Fiscal policy and the crowding-out effect
Fiscal policy uses government spending and taxation to steer demand. Borrowing to pay for it can raise interest rates and crowd out private investment.
What fiscal policy is
Fiscal policy is the use of government spending, taxation and borrowing to influence aggregate demand, output, employment and prices. In Sri Lanka it is set out each year in the Budget, presented by the Ministry of Finance and approved by Parliament. Government revenue comes mainly from direct taxes (on incomes and profits) and indirect taxes (such as VAT and excise duties). Spending is recurrent (salaries, pensions, interest, subsidies) or capital (roads, ports, schools). If spending exceeds revenue there is a budget deficit, financed by borrowing at home or abroad.
Two directions of fiscal policy
Automatic stabilisers work without new decisions: in a slump, tax revenue falls and welfare spending rises, which supports demand.
How expansionary fiscal policy works
A tax cut works the same way, but starts with higher disposable income, so the first round is a little smaller.
Worked example 1: the budget balance
A government's revenue is Rs. 3,000 billion and its total spending is Rs. 4,200 billion, of which Rs. 1,000 billion is interest on past debt (illustrative figures). Find the budget deficit and the primary deficit.
- Overall budget deficit = spending − revenue = 4,200 − 3,000 = Rs. 1,200 billion.
- Primary deficit = overall deficit − interest payments = 1,200 − 1,000 = Rs. 200 billion.
- So most of the deficit comes from interest on past borrowing; without it, the gap would be only Rs. 200 billion.
Budget deficit Rs. 1,200 billion; primary deficit Rs. 200 billion.
The crowding-out effect
When the government borrows to finance extra spending, it competes with firms for loanable funds. The demand for loans rises, so interest rates rise, and some private investment that would have happened is cancelled. This is crowding out. It can be partial (output still rises, but by less than the full multiplier) or full (private investment falls by as much as government spending rises, as classical economists argue happens at full employment). Crowding out is weaker in a deep recession, when there are idle savings and spare capacity, and stronger near full employment. Heavy government borrowing from banks can also leave less credit available for private firms.
Worked example 2: partial crowding out
The government raises spending by Rs. 50 billion. The multiplier is 4. Because of higher interest rates, private investment falls by Rs. 20 billion. Find the change in income and the amount crowded out.
- Without crowding out: ΔY = 4 × 50 = Rs. 200 billion.
- Net injection = 50 − 20 = Rs. 30 billion.
- Actual ΔY = 4 × 30 = Rs. 120 billion.
- Output crowded out = 200 − 120 = Rs. 80 billion.
Income rises by Rs. 120 billion instead of Rs. 200 billion; Rs. 80 billion of the effect is crowded out.
Limits of fiscal policy
- Time lags: recognising the problem, passing the Budget and spending the money all take time.
- Crowding out of private investment, especially near full employment.
- Debt sustainability: large deficits raise interest costs and can lead to a debt crisis.
- Import leakage: in an open economy, part of the extra spending goes on imports.
- Political pressure makes spending easy to raise but hard to cut.
Government infrastructure spending on roads and ports raises demand for construction firms such as Access Engineering and suppliers of cement and steel. But heavy government borrowing can push up interest rates and make bank loans dearer for private businesses, the crowding-out effect.
Short answer: “What is the crowding-out effect?” The fall in private investment (or spending) caused when government borrowing raises interest rates.
Structured question: “Distinguish between expansionary and contractionary fiscal policy, with examples.” Expansionary: higher spending or lower taxes to fight recession. Contractionary: lower spending or higher taxes to cut inflation or the deficit. Give one Budget example of each.
Essay: “Explain how fiscal policy works and discuss the crowding-out effect.” Define fiscal policy and its tools, explain expansionary and contractionary policy through AD and the multiplier, show crowding out with interest rates and a numerical case, and discuss limits.
Fiscal = the government's purse (spend, tax, borrow). Borrowing pushes r up, which crowds out private investment: full multiplier minus the lost investment.