Question

Can monetary and fiscal policy be combined in some way to avoid the “crowding out” effect? Explain and illustrate.

Answer 1

Crowding out effect : During an expansionary fiscal policy government increases spending to boost the economy . This leads to an increase in interest rates . Increased interest rates affect private investment decisions since it depends on interest rates . So private investment falls and this crowding out of private investment lowers the benefits of rise in total investment .

Now to avoid crowding out effect : government can raise the tax rate to fund the extra spending , higher government spending financed by higher tax should not increase overall AD because the rise in G (government spending) is offset by a fall in C (consumer spending) . On the other hand to prevent crowding out central bank can fix the rate of interest . This may restrict the amount government can borrow by selling bonds in the market but can also prevent crowding out of private investment .