Explain the concept of “crowding out”, with respect to fiscal policy. Given that

Question

Explain the concept of “crowding out”, with respect to fiscal policy. Given that the
country in question is operating under a system of flexible foreign exchange rates, under
what conditions, in terms of the short run theory studied by you, would “crowding out”
be perfect, with the consequence that fiscal policy would be powerless as stabilization
device? Under what conditions would “crowding out” be nonexistent? Would it be true
that, when “crowding out” is negligible, monetary policy becomes the dominant
instrument for stabilization purposes? Explain.

Explanation / Answer

The Keynesian fiscal policy does not help the economy. It can be justified by the argument of crowding out effect. In Keynesian policy, it is said that the government spending increases the demand that leads firms to make appropriate supply and create employment opportunities. But, it does not happen since the increased government spending consumes all funds available for the investment. Hence, the firms are crowded out by the spending done by the government. Now, the firms get funds at high interest rates and they are discouraged. Hence, the fiscal policy does not work.
Further, the increase in demand causes the firms to supply more and demand of input factors of the production. As a result, demand pull inflation takes place that only raises the prices and supply comes down. Hence, the fiscal policy does not help the economy.

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