Expansionary fiscal policy of increased government spending (G) to increase aggregate demand (AD) may cause “Crowding Out.” Crowding Out occurs when increased government spending results in a decrease in the size of the private sector.

Key reasons for Crowding Out:

• Higher borrowing requirements:

  • If the government increases spending, it often finances this by borrowing more from the market. This raises interest rates, making it more expensive for private businesses to borrow, leading to a decline in private investment.

• Reduction in private sector activities:

  • As the government spends more, resources such as labor and capital shift towards public projects, reducing availability for private businesses.

• Taxation as a funding method:

  • If government spending is financed through higher taxes, disposable income reduces, lowering consumption and investment in the private sector.

Examples of Crowding Out:

1. Government Bond Issuance:

   • If the government issues more bonds to finance infrastructure, it competes for funds with private firms, raising interest rates.
   • Example: A company looking to invest in expansion might cancel its plans due to higher borrowing costs.

2. Public Sector Expansion:

   • When the government hires more employees or pays higher wages, private firms may struggle to attract talent, raising labor costs in the private sector.

3. Bank Loan Market Impact:

   • Increased government borrowing reduces loan availability for individuals and businesses, reducing investments and economic growth in the private sector.

Thus, while expansionary fiscal policy stimulates economic growth, excessive government spending can diminish private investment and economic efficiency, leading to the “Crowding Out Effect.”