By: Maggie Little
Crowding out refers to any issue with government expansionary fiscal policy. Usually these issues cause the expansionary fiscal policy to have little to no or even a negative effect on output. Typically, crowding out occurs when the government issues deficit spending. Then the government has to seek more loans which causes the demand for loan able funds to increase. This increase of demand causes interest rates to increase which decreases the amount of Investment in the economy because businesses have to pay more for loans. This decrease in Investment hurts the economy and counterbalances the expansionary fiscal policy that was supposed to increase demand. Watch the video for more explanation.
Macro 4.7- Loanable Funds & Crowding Out
In expansionary fiscal policy, you would shift AD to AD1 by increasing government spending (Policy Graph). This would cause MD (demand for loans) to increase to MD1(Loan able Funds Graph). Thus increasing interest rates. Higher interest rates cause aggregate demand to shift down to AD2. If we wanted to combat this decrease in AD and try to keep interest rates set at the same level, we could shift MS (the money supply) to MS1.