LRC - Crowding Out Lesson

Crowding Out

Introduction

Crowding out occurs when the government borrows to pursue expansionary fiscal policy and such government borrowing replaces private borrowing and spending. Because some private borrowing and spending is “crowded out” of the economy, part of the increase in aggregate demand from increased government spending (and/or decreased taxes) is offset by a decrease in aggregate demand from decreased consumption and investment as interest rates rise. The crowding-out effect refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.

 

 

How does "Crowding Out" Happen?

Expansionary fiscal policy increases aggregate demand and moves the budget towards a deficit. If deficit spending is financed through borrowing, the government will demand loanable funds. The government’s demand for loanable funds (Dlf) is added to the demand for loanable funds by private borrowers. Thus expansionary fiscal policy increases Dlf and may cause interest rates to rise. Because the government is borrowing money to finance its expansionary fiscal policy, consumers and businesses will be “crowded out” of financial markets. If consumers and businesses are not able to borrow to finance spending, it will lead to a decrease in aggregate demand (AD).

Crowding out occurs when the government borrows to pursue expansionary fiscal policy and such government borrowing replaces private borrowing and spending. Because some private borrowing and spending is “crowded out” of the economy, part of the increase in aggregate demand from increased government spending (and/or decreased taxes) is offset by a decrease in aggregate demand from decreased consumption and investment as interest rates rise.

Let's review aggregate demand and aggregate supply before moving on.

 

 

 

Let's Take a Closer Look at Crowding Out

Use the graph presentation below to learn how crowding out occurs.

Crowding Out Effect

The presentation below will cover the crowding out effect on our economy. 

 

Review

Review what you have learned by completing the activity below.

 

In Summary . . .

A higher interest rate causes decreases in investment and other interest-sensitive components of aggregate demand.

Crowding-out is the decrease in private demand for funds that occurs when the government’s demand for funds causes the interest rate to rise.

The demand by government for loanable funds decreases or crowds-out the private demand for loanable funds.

 

IMAGES CREATED BY GAVS