Limitations of Fiscal Policy
One of the limitations of fiscal policy explained why fiscal policy should not be used for short run macroeconomic equilibrium. The limitation is how fast the fiscal policy could take effect on the economy. Changing tax rate and government spending will take a long time to take effect. For example, if in the short run, government decides to build a dam, the process of building it would not take effect in one day because of the limited sources that are available such as labour, time, steel and concrete. Furthermore, another limitation of fiscal policy is that it is politically influenced in the economy (Wyplosz, 2001).For example, liberal party that has ruled a country for 20 years and during the reelections, the socialist won the elections, there would have big changes in the macroeconomic and microeconomic policy especially fiscal policy and changes in government goals. Indonesia is one of the countries that have changed its government goal over the past decades. Thus, this shows that, when government spending increase, planned aggregate expenditure (PAE) would not increase directly and with influence from the political party, fiscal policy could not take effect in the short run if there is a changes in government body.
Eliminate Recessionary Gap in the Short Run
Furthermore, with the current government short run goal to fight recession in the economy, fiscal policy could not effectively counter the recessionary gap. Therefore, the government used monetary policy to eliminate the recessionary gap in the short run. 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 (π) 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. When government takes control of money supply, its control over nominal interest rate is zero. Money supply is control by buying and selling government bond between RBA and commercial banks. In conclusion, to eliminate the recessionary gap in the short run, government would use monetary policy instead of fiscal policy. Therefore, this shows that government use monetary policy to counter recessionary gap in the short run rather than using fiscal policy but if government take full control of interest rate, it lost its control in money supply and vica versa.
Current Account Deficit and Foreign Debt
Current Account Deficit (CAD) and foreign debt has been the major economic goal for the government in the long run. In 1996-1997, government fiscal policy had succeeded in eliminating the net debt which stood at $96.3 billion (Government, 2007). This shows that fiscal policy succeeded in achieving long run economic goal. The causes of large deficits in 1980s and 1990s are large net foreign liabilities (Gruen and Sayegh, 2005a)and the low rate of savings in Australia then (Collins, 1994). Government increased the National saving by increasing the tax rate in 1990s and it shows an improvement in current account deficit during the period of 1995-1998. Table 1 show the summary of budget aggregates which lead to an improvement of current account deficit. The action of increasing tax rate shows that government revenue increased and government spending decreased and lead to budget surplus. The budget surplus is then used to pay for the foreign debt(Budget, 1998). Thus, this shows that fiscal policy should be used for achieving medium to long run of macroeconomic stabilization due to the achievement of fiscal policy in eliminating budget deficit and foreign debt.
Demographic Change
Demographic change is the change of the structure of the population according to birth rate and death rates in a country(Samuelson and Nordhaus, 1989). For example, with current low birth rate and high rate of aging population, in the future, the Australian government predicts that health care cost will increase and government spending will increase which will lead to budget deficit where government spending is more than government revenue that receives from the taxes imposed to the citizens. The low birth rate that occur in the future is due to the declining of fertility rates which started in 1960s(Treasury, 2007a). Table 2 shows what would happen when demographic change occurs in the future that leads to increase in budget deficit. In order to prevent this event to reappear, tax smoothing theory explain why government should run a budget surplus not if it anticipates higher government spending in the future. For example, during wars, government will run budget deficit by borrowing and during and after the war government will increase tax until it could cover the debt that had occurred (Sargent, 2002). This action will minimize the cumulative distorting effect of taxes. In conclusion, demographic change shows that why fiscal policy should be used in long run in order to decide how much government spending and revenue should be obtained.
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.
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