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the limitations of Fiscal Policy

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Executive Summary This report will explain why fiscal policy should be used in medium to long run macroeconomic stabilization rather than in the short run. Limitations of fiscal policy is pointed out such as time lag and current goal of Australian government in the short run using monetary policy to counter recession facing by the world. Furthermore, looking back to 1980s and 1990s budget balances, fiscal policy was majorly used in order to eliminate foreign debt and achieving budget balance and surplus. Some data from the Reserve Bank and Australian Government is used in this report to support the statement. In addition, this report also includes one of the current issues in Australian government, which is the future demographic change that would affect the economy. Lastly, a conclusion will summarized every point that explain why fiscal policy should be used in the long run macroeconomic stabilizations and bibliography is also included in order to appreciate the work of the original writer. Introduction Fiscal policy is the macroeconomic policy that is used by the government to achieve macroeconomic stabilization by changing the tax rate and government spending. The macroeconomic stabilizations in Australia are low unemployment rate, low inflation rate, equality in the income distributions and to close the output gap in the ...read more.


For example, RBA cut down the interest rate from 7.25% to 7% in order to increase the consumption and investment expenditure in the economy. This shows how the government uses monetary policy to eliminate the recessionary gap (Y* - Y) by changing the nominal interest rate and money supply in the economy. Figure 1 shows the changes in nominal interest rate from 7.25% to 7% could eliminate the recessionary gap in the short run which lead to increase the consumption and investment from I1 to I2 and in the end, lead to increase in output from Y to Y*. Changes in nominal interest rate would directly change the real interest rate assuming that inflation rate (?) is constant in the short run. Equation E.1, called as Fisher equation, shows the direct relationships between real interest rate (r) and nominal interest rate (i) when government changes the nominal interest rate in the overnight cash market. In addition, government may use money supply to control interest rate in the economy. However, when government takes control of money is used to eliminate the recessionary gap, the effect of changing the budget would take effect in a longer time. ...read more.


Conclusion In conclusion, the limitations of fiscal policy such as time lag and influence of political view explains why fiscal policy should not be used in short run period but in the long run macroeconomic stabilizations. Secondly, with the goal to eliminate the recession gap in the short run, government uses monetary policy instead of fiscal policy because nominal interest rates have a direct relationship with real interest rates as Fisher equation shown. Furthermore, the success of fiscal policy in eliminating the budget deficit and foreign debt in 1990s and achieved budget surplus by charging high tax rate lead to increase in National Saving shows that fiscal policy should be used in long run macroeconomic stabilizations. Thus, from the National Saving, Australian government paid the foreign debt. In the end, with an expectation of demographic change in Australia, the government has to adjust their current fiscal policy so that budget surplus would not always be the goal but to counter the future spending such as health care and public transport for the aging population which are highly more than proportionate birth rate in the future. Therefore, this report explains why fiscal policy should be used in long run macroeconomic stabilizations but not for short run. ...read more.

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