If a government
wishes to persue expansionary fiscal policy, it may have to run a budget deficit. This means that it will have to borrow the difference between its spending and its revenue, necessitating a PSBR
. Let us say that the government needs to borrow £10 billion
. This increase in demand
for borrowed funds in the economy may increase the price of borrowing i.e. the interest rate.
However, an increase in the rate of interest is likely to cause a fall in the level of consumption and investment in the economy. This suggests that a government's attempts to increase AD by raising government spending may be frustrated if its need to borrow causes interest rates to rise, as this may reduce investment and consumption. In such circumstances, public sector spending will simply 'Crowd Out' private sector spending. AD will not rise, government spending will go up but consumption and investment will fall.