Criticisms of Fiscal Policy: Videos & Practice Problems

Fiscal policy faces criticism due to time lags, political influences, and the crowding out effect. Recognition and operational lags delay responses to economic downturns, while political motivations can lead to inappropriate spending aimed at re-election. Additionally, state and local governments often implement procyclical policies, worsening recessions. The crowding out effect occurs when increased government borrowing raises interest rates, reducing private investment and hindering long-term growth. Understanding these dynamics is crucial for evaluating the effectiveness of fiscal policy in managing economic cycles.

Political Environment

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 reelection. Right? They want to be reelected. So they're going to support sometimes inappropriate fiscal policy to get them reelected. They might increase spending in their district just to look good to their constituents and be reelected. And maybe 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 going to increase spending, increase the economy, while they're in office, to help them get reelected. So they might have tax cuts or increased spending for subsidies, right? Maybe for their constituents. They might vote for health care reform or education, which are not necessarily bad things, but maybe it's not appropriate when we think about the long-run growth of the economy from a macroeconomic perspective. Okay? So on top of reelection, there could also be policy reversals, right? Just because there's some sort of change that happens right now, some sort of 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, something viewed as temporary by the public like, "Hey, I know they cut the taxes but it's likely that that's going to be reversed when the Democrats get in power or whatever it might be." They might have that mentality and then they're not going to 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

So next, there's the balance between the federal government's actions and the state and local government actions. There are going to be actions taken by the federal government. However, the state and local governments are going to be making their own decisions about spending as well. One thing that has been noticed is what's called Procyclical Fiscal Policy, which is employed by the state and local governments. 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. 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, a state and local government, they have more requirements to keep their budget in line, okay? So if they have to keep their budget in line, well, during a recession, they're going to 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 worsened recession as well. Okay? So that's another ineffective 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

So the biggest criticism that we have of fiscal policy is the idea of the crowding-out effect. The crowding-out effect is a situation where the government has a deficit, necessitating borrowing money to balance its budget. Well, that's going to 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 the government increases their fiscal policy, has expansionary fiscal policy, spending more money, borrowing more money, they're going to demand more money to make this government spending happen. And when there's higher money demand, well, there's going to 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 going to decide how much money we're going to want. And then over here, we're going to have the supply of money, whatever the supply of money is. And then on aggregate demand, we've got the price level and our GDP on this side. Okay.

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. 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, the Fed chooses a 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 1 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 interest rates are higher, firms are less likely to borrow money for their investments.

So what do we see happening to aggregate demand? At 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 government spending increases our aggregate demand because of 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. 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 going to write that here in the middle. Less long-run growth because remember, investment spending is an important part of our long-run growth. Investment spending is spending on factories and equipment and things that are going to help us be more productive in the future. So if there's less investment spending, well, there's going to be less of that future production, future fiscal and we'll move on to the next video.

Here’s what students ask on this topic:

What are the main criticisms of fiscal policy?

The main criticisms of fiscal policy include time lags, political influences, and the crowding out effect. Time lags, such as recognition and operational lags, delay the response to economic downturns. Political influences can lead to inappropriate spending aimed at re-election, which may not be beneficial for long-term economic growth. Additionally, state and local governments often implement procyclical policies, which can worsen recessions. The crowding out effect occurs when increased government borrowing raises interest rates, reducing private investment and hindering long-term growth. Understanding these dynamics is crucial for evaluating the effectiveness of fiscal policy in managing economic cycles.

How do time lags affect the effectiveness of fiscal policy?

Time lags significantly affect the effectiveness of fiscal policy. There are two main types of lags: recognition lag and operational lag. Recognition lag is the delay in identifying that the economy is in a recession, which can take 4 to 6 months. Operational lag is the time between the approval of fiscal policy and its actual impact on the economy. For example, government spending projects may take 6 to 12 months to start after approval. These delays mean that fiscal policy may not provide timely relief during economic downturns, reducing its overall effectiveness.

What is the crowding out effect in fiscal policy?

The crowding out effect occurs when increased government borrowing to finance a deficit raises interest rates, which in turn reduces private investment. As the government demands more money, the overall demand for money increases, leading to higher interest rates. Higher interest rates make borrowing more expensive for private firms, discouraging them from investing in new projects. This reduction in private investment can hinder long-term economic growth, as investment in factories, equipment, and other productive assets is crucial for future productivity and economic expansion.

How do political influences impact fiscal policy decisions?

Political influences can significantly impact fiscal policy decisions. Politicians often focus on re-election and may support fiscal policies that are popular with their constituents, even if they are not economically appropriate. For example, they might increase spending or cut taxes to boost the economy temporarily, making themselves look favorable to voters. However, these decisions may not be beneficial for long-term economic growth. Additionally, policy reversals can occur when a new government reverses previous fiscal policies, leading to uncertainty and reducing the effectiveness of fiscal measures.

Why do state and local governments often implement procyclical fiscal policies?

State and local governments often implement procyclical fiscal policies due to legal requirements to maintain balanced budgets. During a recession, these governments collect less tax revenue and are forced to reduce spending to balance their budgets. This reduction in spending can worsen the recession, as lower government spending leads to decreased overall demand in the economy. Unlike the federal government, which can run larger budget deficits during economic downturns, state and local governments have more stringent budgetary constraints, making it difficult for them to implement countercyclical policies that could help stabilize the economy.