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 refers to a situation in which an increase in government expenditure or investment, leads to a decline in the private investment such that the total output is not affected and the fiscal policy has limited effect.

Let us consider an example. we have interest rates depending on government expenditure and private investment dependent on the interest rate as follows:

Interest rate = x + a*Government spending

Private investment = P - b*interest rate

Let a = 0.1 and the government spending increase by 100

This increases the interest rate by 10

Now, let b = 10

Thus, change in private investemnt = -10*10 = -100

This is an example of complete crowding out where the increase in interest rate is such that the entire increase in government investment is compensated by a decrease in private investment.

If b < 10, then there will be incomplete crowding out and the total investment will increase.

In the case of complete crowding out, the fiscal policy is very ineffective as it can not be used to stimulate output. Whereas, in the case of incomplete crowding out, the fiscal policy is more effectibe in stimulating output as the the government can increase the total investment.