Explain how fiscal policy works and discuss the crowding-out effect.

1. 1 · Define fiscal policy. Government spending, taxation and borrowing used to influence aggregate demand; set in the annual Budget.
2. 2 · Expansionary and contractionary policy. G ↑ or T ↓ in a recession; G ↓ or T ↑ against inflation or debt.
3. 3 · How it works. Higher G raises AD, output and incomes, with further rounds through the multiplier.
4. 4 · Draw the effect. [Diagram: AD shifting right in the AD-AS model, or IS shifting right in IS-LM with the interest rate rising]
5. 5 · Explain crowding out. Borrowing raises interest rates and cuts private investment; partial or full; weaker in recession, stronger at full employment.
6. 6 · Numerical illustration. ΔG = 50, k = 4: expected ΔY 200; ΔI = −20 so ΔY = 120; 80 crowded out.
7. 7 · Sri Lankan business link. Infrastructure spending helps construction firms, but heavy government borrowing raises loan costs for private business.
8. 8 · Limits and conclusion. Time lags, debt, import leakage and crowding out limit fiscal policy; it works best in a recession and with sustainable debt.

Scoring tip: Name crowding out as a weakness of fiscal policy and explain the interest rate link in one clear sentence.