Criticisms of Fiscal Policy
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so there's no good economic topic that doesn't come with some criticism as well. Let's see the criticism that goes with fiscal policy. So government's fiscal policy can be ineffective because of a time lag. So we're trying to think of reasons that fiscal policy would not work. Okay. There's a time lag when it comes to fiscal policy. When compared to monetary policy with fiscal policy, there's a recognition lag. First. We have to be able to recognize that we're in a recession. Excuse me. We have to recognize we're in a recession the beginning of a recession And uh, and be aware of its existence. Sometimes it takes up 4-6 months to realize that we are actually in a recession because sometimes there's going to be some small decreases in the market, some small decreases. And we're not sure if this is just a temporary fix or if it's an actual long sustained recession. Okay, so there's this recognition lag before they can actually uh say, Hey, we're in a recession. We need to, uh, we need to react to this. That's the recognition lag recognizing we're in a recession and then there's the operational lag. So the time between the approval of fiscal policy and its impact on the economy. So some fiscal policy can take awhile, right? There's bills that can go that might take a while to go through Congress. So that's already a lag in the time that hey, we need to make this bill and the time for all of the those senators and the representatives to actually um agree on the bill. However, let's say that it happens quickly. They're able to agree we're in a recession, we need to make some changes. Let's say that the tax policy can be put into effect relatively quickly. However, government spending, even if they approve it, it can take 6 to 12 months just to just to take effect right now that it's been approved. Well, they've got to hire contractors, they've got to plan out the project and it can take a long time before the project actually starts and that government spending actually starts to get the wheels in motion. So that's the operational lack that we see um when it comes to fiscal policy as well, it takes a while for it to kick in. All right, let's pause here and let's discuss the next criticism of
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so fiscal policy can also be ineffective because of the political environment. Okay, the political environment affects fiscal policy as well. A lot of politicians are focused on re election, right? They want to be re elected, so they're gonna support sometimes inappropriate fiscal policy to get them reelected, they might um, increased spending in their district district just to look good to their, to their constituents and be reelected. And maybe during a strong economy, um or the idea is that they want to be, they want the economy to be strong during the election period to help them get reelected right? If the economy is booming, they can say, hey, look what I've done for you. Look at how great the economy is vote for me again, right? So they want to do things that are increased spending, increase the economy while they're in office, uh to help them get reelected, so they might have tax cuts or increased spending for subsidies, right? Maybe for their constituents, um they might vote for health care reform or education, um which are not necessarily bad things. Um but maybe it's not appropriate when we think about long run growth of the economy from a macroeconomic perspective. Okay, so, on top of re election, there could also be policy reversals, right? Just because there's some sort of change that happens right now, some sort of uh reform that gets put into place, some sort of tax cut. Well, maybe a future Congress with different people in Congress might reverse it completely. Right? So if these changes are viewed as temporary, Well, they're not going to have long term effects, right? If there's some sort of temporary, uh, something viewed as temporary by the public, like, hey, I know they cut the taxes, but it's likely that that's gonna be reversed when, uh, when the democrats get in power or whatever it might be, uh, they might, they might have that mentality and then they're not gonna actually affect their spending. So even though there's a tax cut, it may not increase consumption because the constituents might actually just save the money rather than increase consumption because they know those taxes will increase in the future. Okay, so that's how the political environment can affect fiscal policy. Let's pause here and let's talk about another criticism.
Pro-Cyclical Fiscal Policy
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So next there's the balance between the federal government's actions and the state and local government actions, so there's going to be actions taken by the federal government. However, the state and local government are going to be making their own decisions about spending as well. So, one thing that's been noticed is that there's this what's called pro cyclical fiscal policy, which is employed by the state and local governments. So these governments generally make policy decisions that worsen recessions and inflation. How is that possible? How would these state and local governments worsen inflation or recessions in general? Well, the thing is that state and local governments act very similar to households, um a state and local government is going to reduce their spending during a recession. And this is because state and local governments have a lot more legal requirements to keep a balanced budget where the federal government might be able to go into a bigger budget deficit during a recession. Well, a state and local government, they have their they have more requirements to to keep their their budget in line. Okay, So if they have to keep their budget in line well during a recession, they're gonna be collecting less taxes so they need to spend less as well. And like, you know, during a recession, lower spending. Well, that's going to lead to a worsening recession as well. Okay, so that's another ineffective uh measure here of fiscal policy. Now, let's talk about the big one here in the next video. Let's go into more detail about the crowding out effect
Crowding Out Effect
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So the biggest criticism that we have of fiscal policy is the idea of the crowding out effect. The crowding out effect is that government a government deficit where the government needs to borrow money to to balance its budget? Well that's gonna decrease our investment spending because they're crowding out the investors in the demand for money. So let's see how this works when there's increased government spending. Well then money demand increases, right? There's more demand for money. So as government increases their fiscal policy has expansionary fiscal policy spending more money borrowing more money, they're gonna demand more money to make this government spending happen when there's higher money demand. Well there's gonna be higher interest rates and those higher interest rates lead to less investment spending. Okay let's see how this works out on the graphs here, we've got our money market here on the left and then we've got the aggregate demand here on the right. So remember in the money market the price of money is the interest rate right? The interest rate is how we're gonna decide how much money we're gonna want and then over here we're gonna have the supply of money whatever the supply of money is. And then on aggregate demand we've got the price level and our G. D. P. On this side. Okay let me get out of the way there. So let's start here on the money market graph on the money market graph, we're saying there's an increase in government spending which increases the demand for money, right? That's how we started this. So if this was the money supply and this was money demand over here, remember the money supply is fixed by the Fed, the Fed, uh the Fed shows, uh, pixel level for the money supply and based on their monetary policy, they'll change the money supply. But let's hold that constant for now. And let's say that there's an increase in government spending leading to an increase in money demand. So we shift our money demand curve to the right. And what's happened here in this market? So, we were at this original equilibrium with interest rate, interest rate one there. However, we're now at this new equilibrium up here at this higher interest rate, right? And the higher interest rate is going to crowd out some of our investment spending. That's what we see here. Remember when when interest rates are higher, firms are less likely to borrow money for for their investments. So what do we see happening to aggregate demand is, first we see this increase in government spending, right? There's going to be an increase in government spending leading to an increase in aggregate demand. However, there's also going to be this decrease in aggregate demand from this decrease in investment. So, although the although the government spending increases are aggregate demand because of our, remember our our equation consumption plus investment plus government spending plus net exports. So we're seeing government spending go up, but we're seeing investment go down. So that increase in government spending leads to a decrease in investment spending. And that's that crowding out effect. And what we see is when there's less investment spending, there's less long run growth. So I'm gonna write that here in the middle less long run growth because, remember, investment spending is an important part of our long run growth. The investment spending is spending on factories and equipment and things that are gonna help us be more productive in the future. So if there's less investment spending, well, there's gonna be less of that future production, future productivity, and we'll have less long run growth because of this crowding out effect. Okay, so that's a big criticism here of fiscal policy, is that the government spending crowds out some of the investment spending. Alright, so that's about it here. Let's go ahead and pause and we'll move on to the next video.