1. The document discusses five potential problems with the effectiveness of fiscal policy: crowding out, time lags, politicians' expansionary bias, the legacy of debt, and not allowing the economy to self-adjust. 2. It specifically examines crowding out in more detail, outlining the three types of crowding out - resource, financial, and exchange rate crowding out - and provides diagrams to illustrate financial crowding out. 3. It also notes some evaluations of crowding out and the possibility of crowding-in through tight fiscal policy.

1. Effectiveness of fiscal policy
WACE Economics - Unit 13
Video 1
(c) Andrew Tibbitt 2017 1

2. Overview of problems
1. Crowding out: Extra government spending can lead to falls
in other components of aggregate demand
2. Time lags: It takes time to change fiscal policy and for
these changes to have an impact on the economy
3. Politicians’ expansionary bias: Politically it may be difficult
to wind back government spending after a period of higher
spending
4. Legacy of debt: Government borrowing leads to
government debt and imposes a servicing and repayment
burden on future generations
5. Economy’s capacity for self-adjustment: Neo-classical
economists believe that economies will adjust
automatically towards a long-run equilibrium at the level
of long-run aggregate supply without the need for an
additional fiscal stimulus
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3. Problem 1: Crowding out
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AD = C + Ip + G + (X – M)
Expansionary fiscal policy involving increased net government
spending may lead to reduced levels of consumption spending,
planned investment and net exports and an overall fall in
aggregate demand
AD = C + Ip + G + (X – M)

4. Problem 1: Crowding out
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AD = C + Ip + G + (X – M)
Expansionary fiscal policy involving increased net government
spending may lead to reduced levels of consumption spending,
planned investment and net exports and an overall fall in
aggregate demand
AD = C + Ip + G + (X – M)

5. Three types of crowding out
1. Resource crowding out: Caused when new or additional
government projects replace spending that the private sector
would have done anyway or use resources that could have
been used more efficiently in the private sector.
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6. Three types of crowding out
1. Resource crowding out: Caused when new or additional
government projects replace spending that the private sector
would have done anyway or use resources that could have
been used more efficiently in the private sector.
2. Financial crowding out: Fiscal stimulus leads to extra
borrowing and higher interest rates which cause a fall in
planned investment and consumption.
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7. Three types of crowding out
1. Resource crowding out: Caused when new or additional
government projects replace spending that the private sector
would have done anyway or use resources that could have
been used more efficiently in the private sector.
2. Financial crowding out: Fiscal stimulus leads to extra
borrowing and higher interest rates which cause a fall in
planned investment and consumption.
3. Exchange rate crowding out: Higher interest rates cause an
appreciation of the exchange rate, a reduction in
international competitiveness and a fall in net exports.
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8. Resource crowding out
Government spending projects may:
a) Replace spending that would otherwise have taken place in
the private sector (e.g. roll out of broadband, development
of Perth’s river front)
b) Use resources that could have been used more efficiently in
the private sector (e.g. construction workers)
Government spending projects need to be carefully targeted to
avoid these issues e.g. using unemployed resources to deal with
situations of market failure.
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9. Financial crowding out
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Fiscal stimulus
increases borrowing
and leads to rise in
interest rates.
Rise in interest
rates reduces
investment and
consumption
AD does not rise as
much as expected

10. Diagramatic representation of financial
crowding out
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Rate of
interest
Quantity
of funds
D1
D2
S
R1
R2
Budget deficit increases demand for
loanable funds.This extra demand
(assuming afixed level of supply)
leads to arise in interest rates.
Rate of
interest
Quantity of
investment
ID
The rise in interest rates leads to a
fall in the level of planned
investment
Price
level
Real
GDP
AD1
LRAS
SRAS
AD2
Expansionary
fiscal stance +
multiplier
GDPor
output gap
AD3 Impact of
crowding out
The expansionary fiscal policy (increased
structural deficit) plus the multiplier effect shifts
the aggregate demand curve to the right.
If there is crowding out,the reduced investment
meansAD only reachesAD3 rather thanAD2.
Rise in demand for loans
leads to rise in interest
rates

11. Diagramatic representation of financial
crowding out
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Rate of
interest
Quantity
of funds
D1
D2
S
R1
R2
Budget deficit increases demand for
loanable funds.This extra demand
(assuming afixed level of supply)
leads to arise in interest rates.
Rate of
interest
Quantity of
investment
ID
The rise in interest rates leads to a
fall in the level of planned
investment
Price
level
Real
GDP
AD1
LRAS
SRAS
AD2
Expansionary
fiscal stance +
multiplier
GDPor
output gap
AD3 Impact of
crowding out
The expansionary fiscal policy (increased
structural deficit) plus the multiplier effect shifts
the aggregate demand curve to the right.
If there is crowding out,the reduced investment
meansAD only reachesAD3 rather thanAD2.
Rise in demand for loans
leads to rise in interest
rates
Rise in interest rates
leads to fall in planned
investment

12. Diagramatic representation of financial
crowding out
(c) Andrew Tibbitt 2017 12
Rate of
interest
Quantity
of funds
D1
D2
S
R1
R2
Budget deficit increases demand for
loanable funds.This extra demand
(assuming afixed level of supply)
leads to arise in interest rates.
Rate of
interest
Quantity of
investment
ID
The rise in interest rates leads to a
fall in the level of planned
investment
Price
level
Real
GDP
AD1
LRAS
SRAS
AD2
Expansionary
fiscal stance +
multiplier
GDPor
output gap
AD3 Impact of
crowding out
The expansionary fiscal policy (increased
structural deficit) plus the multiplier effect shifts
the aggregate demand curve to the right.
If there is crowding out,the reduced investment
meansAD only reachesAD3 rather thanAD2.
Rise in demand for loans
leads to rise in interest
rates
Rise in interest rates
leads to fall in planned
investment
Fall in planned investment
offsets impact of fiscal
stimulus on aggregate
demand

13. Evaluation of financial crowding out
1. With globalisation of financial markets a rise in demand for
funds may be balanced by a rise in money supply – hence
interest rates may not rise.
2. Investment demand may be relatively insensitive (price
inelastic) to changes in interest rates
BUT
3. Business may see a growing budget deficit as a sign of poor
government financial management and this may affect their
confidence to undertake new investment.
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14. Exchange rate crowding out
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Deficits and debt
may cause
interest rates to
rise.
A rise in
interest rates
may lead to a
rise in the rate
of exchange
Exporters and local
firms competing with
imports become less
competitive and the
value of net exports
falls

15. Exchange rate crowding out
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Deficits and debt
may cause
interest rates to
rise.
A rise in
interest rates
may lead to a
rise in the rate
of exchange
Exporters and local
firms competing with
imports become less
competitive and the
value of net exports
falls
Evaluation:
1. Factors other domestic interest rates affect exchange rates
(e.g. interest rates overseas, strength of the economy, credit
ratings, level of risk in global economy)
2. Non-price factors (e.g. productivity, design, quality, delivery)
affect international competitiveness

16. Crowding-in
If crowding out occurs, might it also happen in reverse?
Would tightening fiscal policy (reducing budget deficits in a
program of austerity) actually stimulate the economy?
Crowding-in might happen as a result of:
Resource crowding in: More resources available for private
sector investment
Financial crowding in: Lower interest rates lead to rise in
consumption and investment spending
Net exports crowding in: Lower interest rates reduce the
exchange rate which raises exports and reduces imports
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17. Problem 2: Sovereign debt legacy
Government borrowing leads to government debt. Servicing and
sustaining this debt involves:
• Making interest payments on the debt (representing an
opportunity cost to current and future generations)
• A potential loss of credit rating (leading to higher interest
payments)
• Potential instability caused by need to re-borrow (sustain) the
debt
• Future repayment of debt (imposing an opportunity cost on
future generations in the form of high future taxes, loss of
investment, lower productivity and future economic capacity)
• Possibility of debt cycle or debt trap (debt-interest-more
borrowing-more debt)
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18. Problem 3: Dealing with time lags
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Inside lags
Outside lag
Recognition lag
Action lag
Implementation lag
Effect lag
Time to assess trends in the economy
Time to decide to take action
Time needed to enact new measures
Time before measures change economy
The operation of fiscal policy involves a number of time lags. To
be effective, fiscal measures have to be timed with care.

19. Problem 3: Dealing with time lags
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Inside lags
Outside lag
Recognition lag
Action lag
Implementation lag
Effect lag Time before measures change economy
The operation of fiscal policy involves a number of time lags. To
be effective, fiscal measures have to be timed with care.
RELATIVELY LONG FOR FISCAL POLICY
RELATIVELY SHORT FOR FISCAL POLICY
Time to assess trends in the economy
Time to decide to take action
Time needed to enact new measures

20. Problem 4:
Expansionary bias of politicians
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• Fiscal policy is conducted by the government.
• Politicians are political!
• Politicians have to be re-elected and like to feel they are doing
something – both of which encourage spending.
• There is a danger that temporary stimulus measures become
permanent spending programs.
To avoid this fiscal stimulus should be temporary.

21. Problem 5:
Not letting the economy self-adjust
Rather than stimulate
the economy using
expansionary fiscal
policy measures, neo-
classical economists
recommend doing
nothing and waiting
for markets within the
economy to self-adjust
(e.g. a reduction of
wages in labour
markets).
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Change
in price
level
Real GDP
AD2 LRAS
SRAS1
AD1
Avoid fiscal
expansion
SRAS2
Y1 Y3
Wait for markets to
adjust (e.g.wage
rates to fall)

22. Not letting the economy self-adjust
Evaluation:
It may take time for
markets to adjust.
A recession has its
own opportunity costs
(e.g. loss of output
and capacity, social
and economic
problems of
unemployment).
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Change
in price
level
Real GDP
AD2 LRAS
SRAS1
AD1
Avoid fiscal
expansion
SRAS2
Y1 Y3
Wait for markets to
adjust (e.g.wage
rates to fall)

23. Advantages of using fiscal policy
1. Direct effect on economy (especially government spending
changes) – short outside or effect lag
2. Flexible – different rates for different areas. Can affect
different objectives. Good for two-speed economy.
3. Automatic stabilisation
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24. Disadvantages of using fiscal policy
1. Long inside or action lag – only 1 budget a year. Complex to
introduce changes. Need to consult with interest groups.
2. Political interference.
3. Possible negative multiplier effects as a result of crowding-
out.
4. Crowding-out (or crowding- in) may dampen impact.
5. Debt legacy.
6. State governments may undermine the federal
government’s fiscal plans through their own spending plans.
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25. Avoiding some of the problems
Some of the problems of using fiscal policy to stimulate the
economy can be avoided if the policy measures are:
• TIMELY (avoiding time lags)
• TARGETED (avoiding resource crowding out)
• TEMPORARY (avoiding politicians expansionary bias)
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26. End of slide show
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