Are fiscal deficits inflationary?
Fiscal deficit turns out to be inflationary in the government finances it by way of deficit financing. Deficit financing means that the government borrows from Reserve Bank of India. The government issues treasury bills against which the RBI gives cash to government and this increases money supply in the economy. Increase in money supply leads to increase in the general price level and a persistent increase in price level over a period of time. This increase culminates into an inflationary spiral, which is a wage price spiral. It means wages catching prices and prices catching wages in turn. It affects the process of growth of economy and raises the cost push inflation.
Therefore, the physical deficit should be carefully managed in an economy. If it is managed by increasing production it may not be inflationary.
Suppose that for a particular economy, investment is equal to 200, government purchases are 150, net taxes (that is lump-sum taxes minus transfers) is 100 and consumption is given by C = 100 + 0.75Y (a) What is the level of equilibrium income? (b) Calculate the value of the government expenditure multiplier and the tax multiplier. (c) If government expenditure increases by 200, find the change in equilibrium income.
Consider an economy described by the following functions: C = 20 + 0.80Y, I = 30, G = 50, TR = 100 (a) Find the equilibrium level of income and the autonomous expenditure multiplier in the model. (b) If government expenditure increases by 30, what is the impact on equilibrium income? (c) If a lump-sum tax of 30 is added to pay for the increase in government purchases, how will equilibrium income change?