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Long-Run Consequences of Stabilization Policies

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Long-Run Consequences of Stabilization Policies

What do we mean by Long-Run Consequences of Stabilization Policies? First, we need to understand what stabilization policies are and what they are designed to do. Stabilization policies aim to prevent any major fluctuations in economic growth and prices. Stabilization policies have intended goals, but they can also have unintended consequences. But what exactly are those unintended consequences? Are they good? Bad? Both? These fundamental questions will help us understand the Long-Run Consequences of Stabilization Policies.

Long-Run Consequences of Stabilization Policies Meaning

Stabilization Policy refers to the Monetary and Fiscal policies that are designed to maintain the desired level of economic growth and prices. The government controls fiscal policy through government spending and taxes. The central bank controls monetary policy through the money supply and interest rates. Both institutions have the same goal: to minimize recessionary and inflationary periods in an economy. A noble goal, but it comes with consequences that may be undesirable in an economy.

Examples of desirable stabilization policy outcomes are increased aggregate demand with the following: higher government spending, lower taxes, and lower interest rates. Examples of undesirable stabilization policy outcomes are the following: crowding out, deteriorated trade balance, and defaulting on debt.

Stabilization Policies refer to Monetary and Fiscal policies that are designed to maintain the desired level of economic growth and prices.

Examples of Stabilization Policies

There are two types of stabilization policies that a government or central bank will utilize: Fiscal and Monetary Policy. Fiscal Policies focus on government spending and taxes, whereas Monetary Policies focus on the money supply and interest rates.

Fiscal Policies

Governments will alter government spending or taxes when an economy is not in equilibrium. For example, an economy is not in equilibrium if it is going through a recession or an inflationary period. During a recession, the government will increase government spending and/or lower taxes to increase aggregate demand — this is known as Expansionary Fiscal Policy. In contrast, during an inflationary period, the government will decrease government spending and/or increase taxes to decrease aggregate demand — this is known as Contractionary Fiscal Policy.

Long Run Consequences of Stablilization Policies Expansionary stabilization policy StudySmarter OriginalsFigure 1. Expansionary stabilization policy, StudySmarter Originals

As you can see in Figure 1 above, expansionary stabilization policies (both fiscal and monetary) will increase aggregate demand to get the economy into long-run equilibrium. This will increase the price level from P1 to P2 and output from Y1 to Y2.

Aggregate Demand refers to the total demand for all goods and services in the economy

The Phillips Curve

The Phillips Curve shows the relationship between unemployment and inflation. Higher inflation will lead to lower unemployment; higher unemployment will lead to lower inflation. When looking at the short-run and long-run Phillips Curve, based on where they intersect, we can locate the natural rate of unemployment. The stabilization policy graphs show the same idea as well. Increasing aggregate demand will lead to a higher output and lower unemployment but at the expense of increasing the aggregate price level in the economy.

Interested in this topic? Check our article - The Phillips Curve

Monetary Policies

The central bank can alter the money supply or the interest rate when an economy is not in equilibrium. During a recession, the central bank will increase the money supply to drive down the interest rates to increase aggregate demand — this is known as Expansionary Monetary Policy. In contrast, during an inflationary period, the central bank will decrease the money supply to drive up the interest rates to decrease aggregate demand — this is known as Contractionary Monetary Policy.

Long Run Consequences of Stablilization Policies Contractionary stabilization policy StudySmarter OriginalsFigure 2. Contractionary stabilization policy, StudySmarter Originals

As you can see in Figure 2 above, contractionary policy (both fiscal and monetary) will decrease aggregate demand to get the economy into long-run equilibrium. This will decrease the price level from P1 to P2 and output from Y1 to Y2.

Direct Controls

The government using these tools (fiscal and monetary policy) to control consumer behavior is known as direct controls. Direct controls go against the laissez-faire principle of economics, where little to no government control should be exercised in an economy.

Long-Run Consequences of Fiscal Policy

Let's take a look at the long-run consequences of Fiscal stabilization policy.

Examples of long-run consequences of stabilization policies: crowding out

Expansionary fiscal policy is used to increase aggregate demand during a recession. To finance this policy, governments will need to borrow money and increase their current budget deficit. The government may need to borrow from the same loanable funds market that private businesses use. Since the government is borrowing more to finance an expansionary fiscal policy, there will be less money for private businesses to borrow from, due to increased interest rates, which would subsequently lower economic growth.

But wait, shouldn't expansionary fiscal policy increase economic growth? Your intuition is correct! However, the phenomenon we described above is known as crowding out. Crowding out happens when interest rates increase as a result of expansionary fiscal policy which means that the effect of increasing aggregate demand can be negatively affected - an unintended consequence of an expansionary fiscal policy.

To dive deeper click on our articles - Crowding Out and The Loanable Funds Market

Examples of long-run consequences of stabilization policies: Trade Balance

The trade balance can be affected if interest rates increase with expansionary fiscal policy.

Higher interest rates in the U.S. also mean a higher rate of return for foreign investors. This will cause the demand for the dollar to increase and result in its appreciation. This dollar appreciation will drive up the price of the dollar relative to other currencies, thus, leading to U.S. goods becoming relatively more expensive compared to other countries. More expensive goods will drive down U.S. exports and drive up U.S. imports, leading to a deterioration in the trade balance. This can cause the aggregate demand to decrease in times of expansionary fiscal policy — an unintended consequence.

Trade Balance is the difference between exports and imports

Long Run Consequences of Stablilization Policies US Trade Balance StudySmarter OriginalsFigure 3. U.S. Trade Balance, StudySmarter Originals. Source: Federal Reserve Economic Data1

Mercantilism

A country may purposely choose to depreciate its currency to lower the price of goods and increase its exports! In turn, increasing their trade balance. This practice fits an economic theory known as mercantilism: the goal of increasing exports and minimizing imports. This goal can also be achieved by trade restrictions such as tariffs and quotas.

Dive in our article - Tariffs and Quotas - to learn more!

Examples of long-run consequences of stabilization policies: Defaulting on Debt

The Budget Balance is the difference between government revenue and spending. A budget surplus is when the government's revenue is higher than its spending; a budget deficit is when a government's spending is higher than its revenue. When a government continually runs a deficit, it will be added to the government debt.

You bet we've got you covered on this one too! Check out - The Budget Balance and National Debt

If a country, say the U.S., is borrowing money to fund expansionary fiscal policies, then they need to eventually pay off this debt. How can they do this? One of two ways: increase taxes or continue to borrow to pay for their debt. Raising taxes is unpopular with many, but it is, arguably, a viable solution to pay off the debt. However, continuing to borrow to pay the U.S. debt is not a viable solution. This can lead to the U.S. defaulting on its debt — a disastrous consequence of expansionary fiscal policy.

Implicit liabilities

Implicit liabilities are spending promises that a government makes that act as a debt, such as social security and medicare. However, implicit liabilities are not included in debt statistics. To account for this, governments may be incentivized to balance their budget or run budget surpluses.

Dive in our article - Implicit Liabilities to explore further!

Long-Run Consequences of Monetary Policy

The central bank implements monetary policy by controlling the money supply and interest rate. Just like fiscal policy, there are long-run consequences of utilizing monetary policy that central banks need to be aware of.

Examples of long-run consequences of stabilization policies: trade balance

The trade balance can be affected by monetary policy. The logic is the same as with fiscal policy: increased interest rates will cause the trade balance to deteriorate. The difference is that with monetary policy, interest rate manipulation is intended by the central bank.

Previously, we assumed that increased interest rates would be an unintentional consequence of expansionary fiscal policy. We attributed this to public sector borrowing crowding out private sector borrowing. With monetary policy, increased interest rates are the desired goal of the central bank. Therefore, appreciation of the dollar is inevitable with expansionary monetary policy. With expansionary monetary policy, a deterioration in the trade balance is expected. Contractionary monetary policy will improve the trade balance.

Check out - Balance of Payments Accounts article - to understand the trade balance better

Examples of long-run consequences of stabilization policies: monetary neutrality

Expansionary monetary policy (such as an increase in the money supply) should increase aggregate demand to assist the economy during recessions, leading to an increase in overall prices. However, in the long run, workers will demand higher wages as a result of increased prices — this will decrease the aggregate supply and shift it to the left. This is because firms' costs of production would increase due to increased wages, leading to less supply from producers. This will decrease the aggregate supply as the aggregate demand is increasing. But what does this all mean?

The price level will increase drastically as a result of increasing aggregate demand and decreasing aggregate supply. This will cause the output to stay exactly the same as before the monetary policy took place. This is an example of Monetary Neutrality — the money supply increase has no real effects on the economy. The only change taking place is the increasing price level. This phenomenon can also be applied to a contractionary monetary policy where the overall price level would go down.

Long Run Consequences of Stablilization Policies Monetary neutrality StudySmarter OriginalsFigure 4. Monetary neutrality, StudySmarter Originals

As you can see in Figure 4 above, expansionary monetary policy increased aggregate demand and decreased aggregate supply. The result is the same output at Y3 as Y1 and an increased price level at P3.

Inflation tax

The act of printing money which results in lowering its value results in what is known as 'inflation tax'.

This can happen with all inflation levels, such as disinflation, moderate inflation, and hyperinflation.

Learn more in our article - Inflation Tax!

Examples of long-run consequences of stabilization policies: Economic Growth

While inflation can occur through expansionary monetary policy in the long run, it is not the only outcome. Economic growth is a potential result of expansionary monetary policy. Lowered interest rates can cause an increase in investments, leading to an increase in aggregate demand. These investments can also cause an increase in factories and machines, leading to an increase in aggregate supply. How does this differ from our previous example?

Previously, aggregate demand increased while aggregate supply decreased. Now, both will increase. This does lead to an overall increase in output, not just a change in price. We have achieved economic growth!

Long Run Consequences of Stablilization Policies Economic growth StudySmarter OriginalsFigure 5. Economic growth, StudySmarter Originals

As you can see in Figure 5 above, expansionary monetary policy increased aggregate demand and aggregate supply. The result is the long-run aggregate supply shifting to the right from LRAS1 to LRAS2. This increases output from Y1 to Y2 and keeps the same price level at P1.

Directly controlling fiscal and monetary policies can have both unintended and intended consequences. It is important to recognize what these policies are meant to do, and what they can lead to.

Long-Run Consequences of Stabilization Policies - Key takeaways

  • Stabilization Policies are Monetary and Fiscal Policies designed to maintain the desired level of growth and price level.
  • Fiscal Policy deals with government spending and taxes, whereas Monetary Policy deals with the money supply and interest rates.
  • Long-Run Consequences of Fiscal Policy: crowding out, trade balance, and defaulting on debt.
  • Long-Run Consequences of Monetary Policy: monetary neutrality and economic growth
  • Long-Run effect of direct controls will differ based on each country and consumer behavior.

Sources:

1. Federal Reserve Economic Data - Trade Balance: Goods and Services, Balance of Payments Basis https://fred.stlouisfed.org/series/BOPGSTB

Frequently Asked Questions about Long-Run Consequences of Stabilization Policies

The long-run consequences of stabilization policies are: crowding out, trade balance changes, defaulting on debt, inflation, and economic growth.

The long-run consequences of monetary policy are monetary neutrality and economic growth.

Examples of stabilization policies are fiscal and monetary policies.

Examples of long-run consequences of fiscal policies are: crowding out, trade balance deterioration, defaulting on government debt

Examples of long-run consequences of monetary policies are: effects on the trade balance, monetary neutrality and economic growth.

Final Long-Run Consequences of Stabilization Policies Quiz

Question

What is inflation?

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Answer

Inflation is an increase in the price of services/goods over time.

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What is hyperinflation?

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Hyperinflation is an increase in the rate of inflation by over 50% for over a month.

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What is demand-pull inflation?

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Demand-pull inflation is when too many people are trying to buy too few goods. Essentially, the demand is far greater than the supply. This causes a rise in prices.

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What are exports?

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Exports are goods/services that get produced in one country and then sold to another country.

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What is the quantity theory of money?

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The quantity theory of money states that the amount of money in circulation and the prices of goods/services go hand in hand.

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What causes hyperinflation? 


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A higher supply of money and demand-pull inflation.

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What is an example of hyperinflation?

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Former Yugoslavia in the 1990s experienced hyperinflation to the point that in the month of January 1994, the hyperinflation rate was 313 million percent!

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Name at least three ways to prevent hyperinflation

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  • Set up governmental controls and limits on prices and wages
  • Reduce the supply of money in circulation
  • Reduce the amount of governmental spending
  • Make banks loan less of their assets
  • Increase supply of goods/services

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Question

When the value of money drops, what happens to prices?

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Answer

They increase

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Does printing more money always lead to hyperinflation?

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No. If the economy is doing poorly and not enough money is circulating, it actually ends up being beneficial to print more money in order to avoid the economy falling.

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Why does hyperinflation cause a decrease in the standard of living?

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If wages are being kept constant or not being increased enough to keep up with the rate of inflation, prices for goods/services are going to keep rising and people will not be able to afford to pay their living expenses.

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Why do people hoard during hyperinflation? 

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Since the prices have already risen due to inflation, people assume the prices are going to keep increasing. So in order to save money they go out and purchase larger amounts of goods than they would normally.  

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Why does money lose its value?

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An increase in supply and decrease in purchasing power.

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Who are the two types of people that tend to benefit from hyperinflation?

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Those who profit are exporters and borrowers.

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What happens to inflation when there are shortages of goods and higher demand for goods?

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Inflation increases!

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Define disinflation

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Disinflation is the slowing down of the inflation rate.

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What is deflation?

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Deflation is a negative inflation rate.

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What's a way to remember the difference between disinflation and deflation?

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Deflation is a decrease in prices while disinflation is to discourage a fast pace of inflation.

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Which of the following pushes the inflation rate into the negatives?

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Deflation

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What happens during disinflation?

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During disinflation, the inflation rate goes down and purchasing power goes up!

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What are the causes of disinflation?

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A decrease in the money supply or a recession!

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What's a potential issue with disinflation?

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A potential issue would be a higher rate of unemployment or a possible recession/depression as policy makers work hard to bring the inflation rate back to a normal range.

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What's the CPI?

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The Consumer Price Index (CPI) is a measurement of the shifts in prices of goods/services.

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When would disinflation become problematic? 

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When it's caused by a drop in demand or leads to deflation.

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Why is deflation more dangerous than disinflation?

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Deflations are usually signals of recessions or depressions. There are high unemployment rates, low demand, and an increase in real debt.

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What's one of the only ways to bring the inflation rate down once it has gotten too high?

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Create a temporary depression 

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What's usually the cost of bringing the inflation rate back down to a more acceptable rate?

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The cost is a temporary depression which causes an increase in the rate of unemployment.

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Inflation and deflation are both related to the direction that the prices are going, but what is disinflation about?

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Disinflation is about the general rate of change in regards to inflation.

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What is hyperinflation?

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Hyperinflation is rapid and out of control inflation.

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What is inflation tax?

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Inflation tax is a penalty on the cash you possess.

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How does increasing taxes affect inflation?

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It can lower inflation. In the case of higher inflation, the government might raise taxes in order to discourage spending within the economy and to lower inflation.

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Why do governments impose inflation tax?


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Governments print money to cause inflation because they typically gain from it due to the fact that they obtain a greater amount of real revenue and can lower the real value of their debt.

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Who pays the inflation tax?


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  • Those who hoard money
  • Benefit receivers / public service workers
  • Savers
  • Those newly in a higher tax bracket

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What is inflation?

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Inflation is when the cost of goods and services rises, but the value of money decreases.

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Which of these is not a cause of inflation?

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Businesses decreasing their prices

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What is cost-push inflation?

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Cost-push inflation is a type of inflation that occurs when prices go up due to the cost of production going up.

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Which groups are most effected by inflation tax?

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Lower and middle classes because they keep more of their earnings in cash, are far less likely to obtain new money before the market has adapted to inflated prices, and lack the means to evade domestic inflation by transferring resources offshore like the rich do.

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What's the political benefit of inflation tax?

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 An inflation tax has the political benefit of being simpler to conceal than raising tax rates.

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What's an extreme example of why a government would print more money and cause inflation and inflation tax?

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When the government's expenses are so large that existing revenue cannot cover them. This can happen in impoverished societies when the tax base is small and the collection procedures are flawed.

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What is hyperinflation?

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Hyperinflation is inflation that is rising by over 50% per month and is out of control.

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What's the the quantity theory of money?

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The quantity theory of money states that the money supply is proportional to the price level (inflation rate).

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What is disinflation?

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Disinflation is the decrease in the rate of inflation.

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What is Seigniorage?

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This is when the government prints and distributes additional money into the economy and uses that money to acquire goods/services.

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What is crowding out?

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Crowding out happens when the private sector investment spending decreases due to an increase in government borrowing from the loanable funds market

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How can a government finance its budget deficit?

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When the government is in a budget deficit, meaning it is spending more than its budget, it can finance this deficit by borrowing from the private sector. 

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What is a short run effect of crowding out?

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A loss of private investment

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What are the long run effects of crowding out?

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A slower rate of capital accumulation and a loss of economic development.

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What can cause a budget deficit outside of a recession?

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The government spending over budget

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How does fiscal spending affect government budget?

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It increases government spending.

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Why does an increased interest rate cause the private sector to be crowded out?

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The private sector investment is crowded out because they are relatively more interest-sensitive and borrowing has become more expensive.

Show question

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