- Definition: A situation where the government spends more than it receives in revenue (mainly taxation), and needs to borrow money, forcing up interest rates and “crowding out” private investment and private consumption, since it becomes more expensive to borrow money.
- From the diagram:
- The increased demand for ‘loanable funds’ (D → D1) results in an increase in the interest rate from i1 → i2.
- Increased interest rates leads to a fall in investment from I1 → I2.
- The increased government spending was intended to increase Aggregate Demand… but the higher interest rate causes investment to fall, thus reducing Aggregate Demand.
- Consumption (C) may also fall and further reduce AD.
- The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free-market economists argued against the rising share of GDP being taken by the public sector.
- The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower.
- If the government runs a big budget deficit, it will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may then crowd-out private investment and consumption, offsetting the fiscal stimulus.
- Eventually higher government spending needs to be funded by higher taxes and this again acts as a squeeze on spending and investment by the private sector of the economy.
Rational Expectations View
- According to a school of economic thought that believes in ‘rational expectations’, when the government sells debt to fund a tax cut or an increase in expenditure, a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments.
- Thus, he/she should increase his savings as there has been no increase in his permanent income
- The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become ineffective.
Keynesian response to the crowding out view and rational expectations view
- The probability of 100% crowding-out is remote, especially if the economy is operating below its capacity and if there is a plentiful supply of saving available to purchase newly issued state debt
- Keynesian economists such as Paul Krugman argue that fiscal deficits crowd-in private sector investment. Well-targeted, timely and temporary increases in government spending can absorb under-utilised capacity and provide a strong multiplier effect that generates extra tax revenue.