1Demand-pull inflation is defined as an increase in prices arising from the increased overall demand for a nation’s output when consumption, investment, government spending or net exports rise without a corresponding increase in the level of AS.
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If the government increases public spending by spending more on infrastructure development, social sector spending it will increase the aggregate demand. AD shifts to the right. This will lead to more inflation but it will lower unemployment (thereby removing India from the current phase of stagflation) This inflation which is caused is demand-pull inflation. It will lead to a shortage of basic commodities.
A rise in incomes (due to higher government spending) would also lead to higher savings (even high risk savings), which would make the equity markets grow. Since retail investors would start investing their surplus funds in the equity markets or in mutual funds. Propensity to saving will rise leading to higher investments in the equity markets. If the equity markets now start giving positive returns.
Beyond a certain point, every rise in income will also lead to a rise in savings Propensity to consume falls with a rise in incomes and the propensity to save rises.
Interest rates are high and the option of reducing inflation by increasing interest rates is not applicable in this scenario. Level of risk taking in the economic sector has gone down drastically. People have become risk averse and highly defensive of their original capital.
Consequences of Increase in Government Spending.
1) Assuming that the government spending is done by deficit financing, it will lead to higher borrowing on the part of the government which will affect future tax rates and future disposable incomes thus, this is merely a short term solution.
2) Increase in public spending would lead to demand-pull inflation since the AD would increase but the AS would remain constant.
3) If the government spends on infrastructure development or in building human capital (health care, education, sanitation, etc.) the opportunity cost would be that there would be lesser spending on other areas like defense but this would lead to greater economic development as this will improve the long-term productive efficiencies and increase GDP in the long term. However, if the government would spend this money in sectors like defense, it will increase the AD but will not lead to an economic development.
Due to the current account deficits being high, the government really cannot do further deficit financing and so as a solution this option is only viable in the short run. For a long run solution to this problem, the government can encourage foreign direct investment (FDI) in India, especially in high priority and high growth sectors such as retail, infrastructure, insurance, etc. This would lead to the sectors becoming more efficient and higher employment rates since the sectors mentioned above employ large number of people. The FDI would also act like an injection into the economy thereby, increasing AD and getting the same results that are suggested in the article.
What mechanism coordinates individual decision, so that saving always equals investments?
To answer these question, we need to discover a model about the loanable funds in the market, that is the market which is demanded by individual savers supply funds and individual borrowers.
SUPPLY AND DEMAND FOR LOANABLE FUNDS
If we check the other market, we can analysis the condition of the market for loanable funds which exist around supply and demand. The supply of loanable funds comes from person who has earn and save the money and want to rotate the funds out, through means of share, bond or gold markets directly or indirectly through bank or mutual funds. When these rate goes high, he believe that his investment are right and tries to invest more and more for want of more return from the market, so the supply of loanable funds increases and hence the supply curve for loanable funds rises.
To understand the loanable funds framework, we can consider saving and investment on various government policies such as:
Policy 1. Saving Incentives
Policy 2. Investment Incentives
Policy 3. Government Budget Deficits and Surpluses
Policy 4 : Expansionary monetary
Policy 5 :Contractionar monetary policy
What happens if the government increases the amount of income that individuals can allocate to individual Retirement Accounts and other tax advantaged accounts?
This Policy would increase the after-tax interest return that individual would receive on their saving.
Suppose that the Government institutes an investment tax credit, giving a tax advantage to any firm that builds a new factory or purchase new capital equipment.
Government Budget Deficits and Surpluses
A budget deficit results when government spending exceeds tax revenue. The Government borrows by issuing bonds. The entire amount of government bonds outstanding, representing the accumulation of past government deficits, is the government debt. A budget surplus can be used to retire(repay) existing government debt. If the government spending exactly equals tax revenue, then the government has a balanced budget.
Contractionary monetary policy
Contractionary monetary policy is used by federal reserve for fund rate which is to slow the economic growth. Even during the time of recession federal goal can be achieved. This policy may be used to reduce price in¬‚ation by increasing the interest rate. This policy can’t be used without acknowledging the core inflation rate compared to target inflation rate . Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people to save more in bank deposit accounts so they can reduce their own borrowing from the central bank.
As interest rates rise, consumers may save more and borrow less to spend on
goods and services. Firms may also reduce the amount of money they borrow
to invest in new equipment. A reduction in capital investment by ¬rms will
reduce their ability to increase output in the future. Higher interest rates may
therefore reduce economic growth and increase unemployment.
Expansionary monetary policy
This may be used during an economic recession to boost demand and employment
by cutting interest rates. However, increasing demand can push up prices and may
increase consumer spending on imported goods and services.
The Government Mission should be to provide a tax regime which provides the required revenue for financing governments programmes and commitments encouraging saving and investment and promoting social justice. This is achieved by tax measures, which broaden the tax base by creating a system that facilitates voluntary compliance by being efficient
simple and fair.