Monetary Policy and Fiscal Policy Part II| JAIIB IE & IFS free notes

Previously we covered the monetary policy and tools used by RBI to design the macro economy of India, in this article, we’ll be covering the fiscal policy. 

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Understanding the Fiscal Policy 

Fiscal policy is defined as government expenditures and tax changes to achieve macroeconomic objectives such as inclusive growth, employment generation, large investment, and so on. 

Mainly, fiscal policy is constructed and run on two foundational instruments: Taxation and government expenditure.

Let’s understand it comprehensively.

Taxation and its impact on the Economy

Taxes can influence people’s lifestyles as they directly affect disposable income, consumption of goods or services, etc.

  • Taxes directly affect the savings of individuals, families, and firms, which has further repercussions on the investment in the economy since the investment influences the output it will also influence per capita income.
  • Taxes can impact the activity behaviours and incentives as with the effect of tax production costs are altered resulting in the impact on the prices of goods and services.


Government expenditures and Economy

Government incurs expenses to build the infrastructure to provide public services to the people of the nation. For instance, road construction, railways, ports, foodgrains, etc all form good categories on which government has to necessarily spend whereas there are services-based expenses too like salaries and allowances to the government employees.

Apart from these, there are some other kinds of expenditures as well which we call government transfer payments. For example, Income support to poor, unemployed or elderly people.

Objectives of Fiscal Policy in India

Fiscal policy is critical to economic development, because it provides public benefits, encourages private investment, and provides a socially optimum path, for economic growth.

The key objective of the Government in India is to maintain price stability, promote economic growth, stabilize the price, reduce inequality and mobilize resources. Alongside there are some additional objectives as well that need to be fulfilled. 

Let’s discuss these in detail.

Maintaining Price Stability in the Economy

Whether there is a contraction in the supply or an excess in the demand Inflation can be triggered either way.

With contractionary fiscal policy, the government can reduce the aggregate demand through a reduction in government expenditures/tax hikes to keep the prices under control.

While raising production is a supply-side technique that eventually lowers the price of a commodity. 

The government can induce financing into any particular area or grant subsidies to trigger production and decrease prices.

Mobilisation of Resources

Funding the infrastructure expenditure and Human capital is a critical developmental objective that can be achieved by resource mobilisation is crucial through Tax and non-tax revenue collections alongside capital receipts.

Efficiency allocation

Creation of the best or optimum blend of the outputs from the efficient combination of inputs. For a nation to progress effective and reasonable deployment of resources is vital.

Reducing Inequality in Income and Wealth

Many advanced countries have successfully reduced inequality and induced inclusive growth through fiscal policy.

Promoting Private Sector Investment

Fiscal policy can influence the development of domestic and indigenous technologies or businesses boosting private and foreign investment.

Already, in 1991, tax reforms and the Introduction of GST have considerably improved the country’s credentials globally.


Fiscal responsibility and budget management were enacted in 2003 by the Indian parliament to address the deteriorating budgetary situation during the pre-economic reform period. Fiscal consolidation stalled after 1997-1998, and the fiscal deficit began to rise again.

Some of the key objectives of the FRBM Act are listed under.

  1. Generate the budget surplus 
  2. Achieve long-term macro-economic stability
  3. Introduce prudential debt management
  4. Introduced the nation’s transparent budgetary management techniques and
  5. Eliminate financial obstacles and offer a medium-term framework for budgetary execution. 

What the Act Requires

The FRBM Act mandates that the Government present three statements to Parliament each year, along with the Budget, covering the Medium-Term Fiscal Policy, Fiscal Policy Strategy, and Macroeconomic Framework. 

It establishes the fundamentals of fiscal management, which obliges the Center to “lower the fiscal deficit” and “eliminate revenue deficit” by 31» March 2008. It also imposes a cap on assurances (the Rules prescribe 0.5 per cent of GDP).

The Act forbids the Centre from borrowing from the Reserve Bank of India, and the RBI is not permitted to subscribe to Central Government security core issues. 

Finally, the finance minister is required to keep Parliament informed through quarterly reviews of the implementation and to take corrective measures if the reviews show deviations.

The Act aims to reduce the fiscal deficit and dependence on borrowings in a phased manner, but the onset of financial crises has slowed down growth in several sectors.

In 2008 and 2009, the gross budget deficit in the Indian economy expanded from 6% of GDP to 6.4% of GDP in 2009–2010, exceeding the 2.5% goal.

Amendments to FRBM Act

The FRBM Act of 2003 was amended by the 13th Finance Commission in 2012 to introduce the Medium-Term Expenditure Framework Statement (MTEF) and the Effective Revenue Deficit (ERD).

The two most crucial aspects of the FRBM Act adaptation in the course of expenditure reforms are MTEF and ERD. The deadline date was amended from March 31, 2015, to March 31, 2018, and the budget deficit target of 3% was pushed back one year to the end of 2017-2018. 

However, the revenue deficit was no longer targeted and the effective revenue deficit (difference b/w the revenue deficit and grants for capital asset creation) was discontinued as a fiscal target.

N.K. Singh Committee on FRBM

To review the FRBM Act of 2003, GOI appointed a high-level committee whose report was submitted in January 2017. 

The committee present the following recommendations

  1. Debt must be considered the primary target for fiscal policy and a debt-to-GDP ratio of 60% should be earmarked with a limit of 40% for the centre and with 20% limit for the states. The given target must be achieved by 2023. 

Committee proposed yearly targets to progressively reduce the fiscal and revenue deficits, till 2023 to achieve the debt-to-GDP ratio.

  1. An autonomous fiscal council should be constituted having one chairperson and two members (appointed by the centre) to perform the following functions.
  • Prepare fiscal forecasts for the various years
  • Recommending necessary changes to construct an optimum fiscal strategy
  • Improve the quality of fiscal data
  • Advise the government if circumstances do not match the fiscal target.
  • Advise the government to implement corrective measures if the Bill is not followed
  1. Under the following conditions applied government is allowed to deviate from the specified targets: 
  • the impact of the agricultural collapse on productivity and incomes, war, national catastrophes, and national security
  • Economic structural changes that have fiscal repercussions


  • A decline in real output growth of at least 3% below the average of the previous four quarters. In a year, these deviations cannot be more than 0.5% of GDP.
  1. Based on the course of fiscal prudence and the health of a state 15 Finance commission must recommend the debt trajectory for individuals.
  2. GOI isn’t allowed to borrow from the Central Bank until or unless
  • The Center must make up a brief shortage in receipts.
  • RBI purchases government bonds to finance any departures from the predetermined targets.
  • Government securities are purchased by RBI on the secondary market.

Introduction of Escape Clause under FRBM 

The government increased the fiscal deficit objective in the updated estimates for 2019–20 and 2020–21 from 3.3% to 3.8% by invoking the FRBM Act’s escape clause. This is due to the fact that Section 4 (2) of the Act offers a mechanism for a deviation from the expected fiscal deficit due to economic structural reforms.

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