Question

What are 6 problems with functional finance? Describe.

Answer 1

Functional Finance is a macroeconomic theory developed by Abba Lerner during World War II. It is designed to eliminate the economic business cycle with the help of government intervention in the economy. Functional finance is based on the end result of government intervention policies on the economy.

Six problems with Functional Finance:-

1. Functional finance theory assumes that when government finances its deficit by selling bonds there would be no change in interest rates and thus there would be crowding out effect with respect to private investment but in reality, deficit finance raises the interest rate and thus contribute towards the Crowding out of private investment or spending.
2. Functional finance theory also assumes that government of the day has perfect information with regard to the economic situation of the country. For instance, it knows the size of me and other exogenous variables. On the contrary, it usually takes six to nine months of data to indicate with confidence, the state of the economy, and which way it is heading, and thus, the government generally relies on estimates and prediction about the state of the economy and which way it is heading.
3. Functional finance theory assumes that government exactly knows the potential income level of the economy but in reality potential level of income is not an easy concept to define and actually, the government may not know what the potential level of income in the economy is.
4. Functional finance theory states that government has the flexibility of undertaking changes in its spending and taxing decisions. In reality, the government does not have enough flexibility concerning undertaking changes in spending and taxing decisions. Numerous political and institutional pressures make the task of implementing fiscal policy a difficult task. Government spending and taxes cannot be changed instantaneously.
5. Functional finance model state that size of government debt does not matter and government can increase its debt without any worry but as we know that debt is harmful and always led to declining in future consumption and standard of living. So, debt should never be incurred.
6. Functional finance model suggests fiscal policy does not have any negative impact on the other government goals but in reality, it has been acknowledged that goals often conflict. For instance, when the government implements expansionary fiscal policy, income in the economy expands which led to rise in imports while exports remain constant thus widens trade deficit. If a country's international consideration prohibits it from widening trade deficit then this seriously hampers its ability to run expansionary fiscal policy.