Question

3. During booms, capacity utilisation can be at high levels. Consequently, fiscal expansions during an economic boom can crowd out private spending, particularly investment. Explain.

What does this imply about the size of the government multiplier during an economic boom?

Answer 1

Fiscal expansion, either by a rise in government spending or a fall in taxes, increases budget deficit, to finance which the government resorts to deficit financing via borrowing. Higher borrowing increases market interest rate, which decreases investment demand. This is called Crowding Out of private spending (investment).

This implies that in presence of Crowding Out effect during an economic boom, government spending multiplier is lower in magnitude since full multiplier effect cannot be obtained because of crowding out.