MacroeconomicsI_working_version (1)

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Chapter 12
12.4. Crowding-Out Effect
Having mentioned the effect of financing deficit through government’s borrowing at the
money market, we now move to a basic criticism of fiscal policy itself. This criticism is
based on frequently discussed crowding-out effect. This effect describes the competition
between government and private investors borrowing at money markets, which increases
the interest rate and thus reduce private spending, Accordingly, the expansionary fiscal
effect is weakened or cancelled at all.
Let’s assume the economy is in the contraction phase (recession) of a business cycle.
Government takes an action of discretionary fiscal policy in the form of increased
government spending. Government borrows funds in the money markets to finance its
budget deficit. The resulting increase in demand for money raises the interest rate as a price
paid for borrowing money. Some part of investment or interest-sensitive consumption
spending will be crowded out because investment spending varies inversely with the
interest rate.
12.5. Problems of Timing
In addition to discussed problem of crowding-out effect there are some other problems
associated with enacting and applying fiscal policy. In the case of fiscal policy, some
problems of timing may arise. We can characterise the problem of timing through the lags:
1) Recognition lag. The recognition lag refers to the time between the outset of some
economic problems (such as contraction of output or accelerating inflation) and the
actual recognition of those problems by economists.
2) Administrative lag. This lag relates to the time between recognition of some
problems in the economy and the moment when a fiscal action is actually taken.
The administrative lag is typical for democratic governments with long and difficult
ratification process.
3) Operational lag. The impact of some fiscal action on output or employment
doesn’t reveal immediately. There is a lag between a change in output, employment
or the price level caused by the change in fiscal policy and the time when the
relevant fiscal action was actually taken.
12.6. The Advantage of Monetary Policy
Most economists in these days prefer monetary policy as the main tool to stabilise the
economy in the short or middle-run. Fiscal policy, according to them, should be used to
deal with the nation’s investment-saving imbalances. In this view, the fiscal policy should
be used to deal with some deep economic crisis in terms of a decline in output,
employment or rapid growth in inflation. The advantage of monetary policy is that
monetary policy can be changed quickly because of an independence of the central bank,
which does not need any approval of parliament to use any chosen monetary measures
such as change in credit conditions, interest rates or money stock. In addition to that,
monetary policy is considered very effective in expanding or contracting the economy
comparing to fiscal policy.