Q73+-+Macro+Short+Answers

73. Explain how an increase in government spending can lead to crowding out. [N06, 3]

Crowding out is defined as a situation where the government spends more (government expenditure) than it receives in revenue (mainly taxation), and needs to borrow money, forcing up interest rates and “crowding out” private investment and private consumption, since it becomes more expensive to borrow money.

The government borrows money in order to fund government funding in line with demand-side fiscal policies. The increase in government borrowing increases the demand for loanable funds, which is shown by the shift fromD1 → D2 (in order to finance a deficit), which in turn results in an increase in the interest rate from i1 → i2. The increased interest rates reduces the incentive for businesses to borrow money for investment and/or consumption because the cost of borrowing (interest rates) has now increased thereby leading to a fall in investment from I1 → I2. Although the government wished to increase AD by increasing government spending, the increased demand for loanable funds and subsequent effect have had negative effects instead of positive ones. The reduction of investment will lead to a fall in AD and not an increase in AD.