Answer to Question #307376 in Macroeconomics for Mark

Question

Using the IS-LM model,

a) Illustrate a situation in which fiscal policy does not lead to crowding out

b) Illustrate the economic importance of the crowding out effect of fiscal policy

Answer 1

a) Illustrate a situation in which fiscal policy does not lead to crowding out

The employment of government spending and taxation to impact the economy is known as fiscal policy. Fiscal policy is often used by governments to foster robust, long-term growth and poverty reduction. The crowding out effect is an economic concept that claims that more governmental expenditure reduces or eliminates private spending.

Government expenditure, in general, does not result in crowding out. Spending on physical capital by the government can boost private investment. Roads and bridges, water supply and sewage, seaports and airports, schools and hospitals, power plants such as hydroelectric dams or windmills, and telecommunications facilities are just a few examples of public infrastructure investments. By making it simpler to move products to market, new roads (or other transportation networks) can increase the rate of return on private investment. As a result, infrastructure spending may spur private investment as well.

b) Illustrate the economic importance of the crowding out effect of fiscal policy

The importance of the crowding out effect is it enables the government to balance its spending when executing fiscal policy to avoid depriving the private sector of the investment resources. The crowding out effect is an economic concept that claims that more governmental expenditure reduces or eliminates private spending. The majority of economists think that deficit spending is not a problem in and of itself. In reality, during severe recessions, deficit spending may be needed. However, most economists understand that deficits and debts may have long-term effects. Because of the lower investment spending, a country's capital stock will not increase as quickly. As a result, crowding out has the potential to diminish a country's future productivity.