When the government increases its purchases, the increase in aggregate demand could be more than or less than the increase in government purchases, depending on whether the multiplier effect or the crowding-out effect is larger.

Question

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The multiplier effect occurs when the increase in government purchases leads to an even larger increase in aggregate demand through a chain reaction of increased spending and income. This can be greater than the initial increase in government purchases. On the other hand, the crowding-out effect occurs when the government's increased borrowing to finance its purchases leads to higher interest rates, causing a reduction in private investment and consumption, and therefore a smaller overall increase in aggregate demand. Which effect is larger depends on various factors, such as the state of the economy and the magnitude of the initial increase in government purchases.

When the Government Increases Its Purchases, the Increase in Aggregate