Contractionary fiscal policy is used to fight inflation. The government’s goal is to contain the price level and reduce
aggregate demand so that the economy does not lose its purchasing power.
Problems with Fiscal Policy
Although used to correct macroeconomic problems, fiscal policy may sometimes prove to do more harm to the econ-
omy than good. Two major issues are associated with fiscal policy: problems with timing and political bureaucracy.
Three examples of timing issues are:
■ Realization lag:This represents the time between the beginning of a macroeconomic problem and the time when
the problem is discovered. This lag occurs because of the difficulty of predicting economic cycles. In reality, the
economy may be into a recession or inflationary period for a few months before policymakers realize it.
■ Administrative lag:This is the amount of lag time after policymakers realize the problem but before they elect
to do anything about the problem. Administrative lags are usually bureaucratic tie-ups that have more to do with
the political than the economic scene. In the past, the U.S. Congress took so much time to decide on a type of
action that the economy reversed its situation by the time Congress came to a resolution.
■ Operation lag:This type of lag occurs between the time policymakers have agreed on and implemented the action
and the time it takes to actually affect the economy. Typically, government spending takes the longest to have an
appreciable effect on the economy because of planning and creation of new capital.Political bureaucracy is another factor influencing fiscal policy. Reelections and hidden agendas sometimes come into
play when policymakers are deciding on actions for the economy. Policymakers are elected to do what is best for the
economy and put political pressures and agendas on the backburner. Economists argue that this is difficult for politi-
cians to do because they have to maintain an awareness of reelection.
Review Points
■ The spending multiplier has a greater impact on the economy than a tax change.
■ Government deficits occur during recessions because of expansionary fiscal policy.
■ When the government increases spending, aggregate demand increases.
■ Government finances spending through taxation and borrowing.
■ Crowding out is a result of the government entering the loanable funds market. This increases the demand for
money, which increases interest rates.
■ Expansionary fiscal policy increases government spending and/or decreases taxes. It is financed by deficit spending.
■ Contractionary fiscal policy is implemented to contain inflation. The government raises taxes and/or restricts
spending to slow the economy down.
■ Discretionary fiscal policy is when the government elects to take an “active” role in the economy. Discretionary
fiscal policy involves changing spending and taxes.
■ Nondiscretionary fiscal policy is when the government does not take an active role in influencing the economy.
Automatic stabilizers (taxes) are relied on instead of policymaking.
■ Fiscal policy is the government’s policy on increasing/decreasing government spending and taxes.Chapter Review Questions
- According to Keynesians, which of the following would increase aggregate demand?
A. An increase in investment
B. An increase in the tax rate
C. A decrease in unemployment benefits
D. A decrease in government expenditures
E. A decrease in government loans
Fiscal Policy