Fiscal policy is a policy of the government regarding its revenue, expenditure, debt and its management. Fiscal policy is commonly known as the budgetary police as the government budget is prepared on the basis of this policy. Let me explain the full behavior of this policy in different scenarios. During the expansion period it would be prudential for the government to have surplus budget in order to control the upward trend of the economy because by this measure the government will be able to take way a part of the money supply from circulation. However, during a contraction period of the economy, it would be suitable for the government to make a deficit budget so that excess expenditure may raise the level of income and employment in the country and thus, the tendency towards depression is controlled.

The unbalance budget policy to control the business fluctuations is an economy is highly suitable for economic stability of a country. Keynes attached a great deal of importance to this policy as his suggestions for controlling the depression of the 1930s. On the other hand, this policy is clearly against the classical theory of balanced budget, in which the government is to make sure that the budget is limited in expenditure and as balanced as possible. This policy clearly failed to help the world out of the depression of the 1930s where their principle of limited expenditure tended to deepen the slump rather than bringing back economic stability.

There are various tools of fiscal policy to control the business fluctuations. I will briefly touch some of them. You can read about the others in your own time.

Taxation
Various forms of taxes levied on the people by government would result in the purchasing power of resources of the people to be shifted from the private sector to the public sector. In the Words of Edwin Cannon, “Every tax discourages some kind of production; because the aim of taxation is to divert a portion of the productive force of the community from producing what the inviduals desire as individuals, to producing something else they desire in their corporate capacity.”

Progressive taxes play a vital role in the stabilization of an economy; therefore, taxation policy must aim at imposing more progressive taxes to overcome cyclical fluctuations. These taxes act as an automatic stabilizer of the economy. Several kinds of taxes are levied by the government.

Personal Income Tax
This is a progressive tax as the tax rate increases with the higher level of income and vice versa. During the phase of an expansion the incomes of the people increase rapidly. As a result, more and more people fall in the category of tax payers and thus a greater amount of money in the form of tax is collected. Conversely during the phase of economic contraction, the income level of the people in general falls and therefore more and more people fall out of the income tax bracket and, thus, tax revenue collected there of becomes less. Hence, this form of tax is an automatic stabilizer for the economy as it lowers the purchasing power of the people during the phase of an expansion and vice versa during the contraction period.

Corporate Profit Tax

This is also another form of progressive tax. This form of taxing is rather a built-in stabilizer of the economy. During the phase of contraction the tax rate is kept very low as the incomes of the corporations are low and also to give them the opportunity to promote investment. On the other hand, during the expansion phase, the rate of the tax is higher as the incomes of the corporations are on the rise.

Excise Tax

This is rather an indirect form of taxation, the burden of which the consumer ultimately bears, as the initial amount of tax on a particular product is usually wholly included in its market price. During the phase of expansion the rate of excise tax is increased in order to lower the demand of the consumer for consumer good, or rather the excise tax rate is increased in order to lower the consumers saving capacity and thus an either/both the cases mentioned the investment level is adversely affected and the expansion is controlled. Conversely, during the contraction period the rate of excise tax is lowered down in order to encourage investment to take place.

Tariffs
Contrary to the above taxes, the tariffs rate is lowered during the expansion phase as this will allow more import to take place and the expansion tendencies are controlled. Conversely, during the contraction phase the tariff rate is increased in order to stabilize the economy.

Government Expenditure
Basically government expenditure can be classified into two categories i.e. non-development expenditure and development expenditure.

Keynes has laid a great deal of emphasis on the role government in stabilizing the economy. According to him, during the phase of expansion, government expenditure must be reduced which would result in a multiple decrease in the National Income. Such a measure is necessary as this would stabilize the economy in the sense that the expansion phase would be controlled. On the other hand, during the phase of contraction, government expenditure must be increased so that it results in a multiple increase in the National Income and thus the contraction is controlled. The amount of both types of expenditure has to be adequate to effectively influence the consumption and investment level.

Government expenditure is normally incurred on capital goods e.g. roads, buildings, irrigation projects, low cost houses etc. Therefore, there must be a administrative body to control and regulate government spending under sound planning, during the upward and downward trends of the economy.

Government debt and its management can also play a vital role in the stabilization of an economy. During the revival phase it is advisable that a government ought to start playing back the loans (against order of people) to the people because money starts losing its purchasing power during the phase. Then, during the phase of expansion repayment of the mentioned loans must be completed. These loans are to be paid out of government saving incurred through surplus budget. Conversely during the contraction phase government may obtain loans in order to start development projects or to increase spending to overcome economic depression.

Economics generally believe that there must be flexibility in wages in order to overcome cyclical fluctuations. During the expansion phase, wage rates must be increased so that the entrepreneurs profits are cut down; this stops them from making further investment. Thus, expansion is controlled and the economy is in a stable condition. During the contraction phase, wage rates have got to be lowered so that it results in lower cost of production, and with that the rate of return for the entrepreneurs is increased. This encourages investment and the contraction phase is overcome.

Over the years, it has been observed that price control and rationing can help overcome expansion while support price would combat contraction. During the phase of an expansion government should fix a price-ceiling and strict administrative measures should be adopted against violations of the measure.

The government should also be vigilant against black marketing of goods in this connection. On the other hand, the support price policy should be implemented by the government during the contraction phase. Support price policy should be implemented in the agricultural so that entrepreneurs are given the necessary incentive to produce more and so on. Thus, contraction of the economy is overcome.

In one of the publications of the League of Nations it was stated that: “Cyclical fluctuations in business activity in an economically integrated world are not a national but international phenomenon and require not only national but international action.” This statement shows that government measures at a national level, to control cyclical fluctuations, are always inadequate, simply because the whole world is integrated through trade.

Cycles and International Trade
When cyclical fluctuations occur in some part of the world all the countries of the world are affected through trade relations. For example, during the phase of an expansion, developed countries demand more raw materials from the developing countries. This would increase the exports of developing countries and the developing and services from the developed countries and thus incomes, employment and output in developing and output in development countries would increase and they too would be in the expansion phase.

In the case of contraction period the opposite situation would arise e.g. the great depression of the 1930s has been a witness to this. During that particular period, depression actually took place in U.S.A. Income and employment of the country was so low that it has to tremendously cut down the imports from third countries. As result of this phenomenon, third world countries suffered in the sense that their purchasing power was tremendously cut down and so their income and output level was also reduced and they too were in the depression period. In order to control cyclical fluctuations, international measures were introduced.

International Bank for Reconstruction and Development (IBRD)/World Bank
This body was set up in 1944 and started off with a total capital of $8 billion. Its main function is to give long term loans to member countries in order to enable them to increase their investment level. Before doing so, it wants them to have an access to the feasibility reports on projects intended, particularly where the world countries are concerned, to sanction loans for them. By regulating such measures, it helps the countries to stabilize their economies.

International Monetary Fund (IMF)
This body was also establishes in 1944 at Bretton Wood (USA) Conference. Its main function is to give short term loans to member countries. This would help rectify the countries adverse balance of payment position. The fund has a total capital of $9 billion out of which member countries obtain loans for a period of 5 years for the mentioned purpose. Each member country may depreciate/devalue its currency by 10% at its own choice. However, if devaluation intended is more than 10%, permission is sought from the IMF. This would create a stable exchange rate between member countries and helps in stabilizing the economies of different countries of the world.

General Agreement on Trade and Tariff (GATT)
An Agreement to reduce the tariff rates in order to promote international trade was reached between a large numbers of member countries of the UNO including developed countries. Tariff rates are reduced by negotiations for the mentioned purpose of promoting international trade which is a requirement for stabilizing each and every economy.

International Finance Corporation (IFC)
This body was established in 1956 and started off with a total capital of U.S. $ 100 million.
This main function of this body is to encourage investment in the private sector and also to assist in developing under-developed regions.

European Payment Union
This union was formed by West European Countries in 1950. Its main duty is to settle deficits/surplus of balance of payments multilaterally rather than bilaterally. This union has played a vital role in controlling restrictions in foreign exchange transactions thus; it is another step towards stabilizing the economies.

International Buffer Stock Scheme
The main purpose of this scheme is to stabilize the prices of agriculture commodities. Particularly of those coming from the underdeveloped countries in the international market because the prices of these commodities fluctuate due to the rise and fall in the supply of the commodities. Thus, such an organization is needed so that it may stock the raw materials of the LDCs when prices of the commodities fall. On the other hand, when the prices of such commodities are unnecessarily rising the organization would then release the stock. Hence, prices would only fluctuate within a specific range.

Multilateral Commodity Agreement
There should be a multilateral commodity agreement between different countries of the world which are the main suppliers of the material. The member countries would decide among themselves the range of the price fluctuation, a phenomenon which should be allowed. When the price level reaches the upper limit, exporters should continue supplying at that price. When the price comes down to the lower limit importers would/should continue import at that price.

International Loans
There should be an organization specifically meant for aiding the developing countries. Loans should be given to such countries when they are facing a deficit in their balance of payment due to the fall in the prices of their exports. The recipient countries should make the repayments of the loans when prices of their commodities are stabilized once again in the international market.