Question

Suppose investment becomes less responsive to (i.e., sensitive to) changes in the interest rate. What effect will this have on the effectiveness of fiscal policy? Specifically, what will happen to the output effects of a given change in government spending?

Answer 1

Increased government spending will lead to a higher income of the people in the economy, at a higher income with a fixed money supply the interest rates will rise. This increase in the interest rate will crowd out the investment in the economy and lead to a decreased demand, also reducing the effectiveness of the fiscal policy.

Now, when the investment will not be affected by the increase in the interest rate government can increase the expenditure freely without worrying about the crowding out effect of the expansionary fiscal policy. It will make the fiscal policy more effective.

If the government increases expenditure it will lead to a greater change in the output combined with the investment and the multiplier of the economy.