Fiscal Policy

Crowding Out

Government spending leads to an increase in the interest rate, which can diminish aggregate demand in a process known as crowding out.
One goal of expansionary fiscal policy is to increase government spending and increase incentives for private businesses to increase spending.

Fiscal policy affects the amount that the government borrows in capital markets. While the spending of what is borrowed affects aggregate demand, the borrowing itself affects interest rates. In the case of expansionary fiscal policy, spending increases are intended to raise aggregate demand. Governments typically need to borrow in order to achieve these increases in spending, especially during recessions when tax revenues are low. However, the borrowing of funds that comes with deficit spending (a situation in which expenditures are greater than revenues) increases interest rates. Higher interest rates discourage households and firms from borrowing (and spending on expensive items). When government spending causes interest rates to rise and investment to fall as a result of government borrowing it is known as crowding out. This crowding out is not as large as the effect of increased government spending and thus does not fully offset it, but it does reduce the force of an expansionary fiscal policy.

Thus, crowding out is one potential concern of an expansionary fiscal policy. However, there is a potential solution to this issue. With a coordinated approach between fiscal and monetary policies, fiscal policy can work to its full effect during the use of expansionary measures.