UPSC Prelims 2021 Q3: Fiscal and Monetary Policy in a Recession
Which among the following steps is most likely to be taken at the time of an economic recession?
- Cut in tax rates accompanied by increase in interest rate
- Increase in expenditure on public projects
- Increase in tax rates accompanied by reduction of interest rate
- Reduction of expenditure on public projects
Answer: (b) Increase in expenditure on public projects
Statement-wise explanation
- a: incorrect — This option mixes two policies that pull in opposite directions. A tax cut leaves people with more income and supports demand. A higher interest rate makes borrowing dearer and holds back investment and consumer spending. Central banks raise rates to cool an overheating economy, not to fight a recession. In the COVID-19 downturn the RBI did the opposite and cut the repo rate by 40 basis points to 4.0% on 22 May 2020.
- b: correct — In a recession private spending and investment fall, so the government spends more to make up the lost demand. Spending on public projects adds to demand directly. Through the multiplier it also creates jobs, income and further rounds of spending. The Economic Survey 2020-21 called this counter-cyclical policy: expansionary (more spending or lower taxes) in bad times and contractionary in good times.
- c: incorrect — A rate cut fits a recession, but a tax increase does not. Higher taxes take money out of households and firms when demand is already weak, which works against the rate cut. Raising taxes during a slump is a procyclical move and deepens the downturn.
- d: incorrect — Cutting public project spending during a recession removes demand when the economy most needs it. That is procyclical fiscal policy, and it amplifies the slump. Governments cut spending in boom years to cool demand or to consolidate their finances, not in a recession.
How to eliminate
Start from one rule: in a recession every tool should be expansionary. That means more government spending, lower taxes and lower interest rates. Now test each option. The option on cutting public project spending is contractionary, so it goes. The two mixed options each pair one expansionary tool with one contractionary tool. A tax cut with a rate hike, and a tax hike with a rate cut, would partly cancel each other. That leaves the only option that points entirely in the expansionary direction. UPSC set two 'mixed signal' distractors here, and you can reject both for the same reason. You only need the basic Keynesian logic, not any specific figure.
Know more
Countercyclical vs procyclical policy
The business cycle has booms and recessions. Countercyclical policy leans against the cycle: it adds demand in a slump and withdraws it in a boom. Procyclical policy moves with the cycle and makes the swings bigger.
| Tool | Recession (expansionary) | Boom / high inflation (contractionary) |
|---|---|---|
| Government spending (G) | Increase, especially capital spending | Reduce |
| Taxes (T) | Cut | Raise |
| Policy repo rate (RBI) | Cut | Raise |
| Liquidity (CRR, open market operations) | Inject | Absorb |
Why public spending works. Keynes argued that a short-run slump comes from weak demand. When firms and households stop spending, the government is the spender of last resort. Each rupee spent on roads or railways becomes someone's income, which is spent again. This is the multiplier. The Economic Survey 2020-21 noted that fiscal multipliers are much larger in a crisis than in a boom.
Fiscal policy vs monetary policy. Fiscal policy (spending and taxes) is set by the government through the Budget. Monetary policy (interest rates) is set by the RBI's Monetary Policy Committee. In a deep recession rate cuts can lose force: if rates are already near their floor (a liquidity trap), people hold cash instead of borrowing. This is why fiscal spending becomes the main tool.
Automatic vs discretionary stabilisers. Some stabilisers work without any new decision. Tax revenue falls on its own when incomes fall, and welfare payments rise. Discretionary policy is a deliberate choice, such as a stimulus package or a bigger capital-expenditure budget.
India's case. In 2020 the RBI cut the repo rate to 4% and the government announced the Atmanirbhar Bharat packages. The Economic Survey 2020-21 argued that, because India's growth rate has usually been above its interest rate, spending to support growth would not make debt unsustainable.
In the news
The 2021 paper came after the COVID-19 contraction of 2020-21. In January 2021 the Economic Survey 2020-21 explicitly called for 'a more active, counter-cyclical fiscal policy', and the Union Budget 2021-22 then raised capital expenditure sharply to revive demand.
NCERT Concepts to Revise
- Countercyclical fiscal policy: The question tests what a government does to lean against a downturn in the business cycle.
- Procyclical fiscal policy: Two of the options would move with the cycle; this concept helps you spot them.
- Fiscal policy: Two options use spending and taxes, the government's fiscal tools for managing total demand.
- Recession: The question is set in a recession, so you need to know what falls during one.
- Discretionary fiscal policy: Changing spending on public projects or changing tax rates is a deliberate fiscal decision of this kind.
- Monetary policy transmission: Two options change interest rates; this explains how a rate change reaches borrowing and spending.