8 - Fiscal policy

Summary

Until now hints have been given that fiscal policy needed to be looked into, but nothing has been done about it. The reason for not doing so until now is that, to an extent, Carlin and Soskice (2006, 2014) and other textbooks have followed what was an established consensus, and what has been described as a consensus assignment that applied before the financial crisis. This consensus assignment rested on two propositions: (a) stabilization of inflation and output was the task of monetary policy, and it was for the central bank to deal with such matters in the way described in the preceding chapters, whereas fiscal policy could not be used as a countercyclical tool, in order to stabilize output over the cycle; (b) the purpose of fiscal policy was instead to stabilize the ratio of government debt to GDP, for reasons that will be detailed below. A number of arguments were used to justify the preference for monetary policy as a stabilization tool. In the first instance, there was the undeniable fact that fiscal policy acts with longer lags, and it takes a much longer period of time to be implemented, because legislation will have to be passed for new taxation rates, and new levels of expenditure. All this takes time and the implementation thereof will take longer still, whereas changing the interest rate, which is the main tool of monetary policy, as it was before the financial crisis, takes very little. It may take time to feed through and have the desired effect on output and inflation as detailed before, but in terms of the actual policy change the delay can be deemed to be much shorter than it is the case with fiscal policy. The second obvious reason that could be deemed to be relevant in the context of a small open economy, is the fact that assuming a Mundell-Fleming model, or a variation thereof, provided that the exchange rate regime be a flexible one, it is only monetary policy that is effective at changing output, whereas fiscal policy should be completely ineffective.