Question

What factors might limit the effectiveness of fiscal policy?.

Answer 1

Factors that limit effectiveness of fiscal policy:

• Crowding effect: Exoansionary fiscal policy raises the rate of interest in the economy which reduces the investment by private investors because it raise their cost of borrowing money. A fall in investment due to rise in interest rate leads to fall in aggregate demand.
• Rise in Deficit: Expansionary fiscal policy raise government spending and reduce taxes which will raise the government deficit and put economy in risk where they may not be able to pay their debts and become insolvency.
• Expectations: Consumers and rational in the economy and expect that as government raised their spending in the economy, they will for sure cover that up in future by raising tax. It induces to consume less and keep some money aside which will reduce consumption and aggregate demand.
• Policy effectiveness lag: There is lage in time at which fiscal policy is implemented and the time it start affecting the economy. This time lag limit effectivness of fiscal policy.