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Impact Of Fiscal Policy Economics Essay

Impact Of Fiscal Policy Economics Essay

Gross domestic product is the market value of all authoritatively known final goods and services produced within a country in a given period of time. An advantage of GDP per capita is that it acts as an indicator of standard of corporeal is that it is dignified regularly, broadly, and steadily.

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According to Classical Economist real GDP can be calculated by aggregate supply, and the stable price level can be measured by the money supply. Say’s stated that “when an economy produces a definite level of output, it also creates the income desired to securing that level of real GDP”. In other words we can say that the economy is always skilled of demanding the entire yield that its labors and firms select to produce. Hence, the economy is always accomplished of attaining the natural level of real GDP. According to Keynesians, aggregate demand plays a major role in the determination of GDP and employment. Prices are fixed at all significant levels of GDP. Government is accountable for soothing the economy byrunning aggregate demand. According to Monetarists, changes in the money supply regulate equilibrium, real GDP, and price levels. Business cycles are mainly the result of flexible monetary policy and that innovative policies repeatedly create business cycles worse. Accelerating inflation is artifact of efforts to increase real GDP through expansionary monetary policy. Economic policy functions with flexible gaps. According to Neo Classical Economists, salaries and prices are perfectly elastic. Markets are always in a state of equilibrium. Opportunities are made logically, so that only unanticipated changes in policy can shake production and employment. Fluctuations in real GDP are outcomes of unpredicted changes in the price levels.

There are mainly three methods through which we can calculate GDP. (i) Production Approach is referred to market value of all final goods and services projected during a year. The production approach is also called as Net Product or Value added method. It involves assessing the Gross Value of domestic productivity in different sectors of the economy, determining the transitional consumption, removing transitional consumption from Gross Value to acquire the Net Value of Domestic Output. (ii) Income Approach is referred to total of incomes of individuals living in a state in a year. Income is divided into following categories; Wages, trade revenues, Interest and mixed stock income. agriculturalists’ income, Revenue from other independent industries (iii) Expenditure Approach is referred to all expenditure made by individuals during a year. Well Most of goods created are produced for sale, and were sold in the markets.  Measuring the total spending of money used to buy things is a way of evaluating production. This is known as the expenditure method of calculating GDP. GDP (Y) by Expenditure Approach is the sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).

Fiscal policy is the practice of government income collection (taxation) and spending (expenditure) to affect the economy. The two main tools of fiscal policy are government taxation and expenditure. Changes in these tools may affect government by; (i) aggregate demand and the level of economic activity, (ii)the pattern of resource allocation, (iii)the circulation of profits.

There are majorly three types of fiscal policies adopted by the government in different situations; (i) Neutral fiscal policy is usually commenced when an economy is in a state of stability. Government expenditures are fully supported by tax revenue and total budget consequence has an unbiased effect on the level of economy, (ii) Expansionary fiscal policy includes government expenses above tax income, and is generally commenced in recessions, (iii) Contractionary fiscal policy follows when government outlay is less than tax returns, and is use to pay the government charges.

The relationship between GDP and economic growth can be referred as a measuring the performance of an economy. A relationship between GDP and economic growth can be stated as GDP can be calculated from the total consumption of goods and services within the economy. It can be analyzed from the fact that when the consumption within that erais high, it demonstrates that the economy is executing according to opportunities. When the consumption is low, this may be the cause of anxiety due to the negative macroeconomists effects. Even then consumption is essential to sustain the economic equilibrium; an unwarranted frequency of consumption can have the contradictory consequences as it may outcome in inflation. There exist a constructive connection between savings and economic growth. As improvement in savings can encourage economic growth through investment, supported by Harrod (1939), Domer (1946), Solow (1956) models of growth.

Economic Growth affects the fiscal credits in three ways. First, a slowing down of growth activates instinctive stabilizers, which lessen tax incomes and increase benefit expenditure. Second, a slowing of growth provoked by a financial partnership could end result in an increase in the government debt-to-GDP proportion. Third, a braking of growth stimulated by a fiscal alliance could activate apprehension in money markets.

Review of Literature:

S. Babalola and U. Aminu:

S. Babalola and U. Aminu suggested after examination that there exists a strong relationship between fiscal policy and economic growth. Data was taken from Annual data covering from 1977 – 2009. Augmented Dickey-Fuller technique was applied using unit root of the series after which the co-integration test was applied using the Engle-Granger Approach. Error-correction models were projected to examine the effect in short-run dynamics. The results showed that productive expenditure had a positively impact on economic growth during that era and there exists a long-run relationship between them, established by the co-integration test. Suggested improvement in government expenditure on health, education and economic services, as gears of productive expenditure, to increase economic growth.

Qiang Dai and Thomas Philippon:

The empirical analysis of Qiang Dai and Thomas Philippon gave us a strong relationship holds between interest rates and fiscal policy adopted by the government, which can be stated that some An empirical macro-finance model was made that combines a no-arbitrage affine term construction model with a set of operational constraints that allow us to recognize fiscal policy shocks, and suggestion the effects of these shocks on the costs of bonds of diverse maturities. Results recommend that government deficits shake long term interest rates, at least for a short period of time.

M. Ocran:

Study (M.Ocran) was based purely on observing the effect of fiscal policy variables on economic growth in South Africa. The fiscal policy variables measured include government gross fixed capital formation, tax expenditure and government consumption expenditure as well as budget deficit. Studied over the time period of 1990 to 2004. Quarterly data was used in the valuation with the use of vector regressive modeling technique and impulse response functions. Concluded that the government consumption expenditure has a positive effect on economic growth. Gross fixed capital foundation from government also has a positive influence on productivity but the level of effect is lesser than that attained by consumption expenditure. Tax revenues also have a positive effect on yield growth.

M. Zagler & G. Du’rnecker:

M. Zagler & G. Du’rnecker studied after analyzing strong relationship between fiscal policy and economic growth. A survey on the objective of fiscal policy in economic growth was conducted presenting a combine framework for the analysis of long run growth consequences of government expenditures and revenues. Suggested that tax rates and expenditure categories reveal a direct effect on the growth rate of the economy. Conclusion of the study is that there is a need of conducting surveys on the special effects of fiscal policy on origination driven economic growth has so far been showed. On the basis of some empirical research, only concentrated on specific tax rates or expenditure categories, and has examined only portion of the development equation presented in this survey. Survey recommended that a future empirical work should emphasis on the effects of the whole tax system on economic growth, and more comprehensively analyses the growth inferences of fiscal policy systems.

Martijn Brons, Henri L.F. de Groot and Peter Nijkamp:

Martijn Brons, Henri L.F. de Groot and Peter Nijkamp studied the possible relations among fiscal policies, investments and economic growth. A systematic comparative analysis was performed with sturdy visions among these composite relationships. Utmost pragmatic studies are categorized to simple linear regressions of growth on particular degree of government expenditures. Guidelines were suggested based on realistic tests for future observed research that may develop our information on the multifaceted relationship between fiscal policies and economic growth that may develop from national level to a regional level of economic growth.

J. Alm. & J. Rogers:

J. Alm. & J. Rogers observed the empirical analysis of factors of fiscal policy which had direct impact on economic growth. Data was used from the source “annual state data” from 1947 to 1997 for estimation of taxation and expenditure policies. Technique of empirical work is the usage of orthogonal distance regression (ODR) to deal with the problem of measurement error in various variables. The results interpret that the correlation between public revenue system policies which are rottenly statistically significant. Modification for measurement error is necessary in valuing the progress influences of policies.

C. Cottarelli and L. Jaramillo:

A study of the compound relationships between fiscal policy and economic development in the short and long run (C. Cottarelli and L. Jaramillo). Realistic analysis of impact of fiscal policies adopted by the government must focuses on the short and long-run collaborations among economic growth and fiscal policy. High public debt to GDP ratios must be reduced that may outcome economic progresses. Fluctuations in the fiscal debt may cause harm to growth in short run, which may affect fiscal indicators, including deficits, debt, and financing costs. Tax and outflow policies are some factors that may disturb efficiency and employment progress.

Paul Hiebert & Ana Lamo:

The empirical analysis of relationship between government taxation and economic growth for European Union states done by Paul Hiebert & Ana Lamo and determined a vigorous negative relationship. With an objective to evaluate the combined effect of the government budget balance besides public outlays produced the result that fiscal enhancements inclined to boost up long-term economic growth. The analysis was done by using the technique of estimating growth regressions for a panel of countries using a generalized method of moment’s estimator that eliminates standard problem like endogeneity of the descriptive variables and associated specific effects. Alternative favorable possibility is the use of quasi- maximum likelihood (QML) estimators to evaluate this connection. Such a way of research, presenting potential to clarify the role of fiscal policies in persuading long-term progress is a new organized performance of mixed gradients.

Muhammad Ayyoub, Imran Sharif Chaudhry & Fatima Farooq:

The experiential study of the inflation and economic growth relationship in the economy of Pakistan and to scrutinize empirically the effect of inflation on GDP growth of the economy was determined by Muhammad Ayyoub, Imran Sharif Chaudhry & Fatima Farooq. Annual time-series records for the epoch 1972-73 to 2009-10. Investigation is prepared by commissioning the technique of Ordinary Least Squares (OLS). The outcomes of the study conclude that ultimate inflation is injurious to the GDP growth of the economy after a definite inception level. On the basis of the vivid and econometric analysis, some important precautionary measures suggested to the strategy creators and the State Bank of Pakistan to check the CPI below the limit of 7 percent level and to keep it stable. Preserving price stability resolved finally is the approach suggested to production house and obstinate economic development of the economy which may cause effects on economic progress.

Christiane Nickel & Isabel Vansteenkiste:

Christiane Nickel & Isabel Vansteenkiste premeditated the empirical analysis of affiliation between fiscal policy and the most recent description of the balance of payments and discussed effects of Ricardian equivalence among these variables. Analysis of vigorous panel threshold model containing 22 industrialized states, in which observed or studied the relationship between the present account and the regime stability is permitted to modify as per change to the government debt to GDP ratio. The conclusion of the analysis showed that for those countries whose debt to GDP ratios approximately up-to to a limit of 90% the relationship among the government balance and the current account is constructive, i.e. higher the fiscal deficit is it will lead to a high current account deficit. Results suggested that those countries with high debt are termed as Ricardian. Same technique is applied on other European states where GDP to Debt ratio increases, the main factor behind this rise is due to minor relationship between the governmental budget and current account.


The study of article of Z. K. KAKAR, determined the short and long-run effects of fiscal variables on economic growing in Pakistan. The data for analysis was used from period 1980-2009. Econometric techniques like Johansen Co-integration test and vector error correction model are used for analysis and the direction of interconnection was determined by using Granger causality test. Thus it may lead to regulate the significance of fiscal policy in the evolution of economy of Pakistan.


To study the impact of fiscal deficit on the economic development.

To study the impact of rate of CPI on the economic development.

To study the impact of rise in population growth rate on the economic development.

To study the impact of government expenditures on the economic development.

To study the impact real interest rate on the economic development.

To study the impact of tax revenue on the economic development.

To study the impact of gross fixed capital formation on the economic development.


To perceive of impact of fiscal policy on the economic growth of Pakistan involving some fiscal variables like tax revenue, population growth rate, real interest rate, consumer price index, gross fixed capital formation and government expenditure as independent variables and growth rate as dependent variable.

Data was collected from a period of 1972 – 2011 and source of data is World Development Indicator.

To examine the orders of integration of the variables of the model, we accompanied Augmented Dickey-Fuller and Phillips-Perron unit-root tests. Then Johansen co-integration (or ARDL) and error correction model is used to get the short and long run relationship between the variables. J.Q. test has been applied to check the normality between the variables. Durbin Watson test is employed to check the autocorrelation among the variables. Ramsey test has been applied to check the problem of Heteroscedasticity. The model used for analysis is given below,

Y = α + β1 (TX) + β2 (IR) + β3 (CPI) + β4 (GX) + β5 (PG) + β6 (GFCF) + μi (1)


Y = Growth Rate.

α = Intercept.

β1, β2, β3, β4, β5, β6 = Slope Coefficients.

TX = Tax Revenue.

PG = Population Growth Rate.

IR = Real Interest Rate.

CPI = Consumer Price Index.

GX = Government Expenditure.

GFCF = Gross Fixed Capital Formation.

μi = Error Correction Term.

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