UPSC Prelims 2021 Q3: Indian Economy – Fiscal Policy & Budget
- (a) Cut in tax rates accompanied by increase in interest rate
- (b) Increase in expenditure on public projects
- (c) Increase in tax rates accompanied by reduction of interest rate
- (d) Reduction of expenditure on public projects
Answer: (b) Increase in expenditure on public projects
Explanation
Fighting Recession: Fiscal and Monetary Response
| Policy Option | Effect | Right for Recession? |
|---|---|---|
| Cut tax rates + raise interest rate | Contradictory: fiscal boost but monetary tightening chokes borrowing | No - conflicting signals |
| Increase expenditure on public projects | Direct injection of demand: fiscal stimulus creates jobs, income, multiplier effect | YES - textbook Keynesian counter-cyclical response |
| Raise tax + cut interest rate | Contractionary fiscal + expansionary monetary: net effect uncertain | No - tax hike depresses demand further |
| Reduce expenditure on public projects | Pro-cyclical: worsens recession by cutting demand | No - amplifies downturn |
In recession, government uses fiscal stimulus via higher public spending (Keynesian counter-cyclical policy).
Answer: (b) Increase in expenditure on public projects.
Why each option is right or wrong
- (a) Incorrect. Raising interest rates during recession would suppress borrowing and investment, worsening the slowdown.
- (b) CORRECT. Higher public expenditure (infrastructure, welfare, capital works) is the classic Keynesian anti-recession tool - it boosts aggregate demand, creates jobs and triggers the multiplier effect.
- (c) Incorrect. Raising taxes during recession reduces disposable income and demand - the opposite of what is needed.
- (d) Incorrect. Cutting public expenditure during recession is a pro-cyclical mistake that deepens the downturn.
Key point
Recession response = Keynesian fiscal stimulus. Increase public spending (roads, welfare, capex) to boost aggregate demand and trigger the multiplier. Cutting spending during recession is pro-cyclical and worsens the downturn.
Remember
During recession, the government increases expenditure on public projects (fiscal stimulus) to raise aggregate demand and trigger the multiplier effect. This is the Keynesian counter-cyclical response used by India during COVID-19 (Atmanirbhar Bharat).
Common mistakes
- Confusing recession response with inflation response. Inflation calls for higher interest rates and lower spending; recession calls for the opposite.
- Assuming tax cuts alone are enough. Tax cuts help but must be combined with government spending to have quick impact on aggregate demand.
- Missing the multiplier effect. Rs 1 of public spending on infrastructure can generate Rs 2 to Rs 3 of total demand through wages, materials and consumption.
Exam tip
Recession = expand demand. Inflation = compress demand. In a slowdown, government spends and RBI cuts rates. In inflation, government tightens spending and RBI raises rates. India used this playbook in COVID-19 (2020-21) with the Atmanirbhar Bharat package.
Sources
- NCERT Class XII Macroeconomics - Chapter on Government Budget
- Ministry of Finance, Government of India — Economic Survey (chapter on Public Finance)