The interest rate can play a strong role in reducing the size of the multiplier. One economic model has estimated the multiplier to be about 2.0 if the interest rate is held constant, but only about 0.6 if the interest rate is allowed to rise.
All four examples of reactions that lower the multiplier value operate regardless of whether the initial stimulus to aggregate demand takes the form of an increase in government spending or an increase in some other form of aggregate demand. In the case of an increase in government spending, however, the means used to finance that spending can have an additional offsetting impact on aggregate demand, referred to as crowding out. This terminology comes about because if the government is to gain control over more resources, it may in part need to do so by shouldering aside, or crowding out, others who were controlling those resources.
7.2 Financing an Increase in Government Spending
The Keynesian story of the multiplier phenomenon, presented in chapter 4, traditionally sweeps under the rug the fact that the government must somehow finance an increase in spending. This is important because the means chosen to finance spending may have an influence on aggregate demand that to some extent could offset the stimulus of the fiscal action. An increase in government spending can be financed in three basic ways: raising taxes, selling bonds to the public, and selling bonds to the central bank (often referred to as printing money). Let us look at the crowding out that may occur with each of these three financing means.
If taxes are raised to finance an increase in government spending, consumers reduce consumption spending to be able to pay the higher taxes. The decrease in consumption demand partially offsets the increase in government spending, reducing the size of the multiplier. The offset is only partial because not all the financing for extra taxes comes from reducing consumption. Some comes from reducing saving, which is not a component of aggregate demand.
Selling Bonds to the Public
Keynesians implicitly assume the government sells bonds to the public to finance an increase in its spending. Crowding out comes about in two ways in this context:
1. Raising interest rates. To sell bonds the government must make them attractive, so it must raise the interest rate. The higher interest rate crowds out all types of spending, as explained earlier.