Discretionary Fiscal Policy

Generally, it is believed that the discretionary fiscal policy is a very effective tool that the government can use for the stabilization of the economy. But, the formation and successful implementation of the fiscal policy is by no mean an easy task. The following are the major limitations of the discretionary fiscal policy:

(1) Information Lag: The government should have adequate and authentic data that is required to change taxes and government spending. It takes a long time to collect, classify, tabulate and analyse the data. The delays in the durability of reliable data may reduce the scope of fiscal policy.

(2) Policy Formation Lag: Policy formation process involves deliberations, consultations, negotiations etc., at so many levels. For example, formulation of budget in India involves the consultation of the Finance Minister with the representatives of industry, traders, farm-growers, exporters, service providers, trade unions, ministries and department, etc. the budget document has to be presented in the parliament. Until and unless the finance bill is passed by the Parliament, the union government cannot spend a single dollar from the consolidated fund of India.

(3) Execution Lag: Even after the formulation of policy and taking decisions about certain changes in taxes and spending, there is still an execution lag, adding time between enactment and execution of the change. Even after implementation of the policy changes. It takes time to observe the effects of these changes on the economy.

The frequent and small changes in fiscal policy to stabilize the GDP are almost precisely at its potential level is called fine tuning. Various lags may appear in the formation and exaction of the fiscal policy, therefore fine tuning is not possible.

In brief, a close monitoring of the fiscal policy or gross tuning is needed to avoid output gaps. Gross tuning refers to the occasional use of the fiscal policy to remove large and persistent GDP gaps. However, other economists believe that fiscal policy should not be used for economic stabilization. They believe that tax and spending behaviour should be the outcome of public choices regarding the long-term size and financing of the public sector and should not be altered for short-term considerations.

Monetary Policy

Monetary policy is concerned with the setting of interest rates in order to influence output or inflation. The difficulties in using fiscal policy have caused current fiscal policy to be targeted on funding long-run government spending plans rather than as a tool for short run demand management.

Monetary policy has some has some advantages over fiscal policy. Although the information lag is the same, the other two lags are much shorter. Policy can be changed frequently.

However, monetary policy is subject to a further time lag before its full effect is felt on the economy.

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