Expansionary fiscal policy, which typically involves increasing government spending or decreasing taxes, can lead to increased overall demand in the economy. However, it can also lead to potential crowding out of certain components of aggregate demand, particularly when the economy is near full capacity. The following are potentially crowded out as a result of expansionary fiscal policy:
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Interest-sensitive consumption: Higher government spending can lead to higher interest rates if the fiscal expansion increases demand for funds. This can reduce consumption spending, particularly on goods that are sensitive to interest rates, such as durable goods (cars, appliances, etc.).
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Investment: Similar to interest-sensitive consumption, higher interest rates can also discourage business investments. When the government borrows more to finance its spending, it can raise interest rates, making it more expensive for businesses to finance new projects.
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Exports: If expansionary fiscal policy leads to higher interest rates and subsequently an appreciation of the domestic currency, this can make exports more expensive for foreign buyers, potentially reducing export levels.
Government spending: This is not typically crowded out since the government is the one conducting the expansionary fiscal policy in the first place. Rather, the concern is with how increased government spending impacts other components of the economy.
In summary, the potentially crowded out components are interest-sensitive consumption, investment, and exports.