Fiscal policy is the manipulation of aggregate demand using taxation
and or government spending. The government tends to make most of its
fiscal decisions in the annual budget, usually announced in March of
However, there are a number of problems in using fiscal policy to
control aggregate demand - one of the most significant is the problem
1. Time Lags
Many aspects of fiscal policy have a delayed effect on aggregate
demand. Changing the fiscal stance can take some time to achieve. For
example switching to an expansionary fiscal policy through increased
government spending can take some time before the full multiplied
effects are felt on the economy. If the government announced increased
health service spending, there could be considerable delays, as
various committees decide how best to allocate the new funding. Then,
if some extra construction work is planned, contracts need negotiating
and awarding, all before actual spending takes place. On top of all
these delays, major capital projects such as new hospital extensions
could themselves take some time to complete. The net effect is that
there may be months if not years before the planned increased in
government spending actually has its full effect on the economy.
This scenario is equally appropriate if the government is intending to
build more roads, employ more teachers, invest more in the military
etc. Admittedly, a tax change is probably quicker to introduce,
although often businesses need some advanced warning so they can
accommodate any change - again building-in some delay.
Question: So what is his the problem of this for demand management ?
The danger is that if the government was attempting to reflate the
economy ( ie boost AD ) because of a lack of demand and economic
activity, by the time the expansionary fiscal policy takes effect -
the economy could have entered an upswing. Thus the economy might end
up being stimulated at exactly the most inappropriate time. This time
lag in fiscal policy could lead to exaggerated swings in the trade
cycle - increasing volatility and hence inducing more uncertainty.
2. Fine Tuning
Fine tuning is difficult when using fiscal policy. This refers to the
ability to manipulate taxes and spending plans to bring abo...
... middle of paper ...
any benefits ?
Alternatively, an interest rate decrease is likely to lead to some
capital outflows and hence a weakening of the currency.
2. Interest rates and time lags
There can be some delays before the full effects of interest rates
change are felt on the economy. When the Bank of England push up rates
for example, it will take some time for the full effects to filter
through the economy. Some estimates put this delay as being as long as
This is because, some banks eg HSBC, NatWest may not immediately
adjust their rates straight away. Even if they do, some individuals
may have fixed rate loans or mortgages, or they have some period of
fixed rate ( eg for the first 3 years of a mortgage). Therefore, these
individuals will not have their discretionary income changed for some
time. Individuals with outstanding amounts on credit cards may also
benefit from a couple of months delay before they start to notice that
their interest payments have started to rise.
Nevertheless, interest rate changes are thought to be much faster
acting that fiscal policy changes, as at least an interest change will
have some immediate impact straight away.
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