APMacro: Fiscal Policy Problems

Spend v Taxes
Governments may encounter a number of problems in enacting and applying fiscal policy. There are problems with timing that may arise. Recognition lag is the time between the beginning of recession or inflation and the awareness that it is actually happening. This lag arises because if the difficulty in predicting the future course of economic activity. Although forecasting tools such as the index of leading indicators provide clues to the direction of the economy, the economy may be four or six months into a recession or inflation before that fact appears in relevant statistics and is acknowledged.Meanwhile, the economic downslide or the inflation may become more serious than it would have if the situation had been identified and acted on sooner. Administrative lag is the tine for the slow turning wheels of democratic government to get a fiscal policy turned into law. There will typically be a significant lag between the time the need for fiscal action is recognized and the time action is taken. Operational lag occurs between the time fiscal action is taken and the time that action affects output, employment, or the price level.

Fiscal policy is conducted in a political arena. This not only may slow the enactment of fiscal policy, but may also create the potential for political considerations swamping economic considerations in its formulation. Politicians want to get reelected. A strong economy at election time will certainly help them.So politicians may favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate. They may also rationalize increased government spending on popular items such as farm subsidies, health care, highways, education, and homeland security.Fiscal policy for political purposes may cause inappropriate changes in aggregate demand and cause rather than avert economic fluctuations. Elected officials and political parties may cause political business cycles. They stimulate the economy using expansionary fiscal policy before elections and use contractionary fiscal policy to dampen excessive aggregate demand after the election.

Fiscal policy may fail to achieve its intended objectives is households expect future reversals of policy. For example, if taxpayers believe a tax reduction is temporary, they may save a large portion of their tax savings, reasoning that rates will return to their previous levels in the future. At that time, they can draw upon this extra saving to maintain their consumption. So a temporary tax reduction may not increase present consumption spending and aggregate demand as much. The opposite may be true for a tax increase. If taxpayers think it is temporary, they may reduce their savings to pay the tax while maintaining their present consumption. Their reasoning is they can restore their saving when the tax rate falls. Therefore, a tax increase may not reduce current consumption and aggregate demand by as much as policymakers desired.This so called consumption smoothing occurs over time and fiscal policy will lose some of its strength.

Fiscal policies of state and local governments are pro-cyclical, which means that they worsen rather than correct recession or inflation. Unlike the federal government, state and local governments face constitutional or other legal requirements to balance their budgets. Like households and private businesses, state and local governments increase their spending during prosperity and cut them during recession.

Another flaw of fiscal policy is the crowding out effect. An expansionary fiscal policy may increase the interest rate and reduce private investment spending thereby weakening or canceling the stimulus of the expansionary policy.

1) Learnerator: Production Possibilities Curve #1-20, Inflation #1-30, Unemployment #1-30



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