Fiscal policy and crowding out Fiscal policy has a very important affect on the division of total output. This is one major negative effect of fiscal policy. Recall that the tools of fiscal policy are taxes and government spending. When the government increases government spending, there should be an indirect increase in output, as mitigated by the government spending multiplier. In reality, government spending does not change output as the government spending multiplier would seem to indicate. It does, instead, significatly change the interest rate. A rise in the interest rate has a strong affect on investment. That is, as the interest rate rises, investment falls. This is because the interest rate is the opportunity cost of holding money, and as this increases, taking out loans becomes relatively less attractive. When the government increases spending, the interest rate rises and investment falls. This is called crowding out. That is, increases in government spending tend to replace, or crowd out,
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