Refer to the figure. If the economy is at E and the government target a spending
ID: 1227018 • Letter: R
Question
Refer to the figure. If the economy is at E and the government target a spending increase to move the aggregate demand curve to AD3, but the increase in spending only shifts the aggregate demand curve to AD2. Which of the following is a possible explanation as to why the targeted increase did not move the aggregate demand curve to AD3?
A. The increased borrowing to fund the spending caused interest rates to fall. B. The short-run aggregate supply curve is steeper than the figure indicates. C. Complete crowding out has occurred. D. Some crowding out has occurred. Submit Answer
Explanation / Answer
Option (D).
When government increases its spending, budget deficit rises, to finance which, government borrows more. Higher borrowing leads to higher interest rate, which decreases investment demand. As government spending rises but investment demand falls somewhat, aggregate demand cannot increase to the maximum possible extent. This is called a partial crowding out.
Not that if there is full crowding out, then
Increase in government spending = Decrease in investment demand, and so, Aggregate demand remains unchanged.