Fiscal Policy Effectiveness: Key Factors

Factors Influencing the Effectiveness of Fiscal Policy

1) The Flexibility of Aggregate Supply:

Aggregate supply must be flexible enough to absorb demand-pull. Otherwise, expansionary fiscal measures may increase production, but at the expense of generating inflation. In rigid situations, fiscal policy may be ineffective in achieving internal balance.

2) The Nature and Flexibility of Intermediate Objectives:

Net external demand is a standalone component that should not be regarded as an intermediate target of budget policy stabilization. By contrast, the behavior of exports and imports is a determinant of economic growth.

[And domestic demand... is it better to act on consumption or investment?]

Private Fixed Capital Formation (FBC) is not raised as an intermediate target of stabilization policy. It is a variable sensitive to changes in economic conditions, with an intense and asymmetric, somewhat predictable reaction. The possible field of action of budgetary stabilization policy is limited to private consumption. This is a strong trend variable: pro-cyclical in upturns, it tends to grow more strongly than the economy; in recession, it reduces harder. Most consumer spending is directed to the purchase of real demand, and is too rigid on the price.

3) The Behavior of Economic Agents:

This includes the Keynesian perspective, in which agents make their consumption decisions based on the level of current disposable income, and the Monetarist perspective, in which agents make decisions based on their entire life.

4) The Nature and Flexibility of Instrumental Variables:

For years, economic policymakers granted taxes a secondary role in stabilization policies for several reasons:

• Taxes have a smaller multiplier effect on economic activity than public spending.
• Their use presents problems of asymmetry, being well-accepted socially as cuts for expansionary policies, but tax increases for restrictive policies are not, so that fiscal factors tend to consolidate.
• Taxes present delays in execution time that may impair their effectiveness as a stabilizer.
• Taxes are the main source of financing public expenditure.

And within public spending... more public investment, public consumption, or transfers?

• Public FBC expenditures are an important tool for influencing economic activity, as they are associated with the multiplier effect.
• Within public consumption, the departure of personnel costs is very flexible, whether it is handled by the side of wages or by the side of recruitment.
• The use of transfers is always attractive to politicians as a stabilization tool.