The Crowding Out Effect

Olivia Pruitt

The crowding out effect deals with the negative effects of expansionary fiscal policy on private investment and consumption. When the economy is in a recession and the government increases spending to stimulate demand, it can have the exact opposite effect. At first the aggregate demand is increased due to the increasing government spending (CIGX), and the price level and output in the economy rise as well. Nominal GDP is also increased and as a result, the demand for money is increased. Interest rates in the money market will rise due to the pressure now put on the supply of money.These high rates drive down the private investment and consumption because businesses in the private sector now have to pay more to the banks for loans. As the components of aggregate demand fall (CIGX), AD will follow suit. Therefore, the increase in government spending financed by borrowing will "crowd out" private investment and lower aggregate demand.
Fiscal Policy - Crowding-out Effect
Another way to explain the crowding out effect is in the loanable funds market. The increased spending is financed by the government borrowing money from the economy. Expansionary fiscal policy is dominated by the increase of the budget deficit; spending more than is collected in taxes. The government issues US Treasury Bills and Bonds in order to raise money to finance the spending. This causes the demand for loanable funds to increase, and the interest rate to rise as well in that market. Higher interest rates mean lower investment from the private sector because rates climb to a point where only the governemnt can afford to borrow. All eventually leads to a decrease in aggregate demand and a detrimental blow to the economy.