Explain how the government can use the budgetary policy in reducing inequality of income in the economy. OR Di

Question 22 of 54

Q. Explain how the government can use the budgetary policy in reducing inequality of income in the economy.

(OR)

Discuss briefly the role of the government budget in influencing 'allocation of resources' in the economy.

Dnh Dd CbseCBSE Class XII Board 2019Subjective· 4mImportance★★★★★

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Part (a)Concept understanding — Fiscal Policy Multipliers

The Fiscal Policy Multiplier: Why One Rupee of Government Spending Can Move the Economy by More Than One Rupee

Imagine you are in a small town. The government decides to build a new road and pays a contractor ₹100 crore. The contractor uses that money to hire workers and buy cement. The workers, now with extra income, go to the local grocery store, buy food, and pay the shopkeeper. The shopkeeper, in turn, uses that money to restock his shelves from the wholesaler. The wholesaler then pays his staff. That original ₹100 crore has now turned into income for many more people than just the contractor.

This chain reaction is the core intuition behind the fiscal policy multiplier.

The Precise Meaning

In macroeconomics, the fiscal policy multiplier measures the magnitude of the ripple effect that an initial change in government spending (or taxes) has on the final national income (GDP).

\text{Multiplier (k)} = \frac{\Delta Y}{\Delta G}

If the multiplier is 2, then a ₹100 crore increase in government spending will eventually increase national income by ₹200 crore. If the multiplier is 0.5, the same ₹100 crore will only increase income by ₹50 crore (which can happen if the spending crowds out private investment).

Why It Matters: The Two Sides of the Coin

The multiplier is the reason governments use fiscal policy actively.

1. Fighting a Recession (Expansionary Policy): When the economy is sluggish and unemployment is high, the government can increase its spending ( $\Delta G > 0$ ). Because of the multiplier, a relatively small increase in spending can generate a much larger boost to total demand and income, pulling the economy out of a downturn.

2. Controlling Inflation (Contractionary Policy): When the economy is overheating and inflation is rising, the government can cut its spending or raise taxes. The multiplier works in reverse — a small cut in spending can lead to a larger fall in aggregate demand, cooling down the economy.

The Formula from Your NCERT Textbook

The NCERT Class 12 Macroeconomics textbook derives the multiplier in a simple two-sector economy (households and firms, no government or foreign trade). The key assumption is that people spend a fixed fraction of any extra income they earn. This fraction is called the Marginal Propensity to Consume (MPC).

Note

MPC = $\frac{\Delta C}{\Delta Y}$ — the change in consumption spending divided by the change in income. If MPC = 0.8, then for every extra ₹100 of income, people spend ₹80 and save ₹20.

The multiplier formula in this simplest case is:

k = \frac{1}{1 - MPC}

Let's see why. If the government spends ₹100 crore:

Round 1: Income rises by ₹100 crore (the initial spending).
Round 2: People spend MPC × ₹100 crore = ₹80 crore. This becomes income for others.
Round 3: Those people spend MPC × ₹80 crore = ₹64 crore.
And so on, in an infinite geometric series.

The total increase in income is:

$\Delta Y = 100 + 80 + 64 + 51.2 + \dots = 100 \times \frac{1}{1 - 0.8} = 100 \times 5 = 500$ …

Part (b)Concept understanding — Fiscal Policy Multipliers

The Fiscal Policy Multiplier: Why One Rupee of Government Spending Can Move the Economy by More Than One Rupee

This chain reaction is the core intuition behind the fiscal policy multiplier.

The Precise Meaning

In macroeconomics, the fiscal policy multiplier measures the magnitude of the ripple effect that an initial change in government spending (or taxes) has on the final national income (GDP).

\text{Multiplier (k)} = \frac{\Delta Y}{\Delta G}

Why It Matters: The Two Sides of the Coin

The multiplier is the reason governments use fiscal policy actively.

The Formula from Your NCERT Textbook

Note

MPC = $\frac{\Delta C}{\Delta Y}$ — the change in consumption spending divided by the change in income. If MPC = 0.8, then for every extra ₹100 of income, people spend ₹80 and save ₹20.

The multiplier formula in this simplest case is:

k = \frac{1}{1 - MPC}

Let's see why. If the government spends ₹100 crore:

Round 1: Income rises by ₹100 crore (the initial spending).
Round 2: People spend MPC × ₹100 crore = ₹80 crore. This becomes income for others.
Round 3: Those people spend MPC × ₹80 crore = ₹64 crore.
And so on, in an infinite geometric series.

The total increase in income is:

$\Delta Y = 100 + 80 + 64 + 51.2 + \dots = 100 \times \frac{1}{1 - 0.8} = 100 \times 5 = 500$ …

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Part (a): The budget reduces income inequality through progressive taxation of the rich and targeted expenditure (subsidies, transfers, public services) that raises the poor's real income.

Part (b): The budget re-allocates resources by using taxes/subsidies to steer production away from demerit goods and toward merit/public goods, and through direct public investment.

Part (a)

Market forces tend to concentrate income among those with capital and skills. The government budget corrects this on two fronts — how revenue is raised and how it is spent.

1. Progressive taxation (revenue side). Higher marginal rates on higher incomes, plus taxes on wealth and corporate profits, take proportionately more from the rich and build the pool for redistribution.

2. Subsidies for essentials. Food (PDS), fertiliser, fuel and electricity subsidies act as implicit income transfers, raising the real income of low-income households.

3. Expenditure on public and merit goods. Free schooling, mid-day meals, public health, low-cost housing (PMAY) and sanitation benefit the poor most, since they cannot afford private alternatives — equalising access to opportunity.

4. Direct transfer payments. Old-age/widow pensions, MGNREGA (guaranteed rural wage employment), PM-KISAN and unemployment/maternity benefits directly lift the incomes of vulnerable groups. …

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Q.Explain how the government can use the budgetary policy in reducing inequality of income in the economy.

Part (a)

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