It may be noted that either under expansionary or contractionary policies the level of income increases or decreases from Y₁ to Y₂ respectively. This becomes possible with fiscal policy of increasing or decreasing public expenditure. But such adjustments in public expenditure need not be of the same size as of the desired changes in the income level. Public expenditure needs to be smaller in size yet because of the presence of the multiplier effect a much larger final change in the income becomes possible.

iii.    Crowding-out effect: Keynes' fiscal policies of expansion and contraction have been popular with modern public authorities. These policies have been used effectively over the past years in many economies the world over. However, modern followers of the classical school, also known as monetarists, point out the faults of such fiscal measures. It is pointed out that extra government expenditure is financed through public borrowings. As a result of this, the money available for loans is reduced and there is a greater demand for loanable funds in the money and capital markets. With a sudden rise in the demand the price of loanable funds or the rate of interest starts rising. Again extra public expenditure, which gives rise to an upward movement of the price level, also has a similar effect on the rate of interest. Rising level of the interest rate has a discouraging effect on private investment activity. Thus increased public investment expenditure causes a fall in the private investment activity. This is called the 'crowding-out' effect. It is claimed therefore that fiscal policy is likely to develop a self-defeating tendency. On the other hand, during the phase of inflation, contraction in public expenditure can be equally self-defeating. In this case with a fall in the effective demand, the rate of interest will tend to fall and will encourage private investment activity. This is exactly the opposite case and therefore can be called the 'crowding-in' effect.

Index