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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[...] expansion does very little to boost real GDP in the long run. They will argue that it mainly causes crowding out and rising inflation expectations. Keynesians however, argue that a fiscal expansion does help [...]
However, financial crowding out may not necessarily lead to higher interest rates. This is because governments may not need to entice the private sector to lend to it because often it is safer to invest or lend to the government that to invest or lend to a private sector company. As a result, the government need not increase interest rates in order to make the private sector lend to it.
[...] spending actually crowds out private consumption and investment. (Learn more about crowding out here or see one form of crowding out at right.) A new NBER paper [subscription required] by Harvard [...]
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