Using graphs, explain how indirect crowding out can occur when the government increases spending in an attempt to stimulate the economy.

What will be an ideal response?

ANSWER:

See the above figure. The original equilibrium is E1, where there is a contractionary gap. The government pursues expansionary fiscal policy by increasing spending. Its goal is to reach E2. However, the increased borrowing causes the interest rate to increase, so private investment spending falls. The aggregate demand curve shifts back to AD3.