Previously we learnt how Central Banks print money and increase/decrease money supply in the economy. Unlike Central bank Government cannot print money. Since Central bank is an autonomous body it is not under any obligation to follow Government orders/directives. In such a scenario, how do Governments increase/decrease money supply in the economy, independent of Central bank’s actions? Read on to know more.
From our article on measuring GDP, we know that both consumption by households and Government expenditure on public goods are used in calculating GDP. As consumption and/or Government expenditure increases, GDP also increases. In order to know more about how government increases/decreases money supply, first we need to understand consumption and government expenditure in detail. Consumption is contingent on income and higher the income, higher will be the consumption. Let us assume X’s salary per month is Rs.50,000 and the tax rate on the same is 10%. Assuming no tax exemption limits, X will receive a post tax income of Rs.45,000 (50,000 – 10%*50,000) every month which can either be saved or consumed. Now if the Government increases tax from 10% to 30%, X’s post tax salary will reduce to Rs.35,000 (50,000 – 30%*50,000). So automatically X’s ability to consume goods and services will also go down.
The above example explained the effect of change in tax rate on an individual’s consumption and saving patterns. Apart from income tax which is a direct tax, 2 other indirect taxes – sales tax and service tax can also affect consumption patterns. Sales tax refers to the tax that we pay whenever we buy any goods. Service tax is the tax paid when we avail services in places like restaurants, saloons, cinema theatres etc. If the Government increases these indirect taxes automatically all goods and services will become more expensive and automatically consumption levels will drop down leading to lower GDP. On the contrary decrease in tax rate will make goods and services cheaper, leading their increased consumption. This results in higher GDP.
Government expenditure includes building schools, roads, bridges, ports etc. It also includes expenditure on social welfare schemes as well as salaries paid to various government employees. Whenever Government increases its expenditure, it results in creation of more public goods or higher allocation to welfare schemes like education or healthcare. This leads to increased income for labourers building the road, teachers in the school or hospital workers. So we can conclude that increased Government expenditure puts more money into the hands of the people or increases their income, leading to higher GDP.
When government increases expenditure and reduces tax rate, it acts as a double booster and transfers more money to individuals. This results in increased consumption and higher GDP. Such policies are called expansionary fiscal policy. On the other hand, increasing tax rate and reducing Government expenditure, takes away money from individuals, lowering consumption and GDP. Such policies are called contractionary fiscal policy.
This can also be understood through Government’s deficit. Tax represents Government’s income and and it’s spending is the amount invested in creating public goods and implementing welfare schemes. . If the Government is spending more than what it earns, it will have a deficit. If the deficit is expanding, it could be because of increasing expenditure, decreasing tax or both. In such cases, Government is following an expansionary fiscal policy. Similarly, if Government deficit is decreasing, it is following a contractionary fiscal policy.