Lag of Fiscal Policy
However, in the case of discretionary fiscal policy, the lag of implementation may be significant but the lag of impact will be short. Namely, in order to implement discretional fiscal policy, a budget approved by the Diet must normally be developed. This takes some time. For example, when the central government gives money to local governments, which engage in discretionary measures, central government should first take budgetary action. If the adjustment of intergovernmental financing takes some time, the lag of implementation becomes significant.
Once the budget is approved, though, fiscal action may affect aggregate demand by changing government spending directly. Alternatively, fiscal action may affect the investment and consumption of private agents through changes in taxes and transfers. It should also be noted that although the lag of impact may be short, this does not necessarily mean that the magnitude of the impact is large.
Lag and Automatic Stabilizers
The combination of model uncertainty and time lags makes a mockery of the notion of “fine tuning” the economy so that it always performs at its best. Instead, policymakers try to adjust slowly and more or less grope their way forward to find the best outcome that they can achieve. Thus, both monetary policy and fiscal policy have merits and demerits with respect to policy lags. Moreover, the lag of recognition may be serious for both policies.
Consequently, it is hard to conduct appropriate discretionary policy at the right time. Even if a discretionary policy is effective in the short run, as suggested by the standard Keynesian model, it may be undesirable to use it unless it is implemented at the right time.
For example, suppose the economy is in a recession and the government is required to engage in expansionary monetary and fiscal policies. This may take some time; consequently, actual implementation may occur after the economy has already recovered. If so, the expansionary policy may not stabilize output fluctuations but in fact destabilize the economy. Alternatively, even if social welfare measures are needed in a recession, their implementation could take a while. However, such measures may not necessarily be desirable anymore because the economy will already have recovered.
If the government can anticipate the time lag precisely, it can make the necessary decisions. However, it is hard to anticipate the size of lags correctly. Thus, it may be desirable not to use discretionary policy but to use monetary and fiscal rules to smooth out fluctuations in output. This is the issue of rules versus discretion.
Those who support discretion argue that the government may anticipate policy lags to a significant extent so that a discretionary policy can produce the desirable impact at the right time. However, those who emphasize the merit of rules are not confident about the correct anticipation of policy lags or the effectiveness of discretionary policy. Rather, they are concerned with the distortionary effect of bad discretionary intervention. From such a perspective, automatic built-in stabilizers and/or rules are better for the avoidance of distortionary costs. For example, fiscal authorities should maintain the public investment/GDP ratio as fixed over time. Alternatively, monetary policy should increase money supply at a given fixed rate.
Which argument is appropriate depends upon the capabilities of the government, the nature of business cycle risks, the macroeconomic situation, and fiscal conditions.