Crowding out effect
Crowding out effect is the consequence of changes made by the government to fiscal policy that affect private investment and consumption. There are two types of crowding out; resource and financial, and there are two stages of crowding out; partial and complete. Resource crowding out occurs when the government uses up resources that would otherwise be used by the private sector, and financial crowding out occurs when the government spends more than it earns in tax revenues. By spending more than it earns the government is left with a budget deficit that needs to be made up by either raising taxes or borrowing. Borrowing causes the liquidity preference of money to rise.
Considerations of crowding out effect in economics
In crowding out private investors, economic productivity tends to take a rather immediate downturn as government spending is rarely aimed at construction of new factories, production of new consumer products, or the propensity for creating jobs. Granted, there are certain private investors given financial incentive by the government (i.e. Boeing with its defence contracts), but the ultimate goal of government borrowing is to maintain the status quo of the economy rather than actually stimulate further growth. The fatal flaw to the supposed solution of borrowing is that it only accounts for the short-term results and ignores the more than likely potential of augmenting the national deficit.
Crowding out effect prevention
Crowding out hampers the economy when a government crowds out private investment simply to fund more irresponsible spending habits, it does not just affect that particular country any more. Now that we live in an age when financial markets are hopelessly interconnected, the gamble of employing behaviour that will trigger the crowding out effect is no longer economically viable. While many economists still speculate about the validity of the crowding out theory, the best solution to eschewing its ramifications is for governments of every nation to start managing budgets as though they were tangible and stop looking at them from the perspective of a society dependent upon borrowing, loans and using credit.
Examples of Crowding out effect
- Resource Crowding Out: When a government increases its spending on infrastructure projects, resources such as labor, capital and land are taken away from the private sector, leading to a decrease in investment and consumption. This is known as resource crowding out.
- Financial Crowding Out: When a government increases its spending and does not generate enough revenue to cover it, it may have to resort to borrowing money to finance the deficit. This increases the demand for loanable funds, which in turn increases interest rates, resulting in a decrease in private investment and consumption. This is known as financial crowding out.
- Tax Crowding Out: When taxes are increased to cover the budget deficit, disposable income decreases, leading to a decrease in consumption. This is known as tax crowding out.
- Interest Rate Crowding Out: When the government borrows money to finance its deficit, it increases the demand for loanable funds, which in turn increases interest rates. This makes it more expensive for businesses to borrow money, leading to a decrease in private investment and consumption. This is known as interest rate crowding out.
Advantages of Crowding out effect
The advantages of the crowding out effect include:
- Increased government spending which can stimulate economic growth and provide a boost to consumer demand.
- Reduced unemployment due to the increased demand for labour, which can lead to higher wages and increased job security.
- Lowered interest rates due to the increased demand for loanable funds, which can lead to increased investment and consumption.
- Increased government revenues due to higher taxes, which can be used to fund public services and reduce budget deficits.
- Increased foreign direct investment due to improved economic stability, as investors are more likely to invest when governments are able to maintain fiscal responsibility.
Limitations of Crowding out effect
The limitations of crowding out effect include:
- The crowding out effect assumes that the government budget is fixed, which may not always be the case in reality. If the government has the capacity to adjust its budget, the crowding out effect may not occur, even if the government uses up resources.
- It also assumes that the economy is already operating at full employment, but if the economy is not, the crowding out effect may not occur.
- The crowding out effect does not take into account the impact of government spending on economic growth, which can be positive as well as negative.
- It also ignores the potential for private sector investment to increase as a result of increased government spending. Increased investment can lead to increased productivity and economic growth.
- Finally, it assumes that the government has perfect knowledge of the economy and can accurately predict the effects of its fiscal policies on the economy. This may not always be the case, as unexpected events or changes in the economy can have a significant impact on the outcome.
In addition to the two types of crowding out effects discussed above, there are other approaches related to this phenomenon. These include:
- Rational Expectations Theory: This theory suggests that a government’s fiscal policies can lead to crowding out if private sector participants anticipate that the government’s policies will lead to higher taxes or higher interest rates in the future.
- Monetary Policy: Central banks can also influence crowding out effects by altering the money supply in the economy. If the money supply is increased, the interest rate will decrease, resulting in an increase in private sector investment.
- Foreign Investment: Foreign investors may choose to invest in an economy if they believe that the government’s fiscal policy is beneficial to their returns. This can lead to a crowding out of domestic investors.
In summary, crowding out effects can be caused by both fiscal and monetary policies, as well as by foreign investments. They can lead to a decrease in private sector investment and consumption, and can have a significant impact on an economy’s growth prospects.
| Crowding out effect — recommended articles |
| Demand shock — Galloping inflation — Austrian business cycle theory — Damping effect — Deflation gap — Disinflation — Ratchet effect — Interventionism — Supply shock |
References
- Andreoni, J. (1993). An experimental test of the public-goods crowding-out hypothesis. The American Economic Review, 1317-1327.
- Buiter, W. H. (1977). "Crowding out" and the effectiveness of fiscal policy. Journal of Public Economics, 7(3), 309-328.
- The "Crowding Out" of Private Expenditures by Fiscal Policy Actions, Roger W. Spencer & William P. Yohe, 1970.
- The Effects of Government Deficits: A Comparative Analysis of Crowding Out (Essays in international finance), Charles E. Dumas, Princeton Univ Intl Economics, October 1985
- The crowding-out effect in a macro model with both government and private sector financing constraints, Federal Reserve Bank of New York (1975)
Author: Vira Lysovets
