Question

What is fiscal policy? Who sets it? What are some of the limitations of fiscal policy? Do these render fiscal policy ineffectual? Why or why not?

Answer 1

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply. These two policies are used in various combinations to direct a country's economic goals.

Both the President and Congress set fiscal policy, actually. In the United States, fiscal policy is directed by both the executive and legislative branches. In the executive branch, the two most influential offices belong to the president and the Secretary of the Treasury, although contemporary presidents often rely on a council of economic advisers as well. In the legislative branch, the U.S. Congress passes laws and appropriates spending for any fiscal policy measures. This involves participation, deliberation and approval from both the House of Representatives and the Senate.

Limitations of Fiscal Policy are:

1) Size of fiscal measures

The budget is not a mere statement of receipts and revenues of the government. It explains and shapes the economic structure of a country. When the budget forms a small part of the national income in developing economies, fiscal policy cannot have the desired impact on the economic development. Direct taxation at times become an instrument of limited applicability, as the vast majority of the people are not covered by it. Further, when the total tax revenue forms a smaller portion of the national income, fiscal measures will not step up the sagging economy requiring massive help.

2. Fiscal policy as ineffective anti-cyclical measure

Fiscal measures- both loosening fiscal policy and tightening fiscal policy- will not stimulate speedy economic growth of a country, when the different sectors of the economy are not closely integrated with one another. Action taken by the government may not always have the same effect on all the sectors. Thus we may have for instance the recession in some sectors followed by a rise in prices in other sectors. An increasing purchasing power through deficit financing, a policy may not have the effect of reviving the recession hit economies, but merely result in a spiralling rise in prices.

3. Administrative delay

Fiscal measures may introduce delay, uncertainties and arbitrariness arising from administrative bottlenecks. As a result, fiscal policy fails to be a powerful and therefore a useful stabilization policy.

Other Limitations

Large scale underemployment, lack of coordination from the public, tax evasion, low tax base are the other limitations of fiscal policy.

These limitations to some extent render the fiscal policy as redundant and ineffective

1. With prices predetermined, the interest sensitivity of money demand is zero, or the income sensitivity of money demand is infinite.

2. With prices predetermined, the interest sensitivity of investment or the sensitivity of net exports to interest rates are nfinite.

3. With prices predetermined, the sensitivity of money demand to wealth is high.

4. Output is at full employment levels.