Question

Explain graphically how does crowding out arise in the situation of government budget deficit and how the crowding out can be avoided by following the Ricardo-Barro effect?

Answer 1

Higher government spending will crowd out the private investment. The crowding out effect refers to a situation when rising public expenditure eliminates private sector spending. The main reason for the crowding out effect to take place are increasing of budget deficit by raising government expenditure in social welfare programs and infrastructure projects.. Increased borrowing of government results substantial rise in interest rate which affects the absorbing of lending capacity by private sector and discourages business from making capital investments
Ricardo –Barro effect is an economic theory suggests that when a government tries to stimulate the economy by increased debt financed government spending , demand for loan remain unchanged because public increases their saving for expected higher future tax to pay off the government debt. According to this theory crowding out effect can be eliminated raising future taxes to pay off the government debt that were used to spend in the economy. So demand for loan will remain unchanged. Interest rate will raise if demand for loan increases. So possibility of crowding out can be eliminated