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Crowding Out

Crowding out occurs when government borrowing and spending raises interest rates, reducing private sector investment. Higher interest rates make private investment less attractive as the return is lower. However, government spending can also stimulate private investment through increasing demand, known as the accelerator effect. The degree of crowding out depends on the state of the economy - it is more severe when the economy is already at full employment and capacity as there is no room for increased demand to stimulate more private sector activity.

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91 views

Crowding Out

Crowding out occurs when government borrowing and spending raises interest rates, reducing private sector investment. Higher interest rates make private investment less attractive as the return is lower. However, government spending can also stimulate private investment through increasing demand, known as the accelerator effect. The degree of crowding out depends on the state of the economy - it is more severe when the economy is already at full employment and capacity as there is no room for increased demand to stimulate more private sector activity.

Uploaded by

Akanksha Srivastava
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Crowding out (economics)

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In economics, crowding out theoretically occurs when the government expands its
borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit
spending), crowding out private sector investment by way of higher interest rates. To the
extent that there is controversy in modern Macroeconomics on the subject, it is because
of disagreements about how financial markets would react to more government
borrowing.

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.

However, this crowding-out effect is moderated by the fact that government spending
expands the market for private-sector products through the multiplier and thus stimulates
– or "crowds in" – fixed investment (via the "accelerator effect"). This accelerator effect
is most important when business suffers from unused industrial capacity, i.e., during a
serious recession or a depression.

Crowding out can, in principle, be avoided if the deficit is financed by simply printing
money, but this carries concerns of accelerating inflation

Crowding out of another sort may occur due to the prevalence of floating exchange rates.
Government borrowing leads to higher interest rates, which attract inflows of money on
the capital account from foreign financial markets into the domestic currency (i.e., into
assets denominated in that currency). Under floating exchange rates, that leads to
appreciation of the exchange rate and thus the "crowding out" of domestic exports (which
become more expensive to those using foreign currency). This counteracts the demand-
promoting effects of government deficits but has no obvious negative effect on long-term
economic growth.

In the United States during the late 1990s, another kind of crowding out of exports
occurred: large increases in private fixed investment and consumer spending encouraged
high interest rates, a high dollar exchange rate, and hurt exports.
Crowding out is most serious 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 the private sector. This
phenomenon is sometimes called "real" crowding out.

The negative effects on long-term economic growth that occur when private fixed
investment are crowded out can be moderated if the government uses its deficit to finance
productive investment in education, basic research, and the like. The situation is made
worse, of course, if the government wastes borrowed money on such things as "pork
barrel" projects and tax cuts for the political allies of the current politicians.

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