Question

Using the Aggregate Demand-Aggregate Supply graphical analysis, show what happens in the short and long-run if the fiscal policy authorities increase government spending. Start your analysis in long-run equilibrium and label this point A. Does crowding out happen here? Explain.

Answer 1

Fiscal policy is an instrument that allows the government to make changes in spending or taxes in order to influence the economy. There are two types of fiscal policy:
Expansionary: 1) Increasing in Spending ( can be financed by borrowing)
2) Tax cuts.
Contractionary: 1) Decrease in spending.  
2) Tax increase.

In present analysis, using the AD-AS schedule, the effects of expansionary fiscal policy ( increase in spending) are as follows:

Starting from an initial position of recession in the economy described by point A in the diagram. There is vertical Long run aggregate supply curve and Short Run Aggregate supply curve along with 3 Aggregate demand curves.
There is evident recessionary gap: Real less than the Long run GDP. In order to correct recession, the Government employs Expansionary fiscal policy by increasing spending which is usually financed through borrowing. This leads to:
1) Increase in aggregate demand through multiplier effect such that the economy to move from point A on AD1 curve to point B on AD2 curve.
However, the effects of expansionary fiscal policy are somewhat offset by crowding out effect. As the increase in spending is financed by borrowing, this leads to increase in interest rates (along with increase in aggregate demand) that crowds out private investment.
2) As private investment falls, this forces the aggregate demand to shift left from point B to point C.

Some economists argue that fiscal policy is ineffective in correcting the economy in the Long run and that monetary policy should be made use of.