Question

what is the "crowding effect"? how does it affect economy?

Answer 1

Crowding In

Crowding in occurs when higher government spending leads to an increase in private sector investment.The crowding in effects occurs because higher government spending leads to an increase in economic growth and therefore encourages firms to invest because there are now more profitable investment opportunities.This is due to the income effect of higher government spending. If the economy is in a recession or below full capacity, expansionary fiscal policy can increase the economic growth rate and create a positive multiplier effect, which leads to greater private sector investment.

Crowding Out

Crowding out Effect refers to the tendency for increases in government spending to cause offsetting reductions in spending in the private sector. Sometimes, government spending just replaces private spending. Sometimes, government spending causes an increase in interest rates which leads to a decrease in private spending. A recession causes the government to borrow from the federal reserve, there is less savings for businesses, new investment gets choked off. Government spending reduces private spending.

Crowding out as a result of Dispalced Private Spending

Suppose the government provides funding for a new sports arena. It would appear that this increase in autonomous government spending would lead to a large multiplier effect and large increase in total output. But suppose that, in the absence of the government funding, the same arena would have been built using funds provided by the private sector. In this situation, there is no net gain as a result of the increase in autonomous spending by the government.
In this situation, the government spending has crowded out (or displaced) private spending. The government spending merely replaced private spending that would have occurred in the absence of the government spending.

Crowding Effect as a result of Higher Interest Rates

Suppose that an increase in autonomous spending leads to a budget deficit and an increase in the national debt. As a result, government borrowing increases. This increase in government borrowing may cause an increase in interest rates. An increase in interest rates may lead to a decrease in borrowing for consumption spending and investment spending. In this case, the increase in autonomous government spending crowded out consumption and investment spending that would have occurred in the absence of the government spending. In an increase in government spending has crowded out some consumption or investment spending, then the magnitude of the multiplier will be reduced.

Effect on Economy

• The magnitude of crowding out is the difference between the original equilibrium quantity and the new Quantity demanded when interest rates increase. The Nominal rates on the Money Market graph increases when crowding out occurs. Because of higher interest rates, the quantity of loanable funds that will be demanded by consumers and businesses is lower.
• Crowding out make expansionary policy less effective. The increase in AD that happens because of expansionary fiscal policy is offset by the decrease in AD that occurs because the government has crowded out Consumption and Investment spending in order to carry out that expansionary fiscal policy.
• Crowding out does not occur in case of contractionary fiscal policy. The decrease in government spending and/or increase in taxes moves us toward a budget surplus.The government needs to borrow less (or doesn't need to borrow at all) so the demand for loanable funds and the interest rate decrease (or doesn't change).
• To correct crowding out Fed has to monitize the debt. Monetizing the debt is when the central bank purchases bonds directly from the government to counteract crowding out. In other words, the Fed, instead of consumers and businesses, are buying the government bonds. Consumers and businesses are no longer given the opportunity to divert funds from private saving to buying government bonds, so the supply of loanable funds does not decrease and the interest rate does not increase. But monetizing the debt may lead to high inflation.