The Effectiveness of Fiscal Policy.
Fiscal policy does have some drawbacks. Not only do changes in G and T take time to
have an effect on the economy (a time lag), it can also take time to recognise the need for
a change in policy and to gather the information on which to base the change.
There is also a time lag between introducing a fiscal policy instrument and that instrument
having an impact on the economy. For example, households may take some time to adjust
their spending when income tax is changed. Or if the government decides to build some
new schools, the rise in spending and employment will not occur immediately.
A number of forms of G are inflexible. For example, it is difficult to reduce spending on
pensions or health care. Also, once a big investment project (a hospital or a motorway)
has been started, it is very difficult to stop it.
For fiscal policy instruments to work effectively, they need to be based on accurate
information. For example, if a recession is (inaccurately) forecasted, then the government
may initiate expansionary fiscal policy. However, if the forecasts were incorrect (and the
economy is still growing) then expansionary fiscal policy will simply add to inflationary
pressure in the economy.
Another reason why fiscal policy instruments may not work in the way that the government
expects is because households and firms may react in unexpected ways. For example, a
cut in income tax and corporation tax may not lead to higher C and I if households and
firms lack confidence about the future. Even if changes in T and G move the economy in
the right direction, it may not alter economic activity to the extent the government wants,
because the government may have inaccurately estimated the size of the multiplier effect.
Changes in fiscal policy may also have an adverse effect on other macro-economic
objectives. A rise in income tax or an increase in benefits may discourage some people
from working. Higher corporation tax may discourage firms from undertaking investment
projects. A rise in tax designed to reduce inflation may cut A.D. too far and cause a fall in
real G.D.P. and a rise in unemployment.
Fiscal policy changes can also be offset by changes in economic activity in other
countries. For example, if the UK is pursuing an expansionary fiscal policy, but its main
trading partners are experiencing a recession, then A.D. may not rise by much in the UK.
1
The effectiveness of Monetary Policy.
As with fiscal policy, monetary policy depends on reliable information. There is always a
danger that data such as business confidence surveys and forecasts of trends in
unemployment may be inaccurate and, therefore, interest rates are moved in the wrong
direction.
Monetary policy instruments can be difficult to control. In the past, UK and US
governments tried to keep inflation in check by controlling the money supply. They did not
find this process easy due, in part, to the strong profit motive that high-street (commercial)
banks have to increase bank lending.
A central bank can seek to influence the exchange rate by buying and selling currency and
by changing the interest rate. Its attempts, however, may be offset by large movements of
speculative funds.
THE MAIN POLICY INSTRUMENT BEING USED IN THE UK TO INFLUENCE SHORTRUN ECONOPMIC ACTIVITY IS THE RATE OF INTEREST. The use of this policy
instrument by the M.P.C. is generally considered to have been very successful. The
M.P.C, though, has received some criticism for over-estimating the rate of inflation and,
therefore, keeping the interest rate too high and limiting economic growth.
It also takes time for an interest rate change to work through the economy. Interest rates
offered by commercial banks do not always adjust quickly to changes in the base rate. It
has been estimated that it can take up to 2 years for the effects of an interest rate change
to work though the economy completely.
A significant proportion of borrowing is now taken out on fixed rate deals. So even if
interest rates drop significantly, those households and firms on fixed rate loan or mortgage
repayments do not experience a fall in their repayments – therefore C and I will not rise by
much.
There is also the question as to what extent A.D. will change in response to interest rate
changes. A rise in the interest rate may not cause households and firms to reduce their
spending if they are confident and optimistic about the future.
A central bank’s ability to change its interest rate may be limited by the need for it to
remain in line with other countries’ interest rates (in order to avoid large flows of hot money
affecting the value of its exchange rate). The 15 E.U. countries that use the Euro have
their interest rate set by the European Central Bank and they do not each, individually,
have the power to change interest rates for their countries.
Another limit with using interest rate changes is that when the interest rate falls to very low
levels (AS IS HAPPENING AT THE MOMENT IN MANY COUNTRIES), a further cut is
likely to be ineffective in stimulating economic activity. Why would a household or a firm
who was not prepared to borrow when the rate of interest was 1% be prepared to borrow
when it is cut to 0.5%?
Remember, the main purpose of the base rate is to control inflation (keeping it low and
stable). Therefore, the base rate may not be dropped to stimulate the economy if it will
have an adverse effect on inflation.
The effects of monetary policy appear to be more concentrated on certain groups than do
changes in income tax, for example.
2
The effectiveness of Supply-Side Policies.
Supply-side policies are selective, targeted at particular markets, and they are designed to
increase efficiency. Economists agree that if the supply-side performance of the economy
can be improved, then it may be easier for a government to achieve its objectives.
Increasing A.S. enables A.D. to continue to rise over time without inflationary
pressures building up. A higher quality of resources should also make domestic firms
more price and quality competitive and so improve the country’s current account position.
Increasing the productive potential of the economy on its own, however, will not be
sufficient in raising economic performance if there is a lack of A.D. (remember the
arguments of Keynes?). In such a case the extra capacity would not be used. There would
be a much higher potential output, but no increase in actual output.
Some supply-side policies (eg spending on education) can take a relatively long time to
have an effect. They can be expensive to operate and there is no guarantee that they will
work.
Conflicts between policy objectives.
The objectives of economic growth and low unemployment may benefit from expansionary
demand-side policy measures (eg cutting taxation or cutting interest rates). However, such
measures can make it more difficult for a government to achieve low inflation and a
satisfactory B of P position.
The M.P.C. may face a conflict when setting the interest rate. It may want to raise the
interest rate to reduce inflationary pressure, but be concerned about the effect that such a
move will have on the exchange rate (and, therefore, on the B of P) and also on
employment.
Governments and central banks may seek to reduce the possibility of policy conflicts by
using a variety of policy instruments. For example, a government though its central bank
may use the rate of interest to control inflation and it may use labour-market reforms to
promote economic growth. Governments strive to ensure that increases in A.D. can be
matched by increases in A.S. and that the economy is close to full capacity.
3