The crowding-out effect occurs when an increase in government expenditures leads to a reduction in private-sector investment and consumption.
As government spending rises, aggregate demand also increases, contributing to a surge in overall consumption and a higher money supply in the economy.
To finance this increased expenditure, the government often borrows from financial institutions, which in turn raises interest rates. As interest rates climb, borrowing becomes more expensive for businesses and individuals, discouraging private investment and consumption. This shift can slow down economic activity in the private sector.
In periods of high inflation, one approach to mitigating inflationary pressures is not only to raise interest rates but also to reduce government spending.
When monetary policy is aligned with fiscal policy, which means a high interest rate along with the reduce government expenditures, it is possible to curb inflation at the targeted rate.
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