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Strengths and Weaknesses of Fiscal Policy

Economics (Year 12) - Fiscal Policy

Christian Bien


Short Effect Lag

Stimulus spending will have an immediate effect on the economy as it is a direct component of aggregate demand.

Can Target Specific Sectors

Fiscal policy can target specific sectors, industries or groups. Unlike monetary policy which is a blunt instrument and targets the economy as a whole. Fiscal policy can be used to target weaker areas of the economy. For example, in the post-mining boom, fiscal spending can be directed to mining states such as WA or QLD rather than growth states such as NSW or VIC.


Political Tool

Fiscal spending can be used as a political tool to gain votes. Fiscal spending could be influenced and directed to uncertain seats rather than areas of need. The government often uses fiscal spending as a political tool during elections, increasing government expenditure to attract votes.

Long Decision Lag

Budget measures have to be debated in both houses of parliament. Budget measures can often take days or weeks to be passed in both houses of parliament. There is also a risk that budgetary measures could be rejected or modified, which can impact severely on budget estimates.

Interest Repayments on Public Debt

Government budget deficits may require borrowing or the issue of government bonds which can result in high-interest repayments to maintain public debt. In the 2016/17 budget, the Government estimates it will spend $16.6 billion (3.7% of the budget expenditure) on public debt interest, money that could have been better used invested in health, education or infrastructure.

Limits in Flexibility

While governments can easily increase expenditure, there are some difficulties decreasing government expenditure during periods of high economic growth. This can be due to:

  • Investment projects being already bounded by contracts

  • Pressure by public service unions when expenditure to government sectors decreases

  • Difficulties in decreasing expenditure on essential government services such as education, health or defence

Crowding Out

In the long term, fiscal spending could displace private spending. Persistent government budget deficits can increase the demand for borrowing, rising market interest rates and hence, lowering private spending. The raised interest rates could also appreciate the currency as more foreign investment flows into Australia, reducing net exports. A large criticism of government expenditure has been the National Broadband Network (NBN), which argues private sector could have implemented the program more efficiently and cheaply.

The crowding-out effect is shown in the model above, where a government budget deficit increases demand for borrowing in the market for loanable funds. As a result demand for loanable funds increases from D1 to D2, increasing the number of funds loaned from Q1 to Q2 and increasing the market interest rate from I1 to I2. The increase in market interest rates will discourage private spending, hence creating a 'crowding-out effect.

If the government ran a surplus budget, then it would increase the supply of loanable funds, lowering the interest rate and encouraging private spending, hence creating a 'crowding in' effect.

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