Fiscal Consolidation means policy undertaken by government to reduce its Fiscal/Revenue Deficit. Without going into technicality of Fiscal and revenue deficit, we can say that deficit is difference between what a government spend and what a government earned.

Government can practice Fiscal consolidation either by reducing their expenditure (outflow of money) or by increase their earning (inflow of money except debt). Effect on aggregate demand will depends upon how government is going to have fiscal consolidation.

1. Fiscal consolidation through cutting in spending: If government achieve fiscal consolidation through decrease in Government spending then it is going to reduce the Aggregate Demand (AD). This will occur as Govt. spending reduces so the government demand. But AD will not going to decrease by same amount by which Govt. spending reduced but it is going to be reduced much more than that and that is called multiplier effect. To understand the multiplier effect we have to understand what Aggregate Demand (AD) is?

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AD is nothing but demand of the products produced in a country. So demand comes from four sectors –

1. People within county

2. Government

3. Industry (which we call as Investment)

4. People from other country (called as export)

Therefore

AD = C+I+G+NX

Where C= Private Consumption

I = Private Investment

G = Government Spending

NX = Net Export ( Export – Import)

By looking at above equation it can be wrongly considered that if Govt. spending reduced by Rs 100 then AD should reduced by Rs 100 but it is not the case. The reason is that the private consumption depends upon the GDP which in turn equal to AD when economy is in equilibrium. Let’s understand this by an example. Let’s say government decided to reduce its spending and droped the plan of constructing a road. Then there will be less income for road constructor so he will demand less stuff. (Let’s say that stuff is bread). Consequently, there will be less income for bread maker, so further his demand will reduce and so on….. Same has been shown in following figure:

Following figure showing the case what would happen when government increases its expenditure

With this it should be clear that Decrease in Government Expenditure (done to achieve fiscal consolidation) or increase in expenditure going to respectively decrease and increase the AD by many fold amount.

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Caveat: It is not always the case; in some economic situation the government expenditure will not have any multiplier effect. Some of such situation is like when interest sensitivity of money demand is 0, or when interest sensitivity of investment is very high (around infinite). However this situation has been/ will be disused in some other article.

In following part I will going to explain mathematics behind above explanation. You may skip this without losing any understanding

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If you want to know the exact mathematical relationship between AD and Govt. expenditure, you should read the following.

C is proportional to GDP (Y)

Let’s say

C= Cbar+cY

Where “c” is called propensity to consume, which is the sensitivity to consume with income. Higher the “c” higher is the sensitivity that is for a given increase in income higher increase in consumption. Obviously, value of “c” can not be more than 1

And Cbar is some part of consumption which does not depend upon income ( like essential food , cloths etc.)

When economy is in equilibrium then whatever has been demanded that has been produced i.e. aggregated demand (AD) will be equal to GDP (Y)

i.e. AD = Y

So Y = AD = C+I+G+NX

Y = Cbar+cY + I + G + NX

Y = [1/(1-c)] * ( Cbar + G + NX + I)

If G changes by “∆G” the Y changes by [1/(1-c)] *∆G

So if c is 0.6 and G decrease by Rs 100 Crore then GDP (or AD) will reduce by Rs 250 Crore

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2. Fiscal consolidation through increasing revenue:

If govt. try to achieve to fiscal consolidation by increasing its revenue (which generally not the case) in that case effect on AD is not that simple as in previous case. It depends upon how government has increased its revenue, in case it is increased by increase in tax then it will reduce the AD as increase in tax causes the decrease in money in hand of people and they will demand less. If government increase its revenue by selling its assets (like coal block, spectrum etc.) then it will not affect the aggregate demand as directly as in other case.

This is all about the effect of Government expenditure ( which is part of fiscal policy) on Aggregated Demand and GDP. In case of any doubt you may ask in comment section.

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