Effectiveness of Fiscal Policy

Strengths of Fiscal Policy (AO3)

• It can target specific economic sectors.

• Government spending is effective in recessions, as it can boost confidence easily.

• Fiscal policies can include Automatic Stabilizers (HL): Fiscal policies that naturally reduce fluctuations of the business cycle.

• Progressive taxes: A tax system where people with higher income have a higher tax rate. If people suddenly earn less in a recession, tax rates automatically decease as people go into lower tax brackets.

• Unemployment benefits: A form of transfer payments for the unemployed, ensuring they have enough money to cover their needs. This is given to every unemployed person and will therefore automatically adjust when more people lose their jobs.

Weaknesses of Fiscal Policy (AO3)

• Political pressure: Since it is done by the government, it needs political support, which may vary from what's actually best for the economy.

• Time lags: It takes time to implement fiscal policies. Bureaucracy takes time, and the injection of money will take time.

• Fiscal policy will also increase government debt, which is not sustainable in the long run.

The following section is for Higher Level students only.

• Fiscal policy may also crowd out (HL) (AO4): 

^Neoclassicalists do not believe in fiscal policy because it will crowd out. 

• As the government needs to take out loans in order to accomplish a fiscal policy, the overall demand for loanable funds in the economy will increase. 

• Because the demand for money shifts to the right, the interest rates on these loans will increase, as the supply remains the same.

• High interest rates will increase the cost of borrowing money for consumers and firms, which will decrease their investment and consumption. 

• In other words, while the government increases its spending (G), the increase in interest rates as a result of this will mean consumption (C) and investment (I) decreases. 

• The government has therefore ran a budget deficit without accomplishing any economic stimulus, as the decrease in C and I cancel out the increase in G.