Government should levy taxes at high rates on the luxurious goods and services, which there should be lower tax rates on the goods and services that are consumed by poor people.
  3. Increase facilities to the poor class: Basic facilities should be increased to make easier life for poor class than the rich class.
  4. Expenditure on human capital for poor people: Government should spend a lot of money on physical capital and human capital. Such expenditure provides job opportunities for the poor people by developing human capital on them.
vi) Correct adverse balance of payment: Fiscal policy helps to correct adverse balance of payment. This policy discourages the import and encourages the exports of the economy. For this, government should reduce the taxes of imports and increase the tax of exports goods, subsidies and other facilities.

vii) Economic stability: One of the most serious problems of developing countries is economic instability. Generally they are affected by inflationary tendencies. Fiscal policy adopts the various methods to maintain economic stability. Contra-cyclical fiscal policy should be adopted to offset the effects of fluctuations in world market prices thereby to promote economic stability in the economy. During the inflation, government can increase direct tax and reduce the government expenses to control the inflation. On the other hand, the government can increase public expenditure and decrease tax rate to control the deflation. During depression period, government should make deficit budget and surplus budget policy will be made in the period of prosperity. From this stability will be maintained.

viii) Control inflation: The objective of fiscal policy should be to protect the economy of an underdeveloped country from the demon of inflation. Inflation can prove ruinous to an underdeveloped economy. It can undermine the very process of economic growth. As such, the fiscal policy of an underdeveloped country should be designed in such a manner as to curb inflationary forces arising during the process of economic growth.

Besides these, the objective of fiscal policy should be to eliminate, as far as possible, sectoral imbalances arising in the economy from time to time. Though the fiscal policy as visualized above, will help to maintain price-stability in the economy as a whole by curbing inflationary forces, there may arise sectoral price fluctuations in certain sectors of the economy on account of the existence of certain bottlenecks. To ward off that possibility, fiscal policy must be attuned to correct such imbalances in time before they could inflict any damage of the economy.

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