Question

does lag and crowding out affect the explanation of the Keynesian model?

Answer 1

Keynesian economics developed in the 1930s offering a response to the unique challenges of the Great Depression.

Keynesian economics involves:

• Government intervention to stabilise the economic cycle e.g. expansionary fiscal policy – cutting tax and increasing spending. The argument is that governments can speed up economic recovery.

Criticisms of Keynesian Economics

• Borrowing causes higher interest rates and financial crowding out. Keynesian economics advocated increasing a budget deficit in a recession. However, it is argued this causes crowding out. For a government to borrow more, the interest rate on bonds rises. With higher interest rates, this discourages investment by the private sector.
• Resource crowding out. If the government borrows to finance higher investment, the government is borrowing from the private sector and therefore, the private sector has fewer resources to finance private sector investment.
• Inflation. A problem of fiscal expansion is that it often comes too late when economy is recovering anyway and therefore, it causes inflation.

• Encourages big government. In a recession governments increase spending, but, after recession government spending remains leading to high tax and spend regimes. Milton Friedman quipped ‘nothing was so permanent as a temporary government programme.” Government spending projects may be designed for the short-term, but once started it creates powerful political pressure groups who lobby the government to hold onto them.
• Time Lags. It takes a long time to change aggregate demand by the time AD increases it may be too late and it leads to inflation.

Both Time lag and crowding our affects the Keynesian model