Question

Question - Explain the Domestic Crowding out effect and the international Crowding out effect. Explain the implication of Domestic and international crowding out and show them on the graph.

Answer 1

Domestic Crowding out effect is a situation that arise when rising government spending reduces or eliminates the private sector spending. Increase in government spending leads higher amount of government borrowing . The substantial amount of government borrowing results higher demand for loanable funds. As demand for loan able fund rises,rate of interest will increase. It will reduce or eliminates private investment. Because firms often fund such projects through financing, they were now discouraged from doing so because the opportunity cost of borrowing will be risen. Therefore it will reduce the private investment
International crowding out may occur due to the prevalence of floating exchange rate,as explained by the Mundel-Fleming model. When the economy is open to international trade, international flows of short term capital in response to international differences in interest rates usually leads to rise in interest rate. The overvaluation of currency "crowds out" the tradable goods and services of the countries and enhance the profit rates of foreign competitors. Government borrowing leads to higher interest rate, which attracts inflow of money into capital account from foreign financial markets to domestic financial markets. Under floating interest rate leads to appreciation of domestic currency and its results crowding out of exports of domestic economy ( exports become more expensive)