Apart from these automatic stabilizers, there are also discretionary fiscal policy measures that are occasionally put in place. Thus, to moderate business cycle swings during recession, it is common for the legislative to call for tax cuts or for the government to engage in new spending programs, thus, to put an expansionary fiscal policy in place. Nevertheless, discretionary fiscal policy measures may encounter what is termed as in “inside lag” (Weil), that is, the gap between the identification of the need for the policy and the time of its implementation (Weil).
Apart from the inside lag mentioned above, there are still many other problems that explicate the limitations of fiscal policies. For one, fiscal policy’s capacity to affect output weakens over time (Weil). This is due to the fact that there is what is called the natural rate of output that is in turn dependent on the “supply of the factors of production” such as capital, labor, and technology (Weil). Thus, in this means that increased aggregate demand may result to increased prices but not necessarily to increased output.
This necessarily leads to increased inflation (Weil). In the long term, an expansionary fiscal policy may also affect not only aggregate demand but the natural rate of output as well. An increased output today due to the expansion would result to a lower natural rate of output in the future. A contractionary fiscal policy also has its long term effect such that low output today would result to increased output in the future (Weil).
These long term effects, according to Weil, can be accounted for by savings rate, as it is affected by fiscal policy. Expansion means lower government savings. Low government savings means lower government investments and/or increased borrowings, both of which are unpleasant (Weil) and both result to lower output in the future. What Fiscal Policy Affects We have seen how fiscal policy affects a great part of an economy’s output, aggregate demand, pricing, inflation, and many others.
Fiscal expansion means increased aggregate demand either due to increased government spending (which, in constant taxes, naturally increases demand) or lower taxes or increased transfer payments (which result to increased disposable income y-T [recall equation 1], which results to increased consumption C, and eventually results to increased aggregate demand). But apart from these, fiscal policy also affects the composition of aggregate demand (Weil). A deficit, for example, launches an expansionary policy including the issuance of bonds. This puts the government in a competitive position against local borrowers.
This then results to increased interest rates and to the possible crowding out of private investments (Weil). Fiscal policy may also affect trade balance and exchange rate such that in moments of increased interest rate (such as when the government issues bonds), foreign capital is attracted (Weil). Foreigners bid up the price of the dollar in order to get more of them to invest, causing an exchange rate appreciation. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the trade balance (Weil).
With all the effects and the aspects that fiscal policy affects, fiscal policy ought to be understood as naturally complex which ought to be understood in its many facets. Reference List Sparknotes. (2006). Fiscal policy. Sparknotes. Retrieved June 10, 2008 from http://www. sparknotes. com/economics/macro/taxandfiscalpolicy/section1. html. Weil, D. N. (2002). Fiscal policy. The Concise Encyclopedia of Economics. Retrieved June 10, 2008 from http://www. econlib. org/library/Enc/FiscalPolicy. html.