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Macro Economics

Notes via their effects on the long-term interest rate. This channel is emphasized by both Keynesian
and neoclassical models.
Lower future spending commitments mean that future taxes won't have to rise as much. In other
words, such a financing plan, if credible, will help sustaining the spending plans by firms and
households who are currently not credit-constrained, and who therefore immediately respond
to long-term fiscal prospects.
Admittedly, a commitment to reduce spending in the future may lack credibility, especially in
a situation like today, when the uncertainty about the length and the overall fiscal implications
of the crisis is enormous.
It may nonetheless pay to identify measures which are inherently temporary, i.e., matched by
future cuts in spending. An obvious example consists of measures that bring forward in time
investment projects that are already planned, thereby raising current spending while
simultaneously reducing future spending. This is not a perfect solution to the commitment
problem, but it may help.

Notes Monetary and Fiscal Policy should Work Together
Fiscal policy is more effective if it works in consonance with the monetary policy. For
fiscal stimulus to work, central banks should not adhere to narrow-mindedly to their
mandate of price stability.
Yet, one could envision a situation in which, even if policy interest rates were brought
close to zero, it would still be possible that the overall monetary stance of the economy
remain too tight. In this situation, the lower bound of zero for nominal interest rates -
while providing a rationale for a fiscal expansion - may at the same time limit the
effectiveness of any given fiscal intervention.

Limitations of Fiscal Policy

In practice there are many limitations of using a fiscal policy. They are:
Disincentives of Tax Cuts: Increasing Taxes to reduce AD may cause disincentives to work, if this
occurs there will be a fall in productivity and AS could fall. However, higher taxes do not
necessarily reduce incentives to work if the income effect dominates.
Side Effects on Public Spending: Reduced government spending to Increase AD could adversely
affect public services such as public transport and education causing market failure and social
inefficiency.

Poor Information: Fiscal policy will suffer if the government has poor information. For example,
if the government believes there is going to be a recession, they will increase AD, however if
this forecast was wrong and the economy grew too fast, the government action would cause
inflation.
Time Lags: If the government plans to increase spending this can take a long time to filter into
the economy and it may be too late. Spending plans are only set once a year. There is also a delay
in implementing any changes to spending patterns.

Budget Deficit: Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase
in the budget deficit which has many adverse effects. Higher budget deficit will require higher
taxes in the future and may cause crowding out.

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