Question

Explain the impact of the time lags associated with discretionary fiscal policy. Which do you think is the most important? Do you think fiscal policy may be easier to operate during an inflation or a recession? Explain.

Answer 1

Fiscal Policy refers to the use of the spending levels and tax rates to influence the economy. It is the sister strategy to monetary policy which deals with the central bank’s influence over a nation’s money supply. The governing bodies use combinations of both these policies to achieve the desired economic goals. Thus, the essential tools of fiscal policy are taxing and spending.

Monetary policy can be changed several times each year, but fiscal policy is much slower to be enacted. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. The time it takes to determine that a recession has occurred is often called the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. The time to get a bill passed is often referred to as the legislative lag. Finally, once the bill is passed it takes some time for the funds to be dispersed to the appropriate agencies to implement the programs. The time to get the projects started is often called the implementation lag.

Fiscal policy may be easier to operate during recession

As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. Keynes recommended that, during periods of recession, the government should increase spending in order to “prime the pump” of the economy. At the same time, he recommended, it should decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers, and increase household incomes to enable them to buy more.

Fiscal Policy refers to the use of the spending levels and tax rates to influence the economy. It is the sister strategy to monetary policy which deals with the central bank’s influence over a nation’s money supply. The governing bodies use combinations of both these policies to achieve the desired economic goals. Thus, the essential tools of fiscal policy are taxing and spending.

Monetary policy can be changed several times each year, but fiscal policy is much slower to be enacted. Imagine that the economy starts to slow down. It often takes some months before the economic statistics signal clearly that a downturn has started, and a few months more to confirm that it is truly a recession and not just a one- or two-month blip. The time it takes to determine that a recession has occurred is often called the recognition lag. After this lag, policymakers become aware of the problem and propose fiscal policy bills. The bills go into various congressional committees for hearings, negotiations, votes, and then, if passed, eventually for the president’s signature. Many fiscal policy bills about spending or taxes propose changes that would start in the next budget year or would be phased in gradually over time. The time to get a bill passed is often referred to as the legislative lag. Finally, once the bill is passed it takes some time for the funds to be dispersed to the appropriate agencies to implement the programs. The time to get the projects started is often called the implementation lag.

Fiscal policy may be easier to operate during recession

As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. Keynes recommended that, during periods of recession, the government should increase spending in order to “prime the pump” of the economy. At the same time, he recommended, it should decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers, and increase household incomes to enable them to buy more.

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased govt spendings and/or Lower taxes. A recession results in a recessionary gap meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.