Question

How does the crowding out effect tend to offset expansionary fiscal policy

Answer 1

Crowding out refers to the phenomenon which occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market.

Due to crowding out, the output in the economy does not increase by the full amount of the multiplier.

Crowding out effect effect is the force opposite to the multiplier effect.

Now, when government uses expansionary fiscal policy, it either decrease taxes or increase spendings. Now, government needs to borrow in order to cover the cost.

When the government borrows from the market, it reduces the funds for private investment. This is called crowding out.

When private investment reduces, the output will not increase as much as its potential and the very purpose for pursuing the expansionary fiscal policy (rise in output) will get defeated. This is how crowding out offsets the effect of expansionary fiscal policy.