Effectiveness of Fiscal Policy
Uploaded by Anita Acavalos on Oct 24, 2007
Although a fiscal policy does achieve in helping the economy for a short period of time by affecting the elements of aggregate demand namely investment and consumption it does have several problems that hinder its effectiveness.
On the one hand as previously stated an expansionary fiscal policy by decreasing taxation and increasing government spending the fiscal policy will probably achieve in increasing aggregate demand. This will happen since the decrease in taxation will increase people’s disposable income and consequently depending on the marginal propensity to consume the domestic consumption of an economy which in turn will increase aggregate demand. Similarly the government by increasing spending in all sectors of its economy it will increase investment which in turn may lead to an increase in aggregate demand. This is an effective way to combat economic problems such as unemployment and recession. On the other hand if a government wants to eliminate recession it will have to pursue a contractionary demand side policy. This policy will increase taxation thus decreasing the citizen’s disposable income thus in turn reducing consumption which will reduce aggregate demand which will in turn reduce inflation. On the other hand it will decrease government spending thus decreasing investment which will again reduce aggregate demand and thus in turn reduce inflation.
However these policies aren’t always very effective for several reasons. Firstly fiscal policy can’t be effective if consumption isn’t effective to tax changes in other words if there is a high marginal propensity to consume. What this will mean is that no matter how high the government raises taxes the people will still insist on spending as much as they previously did thus not decreasing domestic consumption. On the other hand if there is low marginal propensity to consume no matter how low the government drops the tax domestic consumption wont increase and thus domestic consumption wont increase.
Moreover a fiscal policy could lead to the crowding out effect. This is divided in two categories, resources and financial crowding out. In the case of resources crowding out this indicates an increase in reward for the factors of production. This happens in the case of an expansionary fiscal policy government spending on public and merit goods as a result the government increases demand for specific factors of production. This increased demand will lead to increases in wages, rent and interest rates. In the case of financial crowding out increased government spending will...