Identify and briefly describe some practical difficulties of discretionary fiscal policy.

5 Practical Problems with Discretionary Fiscal Policy :

1)Fiscal Policy and Interest Rates:

2)Long and variable Time Lags:  

3)Temporary and Permanent Fiscal Policy:  

4)Limitations of Fiscal Policy:  

5)Political Realities and Discretionary Fiscal Policy:

Explanation:

Practical Problems with Discretionary Fiscal Policy :

1)Fiscal Policy and Interest Rates:

a)Fiscal policy affects the quantity that the government borrows in financial capital markets, it not only affects aggregate demand-it can also affect interest rate as increase of government deficits shifts demand to the right and interest rates increases.

b)Crowding out: where government borrowing and spending results in higher interest rates, which reduces business investment and household consumption.

i)Can happen during expansionary fiscal policy.

2)Long and variable Time Lags:

a)Monetary policy can be changed several times each year, but fiscal policy is much slower to be enacted.

b)The time it takes to determine that a recession has occurred: recognition lag.

c)Time to get a bill passed: legislative lag.

d)The time to get the projects started: implementation lag.

3)Temporary and Permanent Fiscal Policy:

a)A temporary tax cut or spending increase will explicitly last only for a year or two

i)Then revert back to its original level.

b)A permanent tax cut or spending increase is expected to stay in place for the foreseeable future.

c)The appropriate policy may be to have an expansionary fiscal policy with large budget deficits during a recession.

d)Contractionary fiscal policy with budget surpluses when the economy is growing well.

4)Limitations of Fiscal Policy:

a)Fiscal policy cannot help an economy produce at an output level above potential GDP without causing inflation.

i)Unemployment becomes low, workers become scarce and wages rise rapidly.

5)Political Realities and Discretionary Fiscal Policy:

a)Difficulties of explaining how counter cyclical fiscal policy that runs against the tide of the business cycle should work

i)Believes the opposite:

•Economy has slowed down, it is time for the government to go on a spree, raising spending, and cutting taxes.

b)Preferable to let fiscal policy work through the automatic stabilizers and focus on monetary policy to steer short-term counter cyclical efforts.

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