Introduction

Today's world economy is characterized by a demand-constrained situation in general. Not only the developing world but also the developed world is facing the problem of lack of aggregate demand, which is being manifested in the form of coexistence of large-scale involuntary unemployment and underemployment along with unutilized capacity all over the globe. The level of actual output that is being produced is well below the level of potential output. This is so not because of a shortage of labourers but because of the fact that there is not enough demand in the market for that output to be sold and profit to be realized. In short, present day capitalism is suffering from an acute demand problem. Keynes (1936, 129) argued that a policy of ‘digging holes and filling them up’ can be beneficial for a demand-constrained economy characterized by large involuntary unemployment. The fiscal deficit always finances itself in the sense that it always generates an equal amount of extra net import plus private savings in excess of private investment in the ex post situation. But the expansionary government policy even under a demand-constrained situation is argued to be detrimental because the higher fiscal deficit would necessarily crowd out private investment by increasing the real rate of interest in the economy.

The objective of this particular work is to discuss, both theoretically and with support of empirical evidence, whether or not there is any necessary danger of crowding-out of private investment through increase in interest rate as an inevitable consequence of expansionary fiscal policy by deficit financing in an economy operating well below the full-employment level.