Question

Describe using words, graphs and all appropriate mathematics the various factors that would make fiscal policy ineffective in changing output in the short run. Be as detailed as possible.

Answer 1

There are different factors that can make fiscal policy to be ineffective in the short run. The first factor is the time lag. The time lag is time delayed in the recognition of the problems faced by the economy and implementation of the policy to get the  desired results. It makes fiscal policy to be less effective or ineffective, as the size of the problem increases in comparison to what is expected by the government. The second factor is the crowding out effect. It means that increase in spending is offset by the decrease in investments. As a result, the multiplier effect is only about the size of 1 and AD is not stimulated properly. Hence, fiscal policy becomes ineffective.

As,

Real GDP = C+I+G+NX

If G increases by G, then I decreases by I
Here,

G and I offset each other and fiscal policy does not give the desired effect.

The third factor is the expectations of the people and investors. If expectations are poor, then these people do not spend and cut back to increase the savings. Hence, funds are sucked out of the economy and does not give the desired effect. It also makes fiscal policy to be ineffective.