Implementation of Fiscal Policy

Recall that 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.

Understanding Deficits and Fiscal Stance

Policymakers need to know if the budget deficit truly reflects the government’s fiscal stance, meaning if fiscal policy stimulates or reduces economic growth. But several factors make the actual government deficit a complex measure.

Fluctuations in Deficit Size

The size of the deficit can fluctuate due to various reasons not necessarily related to intentional fiscal policy changes. For instance, automatic stabilizers, like income tax, VAT, and social benefits, can alter the budget deficit without any policy change. This automatic adjustment reduces the economy’s sensitivity to shocks and stabilizes employment and output levels without any deliberate policy changes.

Use of Structural Budget Deficit

Economists often use the structural budget deficit as a fiscal stance indicator, which is the deficit that would exist if the economy operated at full employment or full potential output. For example, during the 2009-2010 period, when unemployment was around 9-10% in the United States and Europe, the actual budget deficits would have been substantially lower if the economies were at full employment, as tax revenues would be higher and social transfers lower.

Distinction Between Real and Nominal Interest Rates

Another factor that complicates using actual government deficits as a fiscal stance measure is the distinction between real and nominal interest rates and the role of inflation adjustment when applied to budget deficits. It is more logical to consider only the inflation-adjusted (or real) interest payments because inflation erodes the real value of the outstanding debt.

Use of Automatic and Discretionary Fiscal Adjustments

Lastly, governments use both automatic and discretionary fiscal adjustments to influence aggregate demand. Discretionary adjustments involve intentional changes in taxes and/or spending to stabilize the economy. However, a pertinent question arises as to why fiscal policy cannot entirely stabilize aggregate demand, thereby ensuring full employment at all times.

Difficulties in Implementing Fiscal Policy

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

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, action against the problem may come when it is too late to be effective (action lag). Upon implementation 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).

Uncertainty About the Economic Future

Another dimension of time in this process relates to the unpredictability of the economy’s direction regardless of policy alterations. 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.

Other Macroeconomic Issues

• Crowding out: Crowding out refers to a case where the consumption of goods, 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 sometimes end up decreasing aggregate demand.
• If the government tries to boost demand to fight unemployment and inflation, it might lead to higher wages and prices, causing inflation. Policymakers may avoid further adjusting fiscal policy to prevent this.
• When the budget deficit is already large relative to GDP, and further fiscal stimulus is necessary, increasing the deficit may be viewed as unacceptable by financial markets. This can lead to higher interest rates on government debt and political pressure to address the deficit, even when further stimulus is needed.
• Accurately measuring the level of full employment is challenging, and fiscal expansion raises demand. However, if the economy is already at full employment, which changes with shifts in productive capacity and workers’ willingness to work at different wage levels, it could lead to inflationary pressures instead of increased output.
• If the lack of demand is not the reason for unused resources but rather a low supply of labor or other factors, then discretionary fiscal policy will not increase demand and will be ineffective, potentially leading to inflationary pressures.

Determining whether a Fiscal Policy is Expansionary or Contractionary

Expansionary Fiscal Policy

Expansionary policies are adopted to stimulate the economy during a recession. For instance, during a recession, the government employs idle resources and tries to boost economic output. This increased spending increases aggregate demand, hence a higher real GDP.

Generally, expansionary policy attempts to raise employment rates and output and often results in an increase in the budget deficit or a reduction in the budget surplus.

The expansionary policy includes:

• Increased Government Spending: This could be in the form of increased public works, infrastructure projects, government salaries, etc.
• Tax Cuts: Reducing taxes increases disposable income for households and can also reduce operating costs for businesses, thereby encouraging spending and investment.
• Increased Transfer Payments: This includes increasing payments for social programs like unemployment benefits, social security, etc.
• Decreasing Interest Rates: Though this is primarily a tool of monetary policy, it’s worth mentioning that lower interest rates can also encourage borrowing and investment, which is expansionary in nature.

Contractionary Fiscal Policy

Contractionary policy is typically adopted when the economy is overheating, i.e., growing too quickly and causing high inflation. It can be explained as a decline in government expenditure or a rise in taxes.

Contractionary policies often lead to a decrease in the budget deficit or an increase in the budget surplus. Contractionary fiscal policies include:

• Decreased Government Spending: Reducing spending on public works, infrastructure projects, government salaries, etc.
• Tax Increases: Raising taxes decreases disposable income for households and increases operating costs for businesses, thereby discouraging spending and investment.
• Decreased Transfer Payments: This includes reducing payments for social programs like unemployment benefits, social security, etc.
• Increasing Interest Rates: Again, primarily a tool of monetary policy, higher interest rates can discourage borrowing and investment, which is contractionary in nature.

Question

Which of the following most accurately explains the term impact lag of a fiscal policy?

1. Policymakers may recognize a problem in the economy when it is already too late.
2. Policymakers may take action against an economic problem when it is already too late.
3. 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.

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

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