Question

Monetarists and Keynesians disagree about the impact of monetary and fiscal policy on spending/income. Monetarists maintain that monetary policy is the more effective way of controlling spending/income. They say that expansionary fiscal policy leads to crowding out. The crowding out story goes like this. Expansionary fiscal policy causes two things to increase:______. As a result, ______ decreases. This decrease ______ on spending/income.

Answer 1

The story goes like this:

The expansionary Fiscal Policy causes the Income and Interest to rise.

As a result, lending capacity decrease. This decrease investment in spending.

In case of crowding out. The government expenditure increases the income of people and with fixed money supply the interest rates have to be increased to keep the money market in equilibrium.

At high-interest rates, the lending capacity of banks reduces and people save more. The opportunity cost of borrowing increase and the projects which were profitable at lower interest rates are not profitable anymore. This decreases the investment and affects demand adversely.