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Fiscal policy is the mechanism by which a government adjusts its spending levels as a way of monitoring and keeping a close eye on the performance of the nation’s economy. It is closely related to the monetary policy. Monetary policy is run by the central bank which controls the levels of money supplied in a country. These two policies are used hand in hand with an aim of attaining the country’s economic goals (Heakal). On the other hand, crowding out effect is a component of fiscal policy. It is the borrowing of funds by the government from other countries with an aim of balancing the economy of the nation. It is basically one of the measures taken by the government to try and rescue a collapsing economy (Answers Corporation). Crowding out effect is a big concern to the government. This is because it increases the debts owed to other countries and its levels of spending in particular. When crowding out effect takes place, it clearly shows that revenue collected from taxes is insufficient to run the budget and other government operations (Answers Corporation). The interest rates of the country which is borrowed go up and this is as a result of increase in demand for loans. This raises the prices. Private borrowing is discouraged due to the increase in interest rates of commercial banks as dictated by the central bank. The term crowding out is basically used because the increase in the spending of the government crowds out private borrowing (Answers Corporation). The rise in interest rates is advantageous in some countries as it attracts investors to rescue it financial market. The effect is the appreciation of its currency which is caused by its high demand. The imports hence become cheaper but the exports become more expensive. This increases imports and declines the exports. The exports are therefore crowded (Answers Corporation).
The multiplier effect is a theory which states that an increase in the government spending increases private spending. Since the income becomes more as a result, the rate and amount of consumption also increases. Firms also earn more revenue hence are able to make new capital investments. This raises the GDP (Welker). The crowding out effect theory is an opposite of the multiplier effect theory. It states that an increase in government spending, as a result of borrowing from other countries reduces private spending. This is because there will be high interest rates imposed on firms and household. The government’s involvment in the private financial markets is the main reason for increase in interest rates (Welker).
On different occassions, the government expenditures are increased without any increase in taxes or the taxes are reduced without a reduction in the expenditure. This is a policy which is known as deficit finance government spending (Welker). High pressure is exerted on the government’s little funds. This hampers the expansion of the economy as little funds are competed for by many projects. The government is therefore forced to borrow from the private sector referred to as government bonds.When it does, it invites lenders which may demand high rates depending on the agreement. This has a negative effect to the private sector as it reduces the supply of loanable funds. These are the funds available in the commercial banks for lending and borrowig. Members of the private sector are always tempted to offer loans to the government when the demand arises rather than saving in private banks. This is because of favourable interest rates provided in the government bonds (Welker).
In the fiscal policy curve, the presence of a recessionary gap leads to the shifting of the aggregate demand curve to the left. When there is a an inflationary gap, the aggregate demand curve shifts to the right. Change in taxes also affects the fiscal policy. Taxes are decreased shifting the aggregate demand to the right in cases of a recessionary gap. The vice versa is done in cases of inflationary gap (FreeEconhelp.com). (FreeEconhelp.com)
In the graph above, A and B represent the expansionary fiscal policy. The aggregate demand shifts to the right due to decrease in taxes or increase in government spending. A is a shift from a recessionary gap to a long run equillibrium. B shows a shift from long run equillibrium to inflationary gap. C and D represent contractionary fiscal policy (FreeEconhelp.com).
The graph below shows how crowding out effect behaves. Point A is at the recessionary gap. The government on increasing its spending, the shift from A to B is witnessed. This increases the interest rates hence crowding out consumption. A left shift is hence witnessed due to a decline in consumption and investment. The shift is from point B to C(FreeEconhelp.com).
Increased government borrowing is a clear representation of the crowding out effect. It has a big impact on the demand for lonable funds. The lonable funds decrease everytime the government borrows from the private sector resulting to a high demand for the remaining funds (Welker). Many Developing countries are in debt with the Most Developed countries due to this crowding out effect. It’s one of the ways their governments can raise funds to support their economies. Pakistan is a good example of the countries that have experienced this crowding off effect in order to meet the public deficit. Its government borrows from banks and the public at large. The public sector corporations also borrow this funds (Khan,Rana and Abid 1). Borrowing is made with the aim of financing expenditures. This borrowed fund is however directed towards the private sectors and politicians instead of supporting public projects. To prevent any forms of inflation, the government should borrow funds more often from the local other than going international (Khan 1).
Crowding out effect is a major component of fiscal policy. Many governments find it as the easy solution of raising funds so as to improve their economies. Governments in the developing countries lead in international borrowing. This has raised their international debts. These nations are characterized by poor infrastructure and a poor economy. With this reason,there’s need for funds which their governments can not readily acquire. One of the options left is to borrow from other countries. Crowding out effect has an advantage and a disadvantage at the same time. It’s an advantage to the government as a source of fund for its projects. On the other hand, it results to increase in interest rates in the borrowed countries and therefore discouraging private borrowing. Poor governance and mismanagement of the borrowed funds can be disastrous to an economy. It amounts to debts which later become difficult to repay.