Fiscal policy, macroeconomic objectives and economic agents

Overview

Strengths of fiscal policy compared with monetary policy, main weaknesses of fiscal policy and fiscal policy be targeted in ways monetary policy cannot.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Which macroeconomic objectives is fiscal policy used to pursue?

   Model answer

   It is used to influence the level of demand and therefore output growth and employment; to contribute to price stability, since the balance between spending and taxation affects the pressure of demand and specific taxes affect prices directly; to influence the balance of payments, since the level of domestic demand determines import volumes; and to affect the distribution of income and wealth, which is something only fiscal policy can do directly, through the progressivity of taxes and the design of transfers. It also has a supply-side purpose, since spending on infrastructure, education and research and the design of taxes on work and investment affect the economy's productive capacity. And it carries an objective of its own, the sustainability of the public finances, which constrains all the others.

2. 2

   What are the strengths of fiscal policy compared with monetary policy?

   Model answer

   It acts on demand directly: when a government spends, the expenditure enters the economy immediately, whereas monetary policy must first persuade someone to borrow. It can be targeted precisely, at a particular region, industry, income group or age group, in a way that a single national interest rate cannot. It is the only instrument that can address the distribution of income deliberately. It remains effective when interest rates have reached their lower bound and monetary policy has run out of room, which is exactly when it is most needed. And it can raise long-run capacity as well as short-run demand, if the spending takes the form of investment in infrastructure, skills or research.

3. 3

   What are the main weaknesses of fiscal policy?

   Model answer

   It is slow to change, because it requires decisions, budgets and often legislation, and slower still to implement where capital projects are involved, so a stimulus can arrive after the recession has ended. It is hard to reverse, since spending programmes create constituencies and tax cuts are difficult to undo, so successive rounds of stimulus can leave a permanently worse structural position. It worsens the public finances directly, which constrains how often it can be used and may raise borrowing costs. It can be crowded out, whether by higher interest rates, by an offsetting response from the central bank, or by leakage into imports. It is highly political, so decisions may reflect electoral advantage rather than economic need. And its effects are uncertain in size, because how much of an injection circulates depends on behaviour that is hard to predict.

4. 4

   Why can fiscal policy be targeted in ways monetary policy cannot?

   Model answer

   Monetary policy operates through a single interest rate that applies to the whole economy, so it cannot distinguish between a booming region and a depressed one, or between an industry in difficulty and one at capacity; it restrains or stimulates all of them together. Fiscal measures are specific by construction: a government can build a road in one region, raise a benefit paid only to low-income households, cut a tax paid only by small firms, or fund training in a particular sector. That precision makes fiscal policy the appropriate instrument where the problem is concentrated rather than general, for example where unemployment is regional or where one industry has been hit by a trade shock. The cost of that precision is that each decision must be taken and defended individually, which is why fiscal policy is slower and more political.

5. 5

   Analyse how leakages reduce the effect of an increase in government spending.

   Model answer

   The initial spending becomes income for those who receive it, and part of that income is spent again, generating further income, so the total effect on demand exceeds the original injection. But at every stage part of the income does not return to domestic demand. Some is taken in tax. Some is saved rather than spent. And some is spent on imports, so it becomes income abroad rather than at home. The larger these withdrawals, the smaller the amount that circulates at each round and the smaller the eventual effect on domestic output. This is why fiscal expansion is less powerful in a very open economy with a large share of spending going on imports, and why the effect is larger for spending directed at households who will spend most of it domestically than for a tax cut that is largely saved.

6. 6

   Analyse how a central bank's response can offset a fiscal expansion.

   Model answer

   If the central bank is targeting inflation and judges that a fiscal expansion will push demand above the economy's capacity, it will raise interest rates to bring the forecast back to target. The higher rates reduce private consumption and investment, and they tend to appreciate the currency, which reduces net exports. The government's addition to demand is therefore partly or wholly matched by a reduction elsewhere, and the composition of output has changed, with more public spending and less private investment and net exports, while the total may be little different. The offset is much weaker when there is substantial spare capacity, since the central bank has no reason to tighten, and weakest of all when the policy rate is already at its lower bound, which is precisely the situation in which fiscal policy has the greatest effect.

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