April 20, 2014
Fiscal Policy Complications
Chapter 13, Question #5, page 277
5) Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the idea of a political business cycle. How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding‑out effect and why might it be relevant to fiscal policy? In view of your answers, explain the following statement: “Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely.”
It takes time to be aware of where the economy is moving (recession or inflation), to recognize that fiscal action is needed, and for fiscal action to take place. It also takes time for that action to affect output, employment, or the price level. These time lags are referred to as recognition lag, administrative lag, and operational lag, respectively. A political business cycle is swings in overall economic activity and real GDP that results from election-motivated fiscal policy, instead of from inherent instability in the private sector. This business cycle is not easy to record and show, but there is not much disbelief that political considerations weigh heavily in the formulation of fiscal policy. Decreasing tax rates may be enacted to encourage consumer spending. Households may hesitate to increase their spending if they believe that taxes may increase in the near future. Instead, households may save their additional after-tax income if they believe they will need to pay taxes in the near future. The crowding-out effect emphasizes its attention on investment and whether the stimulus provided by deficit spending may be partially or completely neutralized by an...
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