Discuss why many economists maintain that continued deficit spending by government is likely to "crowd out" (decrease) investment spending in the long run.

Question

What will be an ideal response?

Answer 1

The long-run real interest rate is the rate that equates aggregate demand with potential output. If government purchases increase or deficit spending continues to increase, this causes aggregate demand to increase. This increase in non-interest sensitive spending in the short run is likely to lead to an expansionary gap which will put upward pressure on the long-run real interest rate. The increased real interest rates will cause interest-sensitive spending to decrease. The most interest-sensitive spending is investment, so often it is argued that large government borrowings lead to reduced private investment. A more general argument could be that government deficits will crowd out private interest-sensitive spending in the long run.