In the view of above complications, there is a long-standing debate on whether the fiscal policy should be active or passive in nature. Note that in the Keynesian context; even a passive fiscal stance will produce the automatic stabilizer effect on the aggregate demand. How this happens? If AD falls, Y decreases; tax collection falls, the net income tax rate decreases, which is equivalent to the passive fiscal policy expansion. Also, when the AD and Y fall, unemployment increases; which means more people become adequate for unemployment benefit, which in turn makes government expenditure to increase, which

is again equivalent to the passive fiscal policy expansion. It is simple to derive the reverse situation: in which the AD increases and fiscal policy becomes passively contractionary.

Additionally to the above, there is an argument which active fiscal policy cannot be changed without the time lag. The government passes its budget on the annual basis, and therefore a mid-year change in AD which warrants the fiscal policy response should wait till the beginning of the next fiscal year. Unfortunately, the demand conditions may have changed by that time!

1.      Other arguments against the active fiscal policy-led to the demand-management include effects of a fiscal expansion on the interest rates and subsequently exchange rate. As stated in the discussion on BOPs, the rising domestic interest rate will make the exchange rate to appreciate in the real terms (because of the interest parity condition). This, however, will make competitiveness to decline will drive down the exports and lead to the BOPs problems.

2.      At last, expansionary fiscal policies can increase the national debt (as you know, national debt is simply the accumulation of the past fiscal deficits) which would have to be given off by the future generations, possibly through a painful rise in their tax contributions.