Question

Explain why government budget deficits crowd out private investment spending in a closed economy, but crowd out net exports in a small open economy. Assume prices are flexible and that factors of production are fully employed in both economies. Use the basic version of the open-economy model that abstracts from foreign debt accumulation.

Answer 1

In a Closed economy,

Increase in budget deficit i.e. increase in government spending increases the transaction demand for money in the market leading to an increase in interest rate. This increase in interest rate leads to an increase in cost of borrowing which disincentivises the private investment, thus, decreasing it. This is called crowding out of investment spending.
If the economy is open, this increase in interest rate makes the home country more beneficial for financial investments as returns have increased. So, this decreases net capital outflow leading to appreciation of domestic currency. This appreciation makes exports from the home country expensive decreasing their demand and makes imports cheaper increasing their demand, thus, decreasing net exports. This is crowding out of net exports.

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