Crowding Out

Effects of Crowding Out

The effects of crowding out can be seen in the private sector and the economy in several ways.

There are short-run and long-run effects of crowding out. These are summarized in Table 1 below:

Table 1. Short and long-run effects of crowding out - StudySmarter

Loss of private sector investment

In the short run, when government spending crowds out the private sector from the loanable funds market, private investment decreases. With higher interest rates caused by the increased demand by the government sector, it becomes too expensive for businesses to borrow funds.

Businesses often rely on loans to further invest in themselves such as building new infrastructure or purchasing equipment. If they cannot borrow from the market, then we see a decrease in private spending and a loss of investment in the short run which reduces aggregate demand.

In the example above, the firm could not invest in expanding its production due to the higher price of funds. The firm has been crowded out of the loanable funds market and it cannot increase its production output.

Rate of capital accumulation

Capital accumulation happens when the private sector can continuously purchase more capital and reinvest in the economy. The rate at which this can happen is partially determined by how much and how quickly funds are invested and reinvested into a country's economy. Crowding out slows the rate of capital accumulation. If the private sector is being crowded out of the loanable funds market and can not spend money in the economy, then the rate of capital accumulation will be lower.

Loss of economic growth

Gross Domestic Product (GDP) measures the total value of all final goods and services a country produces in a given time period. In the long run, crowding out causes a loss of economic growth because of the slower rate of capital accumulation. Economic growth is determined by the accumulation of capital which allows more goods and services to be produced by a nation, thereby increasing GDP. This requires private sector spending and investment in the short run to move the cogs of the nation's economy. If this private sector investment is limited in the short run, the effect would be less economic growth than if the private sector had not been crowded out.

Figure 1. Government sector crowding out private sector - StudySmarter

Figure 1 above is a visual representation of what happens to the size of one sector investment in relation to the other. The values in this chart are exaggerated to clearly depict what crowding out looks like. Each circle represents the total of the loanable funds market.

In the left chart, the government sector investment is low, at 5%, and private sector investment is high at 95%. There is a significant amount of blue in the chart. In the right chart, government spending increases, causing the government to increase its borrowing resulting in interest rates increase. Government sector investment now takes up 65% of the available funds, and private sector investment only 35%. The private sector has been crowded out by a relative 60%.

Crowding Out and Government Policy

Crowding out can occur under both fiscal and monetary policy. Under fiscal policy we see an increase in government sector spending resulting in a decrease in private sector investment when the economy is at or close to full capacity. Under monetary policy the Federal Open Market Committee raises or lowers the interest rates and controls the money supply to stabilize the economy.

Crowding out in fiscal policy

Crowding out can occur when fiscal policy is implemented. Fiscal policy focuses on changes in taxation and spending as a way to influence the economy. Budget deficits happen during, but are not limited to, recessions. They can also occur when the government goes over budget on things like social programs or it does not collect as much tax revenue as expected.

When the economy is close to, or at full capacity, then the increase in government spending to cover the deficit will crowd out the private sector since there is no room for expanding one sector without taking away from the other. If there is no more room for expansion in the economy then the private sector pays the price by having less loanable funds available for them to borrow.

During a recession, when unemployment is high and production is not at capacity, the government will implement an expansionary fiscal policy where they also increase spending and lower taxes to encourage consumer spending and investment, which in turn should increase aggregate demand. Here, the crowding out effect would be minimal because there is room for expansion. One sector has room to increase output without taking away from the other.

Crowding out in monetary policy

Monetary policy is a way for the Federal Open Market Committee to control the money supply and inflation. They do this by adjusting the federal reserve requirements, the interest rate on reserves, the discount rate, or through the buying and selling of government securities. With these measures being nominal, and not having a direct link to spending, it can not directly cause the private sector to be crowded out.

However, since monetary policy can directly affect interest rates on reserves, borrowing for banks could become more expensive if monetary policy increases interest rates. Banks then charge higher interest rates on loans in the loanable funds market to compensate, which would discourage private sector investment.

Figure 2. Expansionary fiscal policy in the short run, StudySmarter Originals

Figure 3. Expansionary monetary policy in the short run, StudySmarter Originals

Figure 2 shows that when fiscal policy increases aggregate demand from AD1 to AD2, the aggregate price (P) and aggregate output (Y) also increase, which in turn, increases the demand for money. Figure 3 shows how a fixed money supply will cause crowding out of private sector investment. Unless the money supply is allowed to increase, this rise in demand for money will raise the interest rate from r₁ to r₂, as seen in Figure 3. This will cause a reduction in private investment spending as a result of crowding out.

Examples of Crowding Out Using the Loanable Funds Market Model

Examples of crowding out can be supported by taking a look at the loanable funds market model. The loanable funds market model demonstrates what happens to demand for loanable funds when the government sector increases its spending and goes to the loanable funds market to borrow money from the private sector.

Figure 4. Crowding out effect in the loanable funds market, StudySmarter Originals

Figure 4 above shows the loanable funds market. When the government increases its spending the demand for loanable funds (D_LF) shifts out to the right to D', indicating a total increase in demand for loanable funds. This causes the equilibrium to shift up along the supply curve, indicating an increased quantity demanded, Q to Q₁, at a higher interest rate, R₁.

However, the increase in demand from Q to Q₁ is entirely caused by government spending while private sector spending has remained the same. The private sector now has to pay the higher interest rate, which indicates the decrease or loss in the loanable funds that the private sector had access to before the government spending increased its demand. Q to Q₂ represents the portion of the private sector that was crowded out by the government sector.