The short-term effects of an expansionary fiscal policy are (a) an increase in AD, which leads to (b) an increase in GDP (y) and (c) an increase in the price level. Very soon, however, the increase in GDP results in an increase in MD, which, in turn, leads to an increase in the interest rate. The increase in the interest rate leads to a reduction in interest rate-sensitive expenditures. Thus, the initial increase in GDP caused by the expansionary fiscal policy is moderated to some extent. In the short-term, however, an expansionary fiscal policy caused both real GDP and the price level to increase.
An expansionary fiscal policy, however, also has an effect on investment expenditures. This effect is the process of crowding-out, which causes a reduction in investment expenditures. Crowding-out occurs when fiscal policy affects interest-sensitive expenditures. When an expansionary fiscal policy incre