13.5 Problems, Criticisms, and Complications of Implementing Fiscal Policy

What is recognition lag?

The delay in realizing a recession or inflation is happening

What causes recognition lag?

The economy’s ups and downs make it hard to spot real trouble early

What is administrative lag?

The delay between recognizing a problem and passing a fiscal policy law.

What causes administrative lag?

Political debate and slow government processes.

What is operational lag?

The delay between passing a law and seeing its effects on the economy.

Which fiscal actions have short operational lags?

Tax cuts — they affect spending quickly.

Which actions have long operational lags?

Infrastructure projects — they take years to plan and build.

Why was the COVID-19 fiscal response unusually fast?

Everyone knew a recession was coming, and Congress acted quickly. Covid was a health concern, so it was easy to spot.

What are political considerations in fiscal policy?

When politicians make tax or spending decisions to win votes, not to help the economy

Why might politicians favor tax cuts before elections?

To make the economy look strong and boost their chances of re-election.

What is a political business cycle?

Swings in the economy caused by election-motivated fiscal policy, not actual economic needs.

Why are political business cycles a problem?

They can make the economy more unstable instead of stabilizing it.

What is a political business cycle?

Economic ups and downs caused by election-driven fiscal policy, not actual economic needs.

Why do politicians create political business cycles?

To boost the economy before elections and improve their chances of re-election.

What’s the risk of political business cycles?

They can cause inflation, debt, or instability by overstimulating the economy.

How is this different from normal fiscal policy?

Normal fiscal policy responds to recessions or inflation; political business cycles respond to election calendars

What is the problem of future policy reversals?

When people expect fiscal policy (like tax cuts or hikes) to be temporary, so they don’t change their spending much.

What happens if people think a tax cut is temporary?

They save the money instead of spending it, weakening the stimulus effect.

What happens if people think a tax increase is temporary?

They reduce savings instead of cutting spending, weakening the contractionary effect.

What is consumption smoothing?

When people try to keep their spending steady over time by adjusting savings.

How does consumption smoothing affect fiscal policy?

It makes fiscal policy less powerful because people don’t change their spending as much.

Why do state and local governments often make recessions worse?

They must balance their budgets, so they cut spending or raise taxes when revenue drops.

What does “pro-cyclical” mean in this context?

Fiscal actions that move in the same direction as the economy — cutting spending during a recession, which worsens it.

How did state/local governments respond during the Great Depression and 2001 recession?

They cut spending and raised taxes, offsetting federal stimulus.

What did the CARES Act do to help state and local governments in 2020?

It gave them $340 billion so they didn’t have to cut spending or raise taxes.

Why was that important in 2020?

It prevented state/local governments from undoing the effects of federal stimulus

What is the crowding-out effect?

When government deficit spending raises interest rates and reduces private investment.

Why does deficit spending raise interest rates?

Because the government borrows money, increasing demand for funds.

Why does higher interest hurt investment?

It makes borrowing more expensive, so businesses invest less.

When is crowding out a big problem?

During full employment or economic booms, when investment demand is high.

When is crowding out a small problem?

During recessions, when businesses aren’t investing much anyway.

What part of GDP does crowding out mostly affect?

Investment — the most volatile component of GDP.

Why does the recognition lag occur?

Because the economy does not move smoothly through the business cycle

Following the terrorist attacks of September 11, 2001, the U.S. Congress was stalemated for five months before passing a compromise economic stimulus law in March 2002. This is an example of what?

The administrative lag

Government spending on public works such as dams and interstate highways requires what?

Long planning periods and even longer periods of construction

_____ thought to be temporary may not increase present consumption spending and aggregate demand as much as expected because people are preparing for a higher tax rate in the future.

Tax cut

There will typically be a significant time lag between the need for _________ action is recognized and the time action is taken.

fiscal

Fiscal policies of state and local government are frequently pro-cyclical in that they _____ the economy.

worsen

The crowding-out effect may result from what kind of fiscal policy?

Expansionary
The crowding‑out effect happens when government borrowing pushes up interest rates, which reduces private investment.

• This effect is linked to expansionary fiscal policy — when the government increases spending or cuts taxes to stimulate the economy.

• To finance that extra spending, the government often borrows more.

• Higher borrowing → higher demand for loanable funds → higher interest rates → less private investment.

Fiscal policies of state and local government frequently worsen rather than correct recession or inflation. This is described as what?

Pro-cyclical