Final answer:
Increased government spending raises aggregate output and demand for money, potentially leading to higher interest rates and decreased planned investment due to the crowding out effect. The effect can be mitigated by central bank policies that maintain low interest rates.
Step-by-step explanation:
When the government increases spending, it typically leads to a chain of events impacting the economy. Initially, aggregate output is likely to increase due to the rise in aggregate demand (AD) as government spending is a component of AD. This higher demand for goods and services may push up the price level, leading to inflationary pressures. As the economy grows, demand for money also increases, which, without any actions from the monetary authority, can raise interest rates. Higher interest rates may then lead to a decrease in planned investment due to the higher cost of borrowing.
The crowding out effect refers to the scenario where increased government spending and the consequent rise in interest rates lead to a decrease in private sector spending, particularly investment. This happens because as the government borrows more funds for its spending, there's less capital available for private investors, driving up interest rates. To fix the crowding out effect, the central bank could intervene to keep interest rates low (for example, by increasing the money supply), which may encourage investment and counteract the government's borrowing impact on the private sector.