Stabilizing the Economy: the Role of Fiscal Policy - Discretionary fiscal policy: changes in government purchases
3 important questions on Stabilizing the Economy: the Role of Fiscal Policy - Discretionary fiscal policy: changes in government purchases
Government purchases reduces output gaps, because:
Government purchases of goods and services, being a component planned aggregate expenditure, directly affect total spending.
A crowding-out effect is:
The tendency of an increase in government expenditure to increase the rate of interest, and reduce consumption and investment.
The strength of the crowding-out effect will depend on two factors:
- The responsiveness of consumption and investment to interest rate changes: the greater the responsiveness of the demand for money to interest rate changes, the smaller the rise in the ingress rate required to clear the money market.
- The responsiveness of the demand for money to changes in the rate of interest: the greater the responsiveness of the demand for money to interest rate changes (flatter LM curve), the weaker the crowing-out effect.
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