While fiscal policy has been used successfully during and after the Great Depression, the Keynesian theories were called into question in the s after a long run of popularity.
In this case, there will be a small increase in income from Y0 to Y1 which is quite inadequate to cope with the problem of large scale unemployment and depression. While, the expected future revenue plays an important role in explaining the low fiscal limits of developing countries relating to developed countries Bi et al.
The direct and indirect effects of fiscal policy can influence personal spending, capital expenditureexchange rates, deficit levels, and even interest rates, which are usually associated with monetary policy. In Ricardian view, individuals anticipate a present tax cut as higher government borrowing that turns into the higher taxes in the future so that there is no change in permanent income.
As a summary, our hypothesis is argued that the relationship between fiscal policy with the economic growth is non-linear one as the positive effect in the low indebted level and the negative effect in the high indebted level.
Now, fiscal stimulus by the government shifts the IS curve to IS2 and given the LM1 curve, equilibrium will be at point E2 where rate of interest rises to r2 which would crowd out private investment. Therefore, the study of the relationships between institutions, external debts and the effectiveness of fiscal policy is more significant for both literature and practice.
Meanwhile, the burdens of external debt on the sustainability of fiscal policy are also concerned. Previous, Khan and Knight find positive nominal income elasticities of government expenditures and taxes and they are close to unity in 29 developing countries.
A larger income equal to Y2Y3 or KH has been wiped out due to crowding-out effect of rise in interest rate on investment. To prevent this crowding out, the Central Bank adopts the monetary accommodation policy and for this it increases money supply sufficiently so that LM curve shifts to the right to LM2 which intersects IS2 curve at point E3 so that interest remains at the initial level r1 and income increases to Y2.
Many previous studies have investigated the effects of fiscal policy in many countries, especially in advanced countries such as USA, Japan, European area .