What determines the effectiveness of fiscal policy

Fiscal policy involves changing tax and government spending to influence Aggregate Demand. The aim of fiscal policy is to keep inflation low and maintain stable growth.

Recently, the US government cut income tax in an attempt to boost the economy. How effective will this be in stimulating the economy?

Factors determining the effectiveness of fiscal policy include:

Consumer Confidence. e.g. the government may cut income tax to boost consumer spending and increase growth. However, if confidence is very low then lower taxes may be insufficient to avoid recession. e.g. US is facing a recession and government have cut taxes but, with house prices falling this may not be effective in encouraging sufficient spending.

Size of the Multiplier.

If the multiplier is high then an increase in government spending to boost growth will have a powerful effect because the increase in AD will be bigger than initial injection into the economy; there is a knock on effect.

Good Information? How accurate are the economic forecasts? People need to be able to predict future economic trends. Expansionary fiscal policy is needed if the economy is heading towards a recession. Therefore, fiscal policy requires good information about the future prospects of the economy.

Crowding Out - Increased government spending or cuts in taxes may not increase aggregate demand because government spending will lead to lower private sector spending.

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