Issues in Fiscal Policy and Monetary Policy

Business cycles are inevitable and have adverse impacts such as recessions and bubbles. This is why we have stabilization policies. Stabilization policies include fiscal policies(change in government spending, change in transfer payments) and monetary policies(change in the money supply) designed to lessen the adverse impacts of business cycles. John Maynard Keynes was the first to argue for such policies, back in 1933, insisting that the government needed to take action to counteract business cycles. Meanwhile, Milton Friedman, an avid proponent of small government, argued the opposing side: active fiscal and monetary policies should not be used to control the economy, rather policy rules needed to be implemented. And so, the question remains today: Should we utilize fiscal policy and/or monetary policy as a means of controlling our economy?

Before policies are considered, we must know when turning points in the economy occur. For this, we look to leading indicators, variables or economic data that tend to change before the whole economy changes. More often than not, leading indicators are used to predict the future behavior of the economy. Examples of leading economic indicators include the Consumer Confidence Index, the Consumer Price Index(CPI), and the Producer Price Index(PPI).

The next step, then, is choosing whether or not to implement policy and if yes, which type of policy. However, one of the largest concerns with fiscal and monetary policy is the associated lag time. The policies may turn out to be pro-cyclical, rather than counter-cyclical, due to the lag effect, making them not only ineffective, but also harmful to the economy. The lag effect can be divided between inside lags and an outside lag. The inside lags include the following: 1) Recognition Lag, which refers to the difference in time between changes in Gross Domestic Product(GDP) and observation of those changes, and 2) Implementation Lag, which is the time difference between recognition of changes in GDP and enactment of counter-cyclical policy. Finally, the outside lag is the Impact Lag and denotes the difference in time between policy enactment and the resulting impact on the economy. As you can see Figure 1 below, total lag time can be up to four years or 2.5 years for fiscal policy and monetary policy, respectively.

Source	Fiscal Policy	Monetary Policy
Inside Lag: Recognition Lag	3-6 months	3-6 months
Implementation Lag	12-24 months	3-6 months
Outside Lag: Impact Lag	6-18 months	12-18 months
TOTAL	21-48 months	18-30 months

Figure 1: Expected Lag Time for Fiscal and Monetary Policy

While policies can take years to help the economy, economic downturns typically do not outlast 12-18 months. Therefore, the policies might not be helpful at all because they fail to be effective within the desired time period. This begs the question: Can the economy be helped at all? Should we even try to change the economy?

There are, fortunately, ways to avoid fiscal and monetary policy and still act to dampen the economy. Automatic stabilizers are government programs or laws (such as tax laws) that act to counter business cycles(counter not eliminate) without discretionary monetary or fiscal policy actions. The following are automatic stabilizers: 1) Progressive Income Tax, 2) Unemployment Compensation, 3) Transfer Payments(food stamps, housing assistance, etc.), and 4) Earned Income Tax Credit(EITC).