Question

The effectiveness of fiscal policy in closing gaps between potential real GDP and real GDP is diminished by: a) lags (inside and outside); and b) crowding out. Explain what inside and outside lags are, and explain what crowding is. Be sure to explain how the lags and crowding out reduce the effectiveness of fiscal policy.

Answer 1

1. In economics, the inside lag  is the amount of time it takes for a government or a central bank to respond to a shock in the economy. It is the delay in implementation of a fiscal policy or monetary policy.

2. In economics, the outside lag is the amount of time it takes for a government or central bank's actions, in the form of either monetary or fiscal policy, to have a noticeable effect on the economy.

3. A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.

4. It takes some time for policy makers to realize that a recessionary or an inflationary gap exists- the recognition lag. Recognition lags stem largely from the difficulty of collecting economic data in a timely and accurate fashion. The current recession was not identified until October 2008, when the Business Cycle Dating Committee of the National Bureau of Economic Research announced that it had begun in December 2007. Then, more time elapses before a fiscal policy, such as a change in government purchases or a change in taxes, is agreed to and put into effect- the implementation lag. Finally, still more time goes by before the policy has its full effect on aggregate demand- the impact lag. Changes in fiscal policy are likely to involve a particularly long implementation lag.

5. Because an expansionary fiscal policy either increases government spending or reduces revenues, it increases the government budget deficit or reduces the surplus. A contractionary policy is likely to reduce a deficit or increase a surplus. In either case, fiscal policy thus affects the bond market. The tendency for an expansionary fiscal policy to reduce other components of aggregate demand is called crowding out. In the short run, this policy leads to an increase in real GDP. Crowding out reduces the effectiveness of any expansionary fiscal policy, whether it be an increase in government purchases, an increase in transfer payments, or a reduction in income taxes. Each of these policies increases the deficit and thus increases government borrowing.