Monday, 22 December 2014

(UPSC Economics Optional 2014) Question 3:

Differentiate between the complete, partial and zero crowding out effect of a given increase in government expenditure in an economy.

  1. Definition: Crowding out refers to the situation when government must finance its spending with taxes and/or with deficit spending, leaving businesses with less money and effectively crowding them out.
  2. For better understanding of crowding effect:click here 


  3. If Crowding out is complete: Decrease in pvt spending is completely offset by govt spending financed by debt and there is no change in equilibrium.
  4. In Partial crowding out, there is a decrease in Private spending which partially offsets the multiplier effect from an increase in deficit-financed government spending. This causes AD1 to shift to AD'2 and E'2 is the new equilibrium instead of AD2 and E2( which is a zero crowding out position).
  5. Keynesian theory predicts  zero crowding out effect which means when Government expenditure increases by borrowing --> AD shifts from AD1 to AD2 while Consumption and Investment remain unaffected.
  6. The channel of its operation is :

  7. Source: Macroeconomics for Today, Tucker

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