Chapter 13, Problem 6P

To determine

Whether the government’s $1 billion expenditure is likely to push U.S real GDP above the level it would have reached in the absence of the government’s construction spree

Concept introduction:

Direct Expenditure Offsets- The concept is alternatively known as the “Direct Crowding Out”. The direct expenditure offsets implies fiscal policy initiatives where the Government increases the public expenditure which culminates into lower investment/expenditure by the private sector. In other words, increased government spending in the market from a macroeconomic perspective, crowds out (pushes out) the private investment from the market. The diminishing private investment offsets the intended value of the government expenditure, partially or completely. If the crowded out private investment is proportional to the government expenditure the latter has no yield. On the other extreme, if the public expenditure does not affect the private spending at all, the government expenditure yields the intent.

Indirect Crowding Out- If the government expenditure indirectly pushes out the private investment from the economy it is the indirect crowding out. As the government increases the expenditure without increasing taxes to fund the spending, it creates a budget deficit. The government resorts to borrowing from the private sector to plug the deficit. To borrow from the business sector the government issues bonds. These bonds are made lucrative by yielding a higher interest rate. This pushes up the rate of interest in the economy. Increased interest rate discourages investment. Thus, the crowding out of private investment is an indirect outcome of the expansionary fiscal policy.