Download Two key limits of fiscal policy are coordination with the nation`s

Two key limits of fiscal policy are coordination with the nation's
monetary policy and differing political viewpoints.
LEARNING OBJECTIVE [ edit ]
Identify the political and economic limits of fiscal policy
KEY POINTS [ edit ]
Conservatives are more likely to reject Keynesianism and argue that government should always
run a balanced budget(and a surplus to pay down any outstanding debt) than Democrats.
Liberals are more likely to be Keynesian and Post­Keynesians than Republicans; they are more
likely to argue that deficit spending is necessary, either to create the money supply(Chartalism) or
to satisfy demand for savings in excess of what can be satisfied by private investment.
There is a dilemma as to whether these monetary and fiscal policies are complementary, or act
as substitutes to each other for achieving macroeconomic goals.
TERM [ edit ]
monetary policy
The process by which the central bank, or monetary authority manages the supply of money, or
trading in foreign exchange markets.
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While fiscal policy can be a powerful tool for influencing the economy, there are limits in how
effective these policies are.
Coordination with Monetary Policy
Fiscal policy and monetary policy are the two primary tools used by the State to achieve its
macroeconomic objectives. While the main objective of fiscal policy is to influence
theaggregate output of the economy, the
main objective of the monetary policies is
to control the interest and inflationrates.
Fiscal policies have an impact on the
goods market and monetary policies have
an impact on the asset markets and since
the two markets are connected to each
other via the two macrovariables — output
and interest rates ­ the policies interact
while influencing the output or the
interest rates.
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There is controversy regarding whether these two policies are complementary or act as
substitutes to each other for achieving macroeconomic goals. Policy makers are viewed to
interact as strategic substitutes when one policy maker's expansionary (contractionary)
policies are countered by another policy maker's contractionary (expansionary) policies. For
example: if the fiscal authority raises taxes or cuts spending, then the monetary authority
reacts to it by lowering the policy rates and vice versa. If they behave as
strategic complements,then an expansionary (contractionary) policy of one authority is met
by expansionary (contractionary) policies of other.
The issue of interaction and the policies being complement or substitute to each other arises
only when the authorities are independent of each other. But when, the goals of one
authority is made subservient to that of others, then the dominant authority solely dominates
the policy making and no interaction worthy of analysis would arise. Also, it is worthy to note
that fiscal and monetary policies interact only to the extent of influencing the final objective.
So long as the objectives of one policy is not influenced by the other, there is no direct
interaction between them.
Political Conflict
Fiscal policy is also a source of significant political conflict along party lines. Conservatives
are more likely to reject Keynesianism and are more likely to argue that government should
always run a balanced budget (and a surplus to pay down any outstanding debt), and that
deficit spending is always bad policy .
American political divide
There are two different approaches to fiscal policy in the US. Broadly, Democrats tend to be more
Keynesian than Republicans.
Fiscal conservatism has academic support, predominantly associated with the neoclassical­
inclined Chicago school of economics, and has significant political and institutional support,
with all but one state of the United States (Vermont is the exception) having a balanced
budget amendment to its state constitution. Fiscal conservatism was the dominant position
until the Great Depression.
Liberals are more likely to be Keynesian and Post­Keynesians than Republican. They are
more likely to argue that deficit spending is necessary, either to create the money supply
(Chartalism) or to satisfy demand for savings in excess of what can be satisfied by private
investment.
Chartalists argue that deficit spending is logically necessary because, in their view, fiat
money is created by deficit spending: one cannot collect fiat money in taxes before one has
issued it and spent it, and the amount of fiat money in circulation is exactly the government
debt – money spent but not collected in taxes.
Fiscal Multiplier
The fiscal multiplier is the ratio of a change in national income to the change in government
spending that causes it. When this multiplier exceeds one, the enhanced effect on national
income is called the multiplier effect. The mechanism that can give rise to a multiplier effect
is that an initial incremental amount of spending can lead to
increasedconsumption spending, increasing income further and hence further increasing
consumption, etc., resulting in an overall increase in national income greater than the initial
incremental amount of spending. In other words, an initial change in aggregate demand may
cause a change in aggregate output that is a multiple of the initial change.
How effective fiscal policy is depends on the multiplier. The greater the multiplier, the more
effective the policy. If for some reason outside of the control of the government the multiplier
remains low, the effectiveness of fiscal policy will remain limited at best.