Implementation of Fiscal Policy

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Fiscal policy refers to all the methods used by a government to influence the economy through tax rates and government expenditures. For example, a government may decide to reduce taxes. These moves should, in theory, stimulate the economy and thereby, increase aggregate demand. Such policies are called discretionary fiscal policies.

Difficulties of Implementation

Note that fiscal policy cannot completely stabilize aggregate demand. Below are some of the difficulties experienced in the implementation of fiscal policy.

1. Time Lag

In many cases, delays in implementing changes in spending patterns exist. This is because spending takes a lot of time to filter, and it might get time barred – the country might already have slid into a recession.

2. Inaccurate Information

Poor information results in fiscal policy sufferings. For example, if a government anticipates a recession, it might want to increase aggregate demand. However, if the prediction is wrong, the economy might grow too rapidly, and trigger an inflation.

3. Recognition Lag, Action Lag, and Impact Lag

It may take time before noticing a slow growth in the economy. Also, policymakers may recognize a problem when it is too late (recognition lag).

Consequently, an action against the problem may come when it is already too late to be effective (action lag). Upon implemention of a policy, there could be a time lag between the time of implementation and the time the impact of the policy manifests in the economy (impact lag).

4. Uncertainty About the Economic Future

It is hard to rely on macroeconomic forecasting models to create policies because of their relative inaccuracy. For example, announcing fiscal adjustments will automatically lead to a change in the behavior of the private sector.

5. Crowding-out

Crowding-out refers to a case where the consumption of goods and services and investments reduces due to increased government spending. When the government increases its borrowing, interest rates increase. Due to crowding-out, an expansionary fiscal policy – financed by debt – may at times end up decreasing aggregate demand.

6. Public Spending Side Effects

Reducing government spending to reduce inflationary pressure affects public services such as healthcare. This results in social inefficiency and market failure. As a result, fiscal policy implementations might experience difficulties.

Question

Which of the following most accurately explains the term impact lag?

A. Policymakers may recognize a problem in the economy when it is already too late

B. Policymakers may take action against an economic problem when it is already too late

C. Once the government has implemented a policy, it may take time before the impact of the policy manifests in the economy

Solution

The correct answer is C.

It may take a lot more time for the impact of an implemented policy to manifest in the economy. This is called the impact lag.

Option A is incorrect. When policymakers recognize a problem in the economy when it’s too late, economists call it a recognition lag.

Option B is incorrect. Taking action against an economic problem when it is already too late is referred to as action lag.

Reading 16 LOS 16r:

Explain the implementation of fiscal policy and difficulties of implementation