Monday, April 27, 2009

On the crowding out effect - ideas for a short essay

Darlings, in two weeks you will be taking HP1 and HP2 (and SP1, of course). I hope you are doing the work you are expected to do and that you are not sipping your soft drink on a beach....

Here are some ideas on crowding out that you may find useful. Many past IB economics examinations have focused on the issue so it is a good idea to have understood the logic of it. For example there has been this short essay:

Explain how an increase in government spending can lead to crowd-ing out.

Here are a few points to consider. Onnce again, this is NOT a model answer. If you are not my students, please follow the advice of your own teacher.

The essay together with the diagrams can be found at our wiki space if you click here.

Expansionary fiscal policy refers to increases in government expenditures and / or decreases in taxes in order to increase aggregate demand (defined as…) and thus increase economic activity and lower unemployment.

The increase in government spending is by many thought to be a powerful tool to lift an economy out of recession (defined as…). The current Obama stimulus plan whereby the US government is spending an extra 787 billion dollars is an example of such a policy (note that using an example is always a good idea). The expected increase in national income is larger as a result of the multiplier effect. The multiplier effect results from the fact that one’s spending is another person’s income as well as that economic activity takes place in successive rounds.

'Monetarists', on the other hand, claim that the increase in government expenditures is not as effective as described above as a result of the crowding out effect.

The extra spending will have to be somehow financed. In the loanable funds market the demand for loanable funds will thus increase as illustrated in diagram 1 below from D1 to D2. This extra demand for funds by the government will put pressure on the interest rate (the ‘price’ for using such funds) to increase. Since private investment (I) (defined as spending by firms on capital goods per period) is inversely related to the interest rate, it may decrease (diagram 2).

Aggregate demand which includes C + I + G +NX will thus tend to increase as a result of the increased G but tend to decrease as a result of the lower I. The net effect is that either AD will increase but by less than what the multiplier predicts (to AD’ instead of AD2 in diagram 3) or that it may not increase at all if private investment is completely crowded out.

The extent of the increase in interest rates is not necessarily large as a country may borrow from a much larger globalized loanable funds market (i.e. from foreigners). Also, the responsiveness of investment spending to the change in interest rates is important because if investments depend mostly on expectations any decrease will be small. Lastly, the type of government spending financed is important as if the government uses the funds to spend on infrastructure, education and health then there will be positive long run supply-side effects.

In addition to the above described 'financial crowding' out that works through the change in interest rates there is also the possibility of 'resource crowding' out. The increase in government spending implies that the government will command (use) more scarce resources (more labor, more capital) so less will remain available for the private sector (i.e. private firms) to use.

Hope this helps a bit!

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