question: How does increasing government spending affect aggregate demand in the economy?
comment: The general idea is that aggregate demand is comprised of _all_ of the entities buying goods. That includes individual consumers, businesses, foreign firms and governments. If any of those groups starts buying more, then aggregate (i.e. total) demand goes up, so increasing in spending from any of them can increase aggregate demand. The US Government is somewhat special in this regard, though, as it basically has access to unlimited funds over the short term. If the economy is flagging due to low demand, it can take on debt with incredible ease and spend that money in the economy buying goods and services. The firms that sell goods to the government then take that money and buy goods and services of their own, so every $1 spend by the government could have a 3-6x effect on demand. Then, once the economy is good again, spending can be reduced, taxes increased and the debt paid back. Of course, that is a very Keynesian opinion. Ask a Chicago-school economist and they will tell you that government spending has zero effect on aggregate demand...
passages: In economics, the potential "shifting" in resources from the private sector to the public sector as a result of an increase in government deficit spending is called crowding out. The figure to the right depicts the market for capital, otherwise known as the market for loanable funds. The downward sloping demand curve D1 represents demand for private capital by firms and investors, and the upward sloping supply curve S1 represents savings by private individuals. The initial equilibrium in this market is represented by point A, where the equilibrium quantity of capital is K1 and the equilibrium interest rate is R1. If the government increases deficit spending, it will borrow money from the private capital market and reduce the supply of savings to S2. The new equilibrium is at point B, where the interest rate has increased to R2 and the quantity of capital available to the private sector has decreased to K1. The government has essentially made borrowing more expensive and has taken away savings from the market, which "crowds out" some private investment. The crowding out of private investment could limit the economic growth from the initial increase government spending.
   BULLET::::- gross private domestic investment (formula_6), such as spending by business firms on factory construction. This is conceived as all private sector spending aimed at the production of some future consumable.
   Section::::Shifts.
  
  One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to that of a lower saving rate or increased private fixed investment, increasing the amount of demand for goods at each individual interest rate. An increased deficit by the national government shifts the IS curve to the right. This raises the equilibrium interest rate (from i to i) and national income (from Y to Y), as shown in the graph above. The equilibrium level of national income in the IS-LM diagram is referred to as aggregate demand.
   Underlying tax manipulation as a stimulant or suppression of consumer spending is an equation for Gross Domestic Product (GDP). The equation is GDP = C + I + G + NX, where C is private consumption, I is private investment, G is government and NX is the net of exports minus imports. Increases in government spending create demand and economic expansion. However, government spending increases translates to tax increases or deficit spending. This creates a potential negative impact on private consumption, investment, and/or the balance of trade.
  
  Section::::Macroeconomic factors.:Consumer sentiment.
   The aggregate demand curve illustrates the relationship between two factors: the quantity of output that is demanded and the aggregate price level. Aggregate demand is expressed contingent upon a fixed level of the nominal money supply. There are many factors that can shift the AD curve. Rightward shifts result from increases in the money supply, in government expenditure, or in autonomous components of investment or consumption spending, or from decreases in taxes.
  
  According to the aggregate demand-aggregate supply model, when aggregate demand increases, there is movement up along the aggregate supply curve, giving a higher level of prices.
  
  Section::::History.
   BULLET::::- gross government investment and consumption expenditures (formula_7), also determined as formula_23, the difference of government expenditures and taxes. An increase in government expenditures or decrease in taxes, therefore leads to an increase in GDP as government expenditures are a component of aggregate demand.
  
  BULLET::::- net exports (formula_24 and sometimes (formula_25)), net demand by the rest of the world for the country's output. This contributes to the current account.
  
  In sum, for a single country at a given time, aggregate demand (formula_26 or formula_27) is given by formula_28.
   If increased borrowing leads to higher interest rates by creating a greater demand for money and loanable funds and hence a higher "price" ("ceteris paribus"), the private sector, which is sensitive to interest rates, will likely reduce investment due to a lower rate of return. This is the investment that is crowded out. The weakening of fixed investment and other interest-sensitive expenditure counteracts to varying extents the expansionary effect of government deficits. More importantly, a fall in fixed investment by business can hurt long-term economic growth of the supply side, i.e., the growth of potential output.
   Section::::Crowding out from government borrowing.:Two extreme cases.
  
  Section::::Crowding out from government borrowing.:Two extreme cases.:Liquidity trap.
  
  If the economy is in a hypothesized liquidity trap, the "Liquidity-Money" (LM) curve is horizontal, an increase in government spending has its full multiplier effect on the equilibrium income. There is no change in the interest associated with the change in government spending, thus no investment spending cut off. Therefore, there is no dampening of the effects of increased government spending on income. 
   Where 'AD' is aggregate demand, 'C' is consumption, 'I' is investment, 'G' is government expenditures, 'X' is exports, and 'M' is imports.
   A deficit does not simply stimulate demand. If private investment is stimulated, that increases the ability of the economy to supply output in the long run. Also, if the government's deficit is spent on such things as infrastructure, basic research, public health, and education, that can also increase potential output in the long run. Finally, the high demand that a government deficit provides may actually allow greater growth of potential supply, following Verdoorn's law.
   The term "crowding out" refers to the extent to which an increase in the budget deficit offsets spending in the private sector. Economist Laura D'Andrea Tyson wrote in June 2012, "By itself an increase in the deficit, either in the form of an increase in government spending or a reduction in taxes, causes an increase in demand". How this affects output, employment, and growth depends on what happens to interest rates:
   Aggregate supply is targeted by government "supply-side policies" which are meant to increase productive efficiency and hence national output. Some examples of supply-side policies include education and training, research and development, supporting small/medium entrepreneurs, decreasing business taxes, making labour market reforms to diminish frictions that may hold down output, and investing in infrastructure.
  
  Section::::Different scopes.
  
  There are generally three alternative degrees of price-level responsiveness of aggregate supply. They are:
   Crowding out is most plausibly effective when an economy is already at potential output or full employment. Then the government's expansionary fiscal policy encourages increased prices, which lead to an increased demand for money. This in turn leads to higher interest rates ("ceteris paribus") and crowds out interest-sensitive spending. At potential output, businesses are in no need of markets, so that there is no room for an accelerator effect. More directly, if the economy stays at full employment gross domestic product, any increase in government purchases shifts resources away from the private sector. This phenomenon is sometimes called "real" crowding out.
   The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for loanable funds by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the real interest rate. A higher real interest rate increases the opportunity cost of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has "crowded out" investment.
  
  Section::::Crowding out from government borrowing.:What factors determine how much crowding out takes place?
   The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Thus the effect of the stimulus is offset by the effect of crowding out. On the other hand, if the economy is below capacity and there is a surplus of funds available for investment, an increase in the government's deficit does not result in competition with the private sector. In this scenario, the stimulus program would be much more effective. In sum, changing the government's budget deficit has a stronger impact on GDP when the economy is below capacity. In the aftermath of the 2008 subprime mortgage crisis, the U.S. economy remained well below capacity and there was a large surplus of funds available for investment, so increasing the budget deficit put funds to use that would otherwise have been idle.
   When there is considerable excess capacity, an increase in government borrowing to finance an increase in the deficit does not lead to higher interest rates and does not crowd out private investment. Instead, the higher demand resulting from the increase in the deficit bolsters employment and output directly. The resultant increase in income and economic activity in turn encourages, or 'crowds in', additional private spending.
  
  Some argue that the 'crowding-in' model is an appropriate solution for current economic conditions."
  
  Section::::Theoretical considerations.:Government budget balance as a sectoral component.
   A post-Keynesian theory of aggregate demand emphasizes the role of debt, which it considers a fundamental component of aggregate demand; the contribution of change in debt to aggregate demand is referred to by some as the . Aggregate demand is "spending," be it on consumption, investment, or other categories. Spending is related to income via:
  
  Rearranging this yields:
   For example, unemployed home builders can be hired to expand highways. Tax cuts allow consumers to increase their spending, which boosts aggregate demand. Both tax cuts and spending have multiplier effects where the initial increase in demand from the policy percolates through the economy and generates additional economic activity.
   Whether an incremental increase to government spending will have a multiplier effect is thought to depend on circumstances in the economy: first, particularly on the extent to which unemployment of resources may be high, so that the additional demand represented by government purchases may be realized by additional production and higher utilization of resources, without bidding up prices; second, by the state of the financial and credit markets, where demand for money and money instruments may welcome additional government debt as low-risk securities, but may regard investment in private production capacity or capital formation as too risky, given a low level of general business activity.
   This means that any one of these components can change and affect the aggregate demand, and large individual increases in these specific components can have the short run effect of raising the overall price of goods. This is known as Demand-pull inflation since the change to overall prices were triggered, or "pulled," by the changes in the aggregate demand. Short run increases in demand can cause output to increase, putting upward pressure on prices. In the long run, this can cause demand to decrease; or, if demand remains at a higher quantity of output, then the aggregate supply curve will also shift to a higher level of output and reach equilibrium at a higher quantity. Growth in long-run aggregate supply can be caused by increases in productive capacity through new infrastructure, new factories, increases in the working population, and labor productivity via technology, education, training or efficiency gains.
   Thus, with a vertical LM curve, an increase in government spending cannot change the equilibrium income and only raises the equilibrium interest rates. But if government spending is higher and the output is unchanged, there must be an offsetting reduction in private spending. In this case, the increase in interest rates crowds out an amount of private spending equal to increase in government spending. Thus, there is full crowding out if LM is vertical.
  
  Section::::Crowding out sources.
   Carefully using ideas from the theory of supply and demand, aggregate supply can help determine the extent to which increases in aggregate demand lead to increases in real output or instead to increases in prices (inflation). In the diagram, an increase in any of the components of formula_27 (at any given formula_30) shifts the formula_27 curve to the right. This increases both the level of real production (formula_4) and the average price level (formula_30).
   Beyond formula_41, this gets more intense, so that price increases dominate. Worse, output levels greater than formula_41 cannot be sustained for long. The formula_45 is a "short-term" relationship here. If the economy persists in operating above potential, the formula_45 curve will shift to the left, making the increases in real output transitory.
   BULLET::::- A change in government spending
  
  BULLET::::- A change in consumption
  
  BULLET::::- A change in taxes
  
  BULLET::::- A change in the monetary rule
  
  "Example": Suppose the government were to cut taxes. This would lead to an increase in expenditures and thus an increase in demand. The demand curve would therefore shift to the right and real GDP would be growing above potential. The inflation adjustment line would then shift upward (reflecting an increase in the inflation rate) causing a movement along the new demand curve until real GDP was equal to potential.
  
  Section::::More advanced.
   The extent to which interest rate adjustments dampen the output expansion induced by increased government spending is determined by:
  
  BULLET::::- Income increases more than interest rates increase if the LM (Liquidity preference—Money supply) curve is flatter.
  
  BULLET::::- Income increases less than interest rates increase if the IS (Investment—Saving) curve is flatter.
  
  BULLET::::- Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift in the IS curve.
  
  In each case, the extent of crowding out is greater the more interest rate increases when government spending rises.
  