Question

Explain what is the crowding out effect. You can use a coordinate axis to support the explanation.

Answer 1

Crowding out refers to the adverse effect of high deficit spending by the government on private investment. More formally crowding out occurs when deficit spending by the government forces private investment spending to contract. The mechanism of crowding out is simple.

When the government takes recourse to high deficit spending, it plans to spend more than its tax revenue. the government has done to borrow from the central bank or from the market through the sale of its bond for the purpose of financing its budgetary deficit. the two methods of borrowing force crowding out of private investment in two different ways:

deficit spending financed to deficit financing results in net injection into the economy. This results in an increase in aggregate demand and therefore rise in general price level. more so when the government increases its spending on remote return projects like economic and social infrastructure projects, such as construction of irrigation canals, roads, etc. deficit spending results in an increase in money income at the rate of expenditure multiplier without a matching increase in the production of goods and services. This set an inflationary trend in the economy. To control inflation the central bank intervention becomes inevitable. The central bank will have to offset the expansionary effect of the government spending. In order to control inflation it tighten the ecredit availability and raises the interest rate. Ryzen interest rate chokes off or crowds out the private investment.

If deficit spending is finance through market borrowing, crowding out effect occurs even without Central Bank interventions by its tight money policy. when government spending is financed through market borrowing through the sale of Government bonds, bond prices go down and interest rate goes up. the rise in the interest rate causes a decline in all the interest sensitive private investment . besides when households decide to invest in Government bonds the investment in real estates decreases. Therefore it is argued that there is a fall in the private investment.

Complete crowding out

Complete crowding out occurs when the following private investment equals the amount of additional government spending. when there is complete crowding out then the total expansionary effect of the government spending is wiped out and the economy returns to the pri government spending equilibrium point. in other words the expansionary effect of government spending is completely neutralized by is crowding out effect. the case of complete crowding out can be explained to the national income equilibrium equation.

Suppose pre - deficit is pending equilibrium equation is given as:

AD = C+ I + G

With complete crowding out effect the equilibrium equation can be written as

AD = C + I + G + ∆G - ∆I

Since crowding out effect -∆I = ∆G, the equilibrium equation is reduced to AD = C+I+G