Question

2. The Japanese government's stimulus spending will result in a large increase in the government's budget deficit. Some economists, however, are relatively unconcerned that crowding out would significantly reduce the effect of the stimulus spending on real GDP. Briefly explain the two types of crowding out, and explain why the Japanese government would be relatively unconcerned about it arising from its stimulus package.

Answer 1

Crowding out: When the government spending increase the aggregate demand in the economy along with interest rates the private spending will decrease both on its investment and consumption.

Two types of crowding out:

1) Physical crowding out: Government increase the public sector expenditure by starting new projects on infrastructure and development which increases the employment rate along with it it pays higher wages to employees to attract more people even from private sector. Thus making the private sector to either increase the wages or reduce the investment in new projects which make them to decrease their expenditure.

2) Financial crowding out: To increase its spending government needs more money which they get from people by selling their securities at higher interest rates. Thus when interest rates go up people will by those securities which helps the government to get money they need. When interest rates go up private sector will not make any new investment as they have to pay high amount as interest.

Japanese government is not concerned about its rising spending because they want the economy to grow to a level where there is full employment, people earn more money as higher interest rates thus making the nominal income in the hands of increase which makes the economy to grow faster and government to cover it's deficit.