posted by sharon on .
Assume that the economy is already in a recession, and both the President and Congress have decided to do something to restore the economy. Both agree that lowering taxes would not be a good idea, but do believe that it is in the best interest of the economy to increase government spending in defense, education & infrastructure.
The President and Congress change the budget accordingly, but after 18 months, GDP only increased by three quarters of the expected amount. What factors might be responsible for this situation?
The government has to finance the additional spending either by taxes or borrowing money.
If they use taxes, the tax lowers consumer consumption (of those being taxed).
If they borrow money, the interest rates rise, which lowers investment.
This is known as crowding out.