A high level of public spending crowds out the level of priv

\"A high level of public spending crowds out the level of private domestic investment. Therefore, if the government cuts its expenditures and free resources for private investment, it can ultimately increase income per capita\" Comment on the statement

Solution

The government policy to deliberately influence the aggregate demand in the economy through changes in taxes or government spending or some combination of both is called the discretionary fiscal policy. The fiscal policy that increases aggregate demand by increasing government expenditure or by cutting the taxes or both is called the expansionary fiscal policy. If the policy decreases the aggregate demand by increasing the taxes or decreasing government expenditure, it is called contractionary fiscal policy.

The crowding out effect refers to the theory that government borrowing increases the interest rate thus lowering the consumption by household and investment spending by firms. If the government increases its purchase, the aggregate demand and real GDP in the economy increases. The increased spending will encourage consumer and firm to spend and buy more. The consumer and the firm will need more money for this additional buying and spending. The demand for money will increase in the economy. The increased demand for money drives up the interest rate in the economy. Thus the individual and firm decrease its investment due to higher interest rate. As investment decreases real GDP also decline. The impact of the increased government spending will be less than predicted by the multiplier theory.

The magnitude of the crowding out effect depends on how sensitive the interest rate is to increased government spending and how sensitive investment to interest rate is. The Crowding out occurs in two steps:

The crowding effect limited the effect of the decreased government spending to increase aggregate demand. Thus the crowding out effect decreased the AD, whereas the increased government spending increases AD. Now there is three possibilities: