Question

Explain 3 factors which might limit the effectiveness of Fiscal policy in controlling the AD of a country.

Answer 1

There maybe inflationary pressures on the economy that might result in an inflationary gap in the short run. To counter this problem the aggregate demand must be shifted to the left if there is an inflationary gap. Fiscal policy can be used to eliminate the inflationary gap but in controlling aggregate demand there are several factors that mitigate the effectiveness of fiscal policy.

Primarily if taxes are increased, there might be discouragement on work incentive where workers may reduce their working hours, productivity by generating less effort when they are taxed more. Secondly if there is a reduction in government spending on public welfare schemes, there will be fewer schools hospitals and other infrastructures which are necessary for development. Thirdly, if the government is using contractionary fiscal policy to control aggregate demand without having proper information about the market variables, it may result in deep time lags. This implies, the effect of the fiscal policy may be too late to influence the economy and it might end up in a recession. This can happen when government policies starts working after the self adjustment process has taken place.