The IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y). In economics, crowding out is a phenomenon occurring when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing investment spending. That means increase in government spending crowds out investment spending.
Changes in fiscal policy shifts the IS curve, the curve which describes equilibrium in the goods market. A Fiscal Expansion shifts IS curve to the right from IS1 to IS2. A fiscal expansion increases equilibrium income from Y1 to Y2 and interest rates from i1 to i2. At unchanged interest rates i1, the higher level of government spending increase the level of Aggregate Demand. This increase in demand must be met by rise in output. At each level of interest rate, equilibrium income must rise by the multiplier times the increase in government spending.
If the interest rate stayed constant at i1, the goods market is in equilibrium in that planned spending equals output, but the assets market is no longer in equilibrium. Income has increased, and, therefore, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms planned spending declines at higher interest rates, thus the aggregate demand falls. Therefore, the equilibrium is at higher interest rates. The adjustment of interest rates and their impact on aggregate demand dampen the expansionary effect of the increased government spending.
- What factors determine how much crowding out takes place?
- Two Extreme Cases
- The Liquidity Trap
- The Classical Case and Crowding Out
- Is Crowding Out Likely?
What factors determine how much crowding out takes place?
The extent to which interest rate adjustments dampen the output expansion induced by increased government spending is determined by:
- Income increases more, interest rates increase less, the flatter LM curve.
- Income increases less, interest rates increase less, the flatter IS curve.
- Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift in the IS curve.
In each case, the extent of crowding out is greater the more interest rate increases when government spending rises.
Two Extreme Cases
The Liquidity Trap
If the economy is in the liquidity trap, the LM curve is horizontal, an increase in government spending has its full multiplier effect on the equilibrium income. There is no change in the interest associated with the change in government spending, thus no investment spending cut off. Therefore no dampening of the effects of increased government spending on income. If the demand for money is very sensitive to interest rates, so that the LM curve is almost horizontal, fiscal policy changes have a relatively large effect on output, while monetary policy changes have little effect on the equilibrium output. So, if the LM curve is horizontal, monetary policy has no impact on the equilibrium of the economy and the fiscal policy has a maximal effect.
The Classical Case and Crowding Out
If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium income and only increases the interest rates. If the demand for money is not related to the interest rate, as the vertical LM curve implies, then there is unique level of income at which the money market is in equilibrium.
Thus, with vertical LM curve, an increase in government spending cannot change the equilibrium income and only raises the equilibrium interest rates. But if government spending is higher and the output is unchanged, there must be an offsetting reduction in private spending. In this case, the increase in interest rates crowds out an amount of private spending equal to increase in government spending. Thus, there is full crowding out if LM is vertical.
Is Crowding Out Likely?
The question is how seriously we must take the possibility of crowding out? This is discussed in three points given below.
- Consider an economy with given prices, in which the economy operates below full employment. Under such conditions, when fiscal expansion increases demand, firms can increase their output by hiring more workers. But if the economy is at full employment level, crowding out becomes a much more realistic possibility because firms cannot increase their output through additional hiring. In this situation an increase in demand will lead to an increase in price level rather than an increase in output.
- In an economy with unemployed resources full crowding out will not occur because the LM curve is not vertical. A fiscal expansion will raise interest rates, but income will also rise depending on the slope of the LM curve. Crowding out, if it occurs, is thus a matter of degree.
- Monetary authorities can accommodate a fiscal expansion by increasing the money supply, thus dampening any rise in interest rates. This monetary accommodation is referred to as "monetizing the deficit", where the central bank prints money to buy bonds issued by the government to pay for its expansionary deficit. In this case, both IS and LM curves shift to right, resulting in increased output at the same interest rate. Thus with an appropriate monetary policy complementing fiscal policy, there need not be any crowding out of private investment.
Roger W. Spencer & William P. Yohe, 1970. The 'Crowding Out' of Private Expenditures by Fiscal Policy Actions , Federal Reserve Bank of St. Louis Review, October, pp. 12-24
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