Question

Define crowding out. Give a hypothetical numerical example to show the difference between complete crowding out and incomplete crowding out. Explain how complete and incomplete crowding out could impact the effectiveness of fiscal policy.

Answer 1

Crowding out occurs when private expenditures (consumption, investment, net exports) fall as a consequence of increased government spending or the financing needs of a budget deficit. Complete crowding out occurs when the cutback in private expenditures is equal to the increase in government spending, and incomplete crowding out occurs when the cutback in private expenditures is less than the increase in government spending. For example, suppose that government spending increases by $1 billion. If private expenditures then fall by $1 billion it would be termed complete crowding out and if private spending falls by $800 million it would be termed incomplete crowding out. In the case of complete crowding out, there would be no resulting impact on Real GDP from the increased government spending, fully negating the use of the fiscal policy. In the case of incomplete crowding out, Real GDP would grow somewhat, but not by as much as it would have in the absence of crowding out.