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Fiscal policy implementation

Not all changes in the budget deficit are a result of discretionary (i.e. deliberate) changes in government spending and taxes. Since fiscal deficit/surplus can change due to the process of automatic stabilization, economists often look at the structural (or cyclically adjusted) budget deficit to determine whether a fiscal policy action is discretionary. It refers to the deficit that would exist at full employment. Another reason why actual deficit may be misleading is that the deficit calculations include nominal interest, but the real value of debt falls with inflation.

There are significant impediments to the implementation of fiscal policy.

  • First, fiscal policy has a significant time lag, including recognition lag, the time it takes in identifying what is wrong with an economy, action lag, the time it takes in putting into action the decisions taken, and impact lag, the time it takes the fiscal policy actions to translate into results.
  • Second, there is a high level of uncertainty regarding what is actually happening in an economy and this may cause, for example, expansionary fiscal policy to have an impact precisely when other expansionary factors kick in.
    *Third, other economic agents may change their behavior in response to fiscal policy actions which may make fiscal policy overshoot or undershoot its target.

Other relevant macroeconomic issues include:

  • Sometimes governments may be concerned with both unemployment and inflation and the right balance might be elusive.
  • When the budget deficit is already high, further stimulus might lead to a higher interest rate and might be politically controversial.
  • As full employment cannot be observed directly, it is very difficult to fine-tune policy actions.
  • When a low output is due to a shortage of supply, for example, of labor, no amount of fiscal policy actions can redress the situation.
  • Government borrowing may lead to crowding out, a reduction in private investments, and cause the interest rate to rise, and economic output and growth rate to fall.

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020

This article can help you prepare for Reading 16 LOSr.

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