Question

Why is it that fiscal expansion (i.e. Increased government spending in relation to net taxation) not constrained by ‘crowding out’ in the Keynesian income-expenditure model?

Answer 1

DETERMINATION OF NATIONAL INCOME :KEYNESIAN THEORY

It is worth that the Keynesian theory is relevant in the context of the short run only since the stock of capital, techniques of production, efficiency of labour , the size of population ,forms of business organisation have been assumed to remain constant in this theory.Therefore , in the Keynesian theory which deals with the short run,the level of income of the country will change as a result of changes in the level of labour employment.Thus , in an advanced capitalist economy in the short -run ,income is a function of employment.Infact ,both income and employment go together.The higher the level of employment; the higher the level of income.As level of employment is determined by aggregate demand and aggregate supply, the level of income is also determined by aggregate demand and aggregate supply.

Aggregate Supply

Equilibrium level of national income in short run depends upon aggregate demand and aggregate supply.The aggregate supply depends on physical or technical conditions of production which do not change in the short -run .Since Keynes assumes the aggregate supply to be stable,he concentrates his entire attention upon the aggregate demand to fight depression and unemployment.

Aggregate Demand

Aggregate demand is determined by consumption demand and investment demand.Therefore,

Aggregate Demand =Consumption Demand +Investment Demand

AD=C+I

Where AD= aggregate demand

C=consumption demand

I=investment demand

Consumption Demand: As for consumption demand,it depends upon the propensity to consume of the community and the level of national income.Given the propensity to consume ,as income will increase consumption demand will also increase.

GOVERNMENT EXPENDITURE AND NATIONAL INCOME

In all economies today including the free market capitalist economies the Government expenditure on goods and services plays an important role in the determination of national income and therefore it should also be included inthe analysis of income determination.We assume that government spends on goods and services keeping taxes unchanged.We denote Government expenditure by G .Thus when we take into account the income generating effects of Government expenditure ,we get the following equation for the equilibrium level of National Income .

Y=C+I+G

Where Y is national income or output and C+I+G represents the level of aggregate demand including Government expenditure ,G.Since consumption function is

C=a+by

where b=mpc

a= autonomous consumption expenditure

We can rewrite the equilibrium level of national income as under:

Y=a+by+Ia+G

Y-by=a+Ia=G

Y[1-b]=a+Ia+G

Y=1 divided by 1-b(a+Ia+G)

Thus it is clear that the equilibrium level of income (when impact of Government expenditure is also considered ) is equal to the sum of three types of fixed autonomous expenditure ,namely ,autonomous consumption, autonomous investment and Government expenditure (a+I=G) multiplied by the value of the multiplier 1 divided by 1-b.

FISCAL POLICY

Modern Concept of Fiscal Policy

The classical concept of fiscal policy has not been accepted by the modern economists like Keynes and Lerner .They believed that the government has to pay a positive role so as to regulate and control the economy by means of taxes and expenditue , which they called as the principle of functional finance.

Modern economists rejected the concept of classical economists , that supply creates its own demand and, threfore , there is no possibility of unemployment , and the equilibrium in the economy is automatically achieved due to the market forces.Contrary to this ,Keynes believed that in an advanced economy, the propensity to consume tends to diminish as income increases , in other words, propensity to save increases with the increase in income.Hence , a larger proportion of the additional incomes is saved and not spent.The tendency of less consumption and larger savings results in lowering the demand for goods and services produced at that time; hence dis-equilibrium occurs in the economy.Thus to maintain income and employment at the present level,it is necessary to offset the effects of decrease in demand for output due to decrease in consumption by a corresponding increase in public expenditure .Hence , if unemployment is to be avoided , the gap between the income and expenditure must be filled either by government expenditure or by increasing the propensity to consume.For instance , during the period of depression ,the effective demand is not enough to absorb the available supply of goods and services,resulting in unemployment and under-employment.Therefore ,according to modern economists,to maintain full employment and income ,it is the duty of the government to increase public expenditure directly by under taking public works programmes on large scale and thereby inducing people to spend more.

Thus ,modern fiscal policy is the policy of government under which the government uses its expenditure and revenue programmes to produce desirable of the incrrease in aggregate production and employment.In other words,the modern fiscal policy is a technique to attain and maintain full employment by manipulating public expenditure and revenue in such a way so as to keep an equilibrium between effective demand and supply of goods and services at that time .Thus, modern fiscal policy is nothing but the application of the principle of functional finance.

DEFINITION OF CROWDING OUT EFFECT

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.Sometimes ,government adopts an expansionary fiscal policy stance and increases its spending to boost the economic activity.This leads to an increase in interest rates.Increased interest rates affect private investment decisions .A high magnitude of the crowding out effect may even lead to lesser income in the economy.With higher interest rates,the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms.This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending.Usually the initial increase in government spending is funded using higher taxes or borrowing on part of the government.