Question

Explain crowding out of investment via increased government spending using both the AD-AS framework and closed-economy loanable funds simultaneously, drawing both the short-run and long-run equilibria.?

Answer 1

The crowding out effect can be explained using the AD schedule and the lonable funds schedule.

Crwoding out basically means when increased government expenditure discourages private expenditure. This happens when the government, recognizing its need to spend more perhpas to boost the economy, plans to borrow more. When the government borrows more, the demand for loanable funds increases at constant supply of loanable funds, which leads to an increase in the interest rates in the economy. This increase in the rate of interest then by dafault discourages private units in the economy from borrowing and spending. Thus, even as the government expenditure increase raises the country's output levels, the reduction in private expenditure reduces this output. This is called crowding out.

Consider the following AD-schedule and loanable funds schedule.

At current levels of government expenditure, the AD curve cuts the 45 degree line at point E1 where the output level is Y1. When the government expenditure increases, the output levels increase and this shifts the AD curve to intersect the 45 degree line at point E2, where the new level of income is Y2. However, once this borrowing raises the interest rates, as is seen in the loanable funds schedule in the right panel, where the demand curve for loanable funds denoted by DL shifts upwards from DL1 to DL2 and at constant supply of funds SL, the interest rates rise from r1 to r2, thus discouraging private investors to spend less, and the AD curve in the left panel shifts downwards to cut the 45 degree line at point E3, where the out has not reduced from Y2 to Y3.

In the long run, the crowding out effect causes lower capital to be formed or invested in the economy. This is because if interest rates are high, then the firms will borrow less and henceforth spend less on increasing capital intensive technology which increase production. Becasue of this, in the long run the aggregate supply curve will shift to the left, and the output levels will be lower than that which could have been achieved had the interest rates been lower. However, the aggregate demand curve will also have shifted towards the right because of the increased government spending, so the net effect can only be seen in terms of which of these two effects have dominated.