Disadvantages of fiscal policy tools Direct taxes are difficult to change

Disadvantages of fiscal policy tools direct taxes are

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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
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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
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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
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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
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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.
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