December, 2011 | The Economics Classroom

Fiscal Policy – another interpretation of the Crowding-out Effect

In our first lesson on the crowding-out effect we examined the impact that deficit-financed government spending may have on the demand for private loanable funds in the economy. A government’s need to borrow to pay for a fiscal policy drives up private interest rates and could, therefore, crowd-out private investment and consumption, making the fiscal policy less effective at stimulating economic activity.

In this lesson we’ll examine another interpretation of the crowding-out effect, which says the supply of funds available in the private sector will decrease when a government deficit spends, due to the fact that government must offer higher interest rates on its debt, making saving in the private banking system less attractive to households. The supply of loanable funds will therefore decrease, driving up private interest rates and reducing the quantity of investment and consumption among households. The end result is the same: government spending is “crowded-out” by a decline in private spending, rendering the fiscal policy less effective than desired.

 

Once you’ve watched this video, learn more about the crowding-out effect by reading one of the following blog posts and responding to the discussion questions included:

Fiscal Policy – the Crowding-out Effect

Previous lessons on fiscal policy have explored the multiplier effects resulting from increases in government spending and decreases in taxes. This video will examine the possibility that expansionary fiscal policy, when financed by a budget deficit, will actually result in less private sector spending, i.e. “crowding-out” of the private sector. When governments borrow to pay for a stimulus, this drives up borrowing costs for households and firms, reducing the amount of consumption and investment. The crowding-out effect reduces the effectiveness of expansionary policies aimed at increasing the total demand for a nation’s output.

Once you’ve watched this video, learn more about the crowding-out effect by reading one of the following blog posts and responding to the discussion questions included: