Fiscal Spending and Crowding Out

Readers Question: the way in which fiscal spending inflates prices and crowds out private spending.

Government spending is a component of AD. Therefore, if we have an increase in G, we would get an increase in AD (AD=C+I+G+X-M)

If AD increased faster than Aggregate Supply, we are likely to get an increase in inflation. We can show this with a simple AD / AS diagram.

Diagram Showing Inflation 

 Note, if AS increased at same rate as AD, then prices may not rise. But, if the fiscal spending causes growth to be above the long run trend rate inflation is very likely.

There is a more complicated reason for fiscal spending causing inflation. I haven’t time to elucidate at moment. But, if government finance debt by selling gilts to the banking sector, this can cause an increase in the money supply and inflation.

Fiscal Spending and Crowding Out.

An increase in government spending can cause crowding out.

1. Resource Crowding out.

To finance the increased government spending, the government need to borrow from the private sector. The Bank of England sell bonds, gilts and other securities to the private sector. Therefore, the private sector lend their money to the government. Therefore, it is argued that the government is increasing their spending, but, only by reducing  private sector spending. (this is disputed by Keynesians)

2. Financial Crowding Out.

The other argument is that government borrowing puts upward pressures on interest rates. To attract enough people to buy bonds, the government need to raise interest rates, to attract enough savers; this can put upward pressure on general interest rates. The higher interest rates can cause lower private sector spending and investment. Resulting in lower private sector output.

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