Disadvantages of fiscal policy tools Direct taxes are difficult to change quickly because of their complexity. Capital spending takes planning and time to implement, which makes it a slow-acting and possibly ill-timed tool. COPYRIGHT © 2014 CFA INSTITUTE 70
The fiscal multiplier The marginal propensity to consume (MPC) is the proportion of additional income that is spent on consumption. • The complement of the MPC is the marginal propensity to save (MPS). • MPC determines the effectiveness of fiscal policies that affect income. The fiscal multiplier is a measure of the effectiveness of fiscal policy and is the change in output for a change in spending or taxation: where c is the marginal propensity to consume, and 0 < c < 1. With taxes, If government spending increases by the same amount as the increase in taxes, output rises because c < 1. COPYRIGHT © 2014 CFA INSTITUTE 71 CFA Optional
Effectiveness of fiscal policy The budget (whether surplus or deficit) may not indicate a government’s fiscal stance because automatic stabilizers may affect the budget. • Should look at the structurally adjusted (or cyclically adjusted) budget deficit . Fiscal policy is difficult to use to stabilize aggregate demand because • there are lags. ◦ There is a lag between a slowing economy and the data to assess such (the recognition lag ). ◦ It may take several months to implement (the action lag ). ◦ It may take time for there to be any impact on the economy (the impact lag ). • it is difficult to predict where the economy is heading apart from any fiscal policy, and some policies may make things worse. COPYRIGHT © 2014 CFA INSTITUTE 72
Monetary and fiscal policy Monetary and fiscal policy use different channels to affect the economy but may have similar policy objectives. • These policies may conflict with one another, or they may enhance one another. • Because of the potential for monetary and fiscal policies to work against each other, coordination between the government and the central bank is important. • Both types of policies are challenging because of lags in data and the inability to predict the future path of the economy. An example of interaction is quantitative easing. • A potential problem of quantitative easing is that when it is used to purchase government debt, fiscal and monetary policy interact. COPYRIGHT © 2014 CFA INSTITUTE 73
Conclusions and Summary Governments can influence the performance of their economies by using monetary and fiscal policy. Money acts as a medium of exchange, provides individuals with a way of storing wealth, and provides society with a convenient unit of account. The banking system creates money through the process of fractional reserve banking. There are three basic motives for holding money: transactions related, precautionary, and speculative.