Answer to Question #279688 in Macroeconomics for Kaju

Question

consider the goods market equilibrium condition in a closed economy, S+TA-TR=I+G. use this equation to explain why in the classical case of fiscal expansion must lead to full crowding out. Explain using the same equation, what happens to the economy when there is less than full employment

Answer 1

When a government runs a budget deficit and borrows to cover the difference between its spending and tax revenue, the term "crowding out" is used. Crowding out occurs when an expansionary fiscal policy raises interest rates, limiting private spending, especially investment. Because a fall in the interest rate boosts investment demand, the IS curve slopes downward. This increases aggregate demand and the level of production at which the goods market is in equilibrium. There will be economic unemployment of resources when an economy is now below its long-run, full-employment real GDP level, which will lead to an economic recession. The economy is producing below, or within, the limits of its productive capabilities (PPF). The long-run real GDP level shows what a country's economy could produce if it were at full capacity. When an economy isn't fully employed, it can't create as much as it could if it were fully employed. The employment shortfall contributes to the production gap.