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Difficulty: HardFiscal Policy Tools and Economic Stabilization

During an economic downturn, a country's government attempts to stabilize aggregate demand by increasing public spending on infrastructure financed entirely through issuing government securities to the non-bank public, while the central bank keeps the money supply constant. Which of the following best explains the secondary macroeconomic effect of this fiscal stabilization policy?

  1. Private capital investment is partially squeezed out because the increased demand for loanable funds drives up interest rates.Answer
  2. B
    The national money supply expands automatically because issuing securities functions as an expansionary open market operation.
  3. C
    Aggregate demand increases by the full magnitude of the theoretical expenditure multiplier without any interest rate feedback.
  4. D
    Government tax receipts rise automatically above spending because public bond issuance transforms flat taxes into progressive ones.

Answer

Private capital investment is partially squeezed out because the increased demand for loanable funds drives up interest rates.
When a government finances public spending by selling debt securities to the domestic non-bank public without monetary expansion by the central bank, it increases the overall demand for loanable funds. This increased competition for available savings pushes up interest rates. Higher interest rates make private sector borrowing more expensive, reducing private investment spending. This dampening effect is known as the crowding-out effect.

Step-by-Step Solution

1
Analyze the primary fiscal action.
The government executes expansionary fiscal policy by increasing infrastructure spending financed via domestic bond issuance.
Understanding how the spending is funded is critical to determining its financial market impact.
2
Examine the loanable funds market under a fixed monetary base.
Government borrowing increases the demand for loanable funds, causing real interest rates to rise.
When money supply is constant, government competition for public savings raises the cost of borrowing.
3
Determine the impact of higher interest rates on private spending.
Higher interest rates increase borrowing costs for businesses, causing a decline in private sector capital investment (the crowding-out effect).
This secondary contractionary impact offsets part of the initial expansionary fiscal stimulus.

Key Concept

Crowding-Out Effect of Deficit-Financed Fiscal Policy
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Topics

Fiscal Policy Tools and Economic Stabilization

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