Question

Let’s say that, in trying to address the problems of a business cycle recession or trough, the government created a deficit through expansionary fiscal policy. First, describe what a budget deficit is in terms of the relationship between G and T. What is the argument against deficit spending known as “crowding out”? In your own words and a graph explain what crowding out is.

Answer 1

Answer -  

Budget Deficit - When the Government spending exceeds the government revenue than the condition obtained from is  called

Budget Deficit.

Condition of Budget Deficit in terms of Government Spending (G) and Taxes (T)

The Budget Deficit occurs when the Government spending (G) is greater than the revenue generated by taxes collected by government .

Budget Deficit = G > T

Crowding Out - When government use expansionary fiscal policy and increases its spending to boost the economic activity. This leads to an increase in interest rates. Increased interest rates affect private investment decisions. With high interest rates private investment decreases and people start pulling down existing investment too crowding out effect may even lead to lesser income in the economy.

With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually the initial increase in government spending is funded using higher taxes or borrowing on part of the government.

That's why in time economic slowdown the Deficit financing is not the very effective to recover from slow down because due to country can stuck in debt trap too which affect not only current but future generation of a nation too and with crowding out which does not help fiscal policies to counter economic slowdown .

Graph of Crowding Out Effect