Answer to Question #187449 in Macroeconomics for pb jelly

Question

How might federal deficits crowd out private domestic investment? How could this affect future living standards? 

Answer 1

There are three different ways in which a national government can fund its spending: 1) taxes 2) printing money 3) borrowing.

When the government has an expansionary fiscal policy, runs a deficit, and finances this deficit through borrowing, crowding out takes place.

Sometimes, the government adopts an expansionary fiscal policy stance and increases its spending to boost economic activity. This leads to an increase in interest rates. Increased interest rates affect private investment decisions. A high magnitude of the crowding out effect may even lead to lesser income in the economy.

With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually, the initial increase in government spending is funded using higher taxes or borrowing on part of the government.