Question

In your own words, explain what crowding out is and explain how it works. What is the effect of

crowding out on the economy’s GDP?

How is the government debt different from a budget deficit?

Assume that the government is in a balanced budget position. Does the government’s budget balance improve, deteriorate, or remain unchanged if the government cuts its spending in a recession, ceteris paribus? Explain and draw a graph to illustrate your argument.

Answer 1

Part A) A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect. A high magnitude of the crowding out effectmay even lead to lesser income in theeconomy.

Crowding out effect on GDP

Crowding out from government borrowing. One channel of crowding out is a reduction in private investment that occurs because of an increase in government borrowing. ... In sum, changing the government's budget deficit has a stronger impact onGDP when the economy is below capacity.

Part b) budget deficit occurs when an individual, business, or government budgets more spending than there is revenue available to pay for the spending, over a specific period of time. Debt is the aggregate value ofdeficits accumulated over time.