What is crowding out effect?

Answer 1

Crowding out effect occurs when governments borrow funds from other countries to finance government spending usually through expansionary fiscal policies.

This is of concern because the government is overspending i.e. revenue that is collected from taxes and other relevant transactions is less than the amount put forward in the budget and more recently, large stimulus packages as what America has done in the past few months of 2009.

When the government borrows from Another Country, interest rate in that country goes up because an increase in demand for loans, hence pushing up the prices. Because the interest rate of the central bank subsequently influences the interest rates of commercial or private banks, this would in turn discourage private borrowing.

Using the Marginal Efficiency Capital Theory, firms with planned investments will choose to postpone them and consumers who have plans of buying large scale durable goods will do likewise.

Hence, the term crowding out: Increase in government spending crowd outs some private borrowing. Again, the severity of the effect is largely determined by the magnitude of the crowding out effect i.e. if the effect was significant, fiscal policies undertaken by governments would largely become ineffective.

We might consider another source of crowding out effect through the FOR-EX markets. Using the same explanation as above, the increase in borrowings of foreign funds raises the interest rates of the central bank and commercial banks. Given that most countries adopt a free capital movement policy, the rise in interest rate makes it attractive for investors to save in that country's financial market. This raises the demand for the country's currency causing it to appreciate which would in turn make imports cheaper and exports more expensive relative to the prices of foreign goods. This increases imports and decreases exports causing net exports to decrease - this is actually a decrease in aggregate demand (AD). Hence, the increase in government spending to boost the economy fails to do so as expected as it crowds out an increase in net exports, even causing it to fall further.

In conclusion, the crowding out effects of fiscal policy must be minimised in order to maximise its effectiveness. Crowding out effect is one of the adverse effects of Keynesian policies; the other being chronic budget deficits. In fact, many economic analysts are fearing that President Obama's fiscal stimulus plan might cause America to suffer huge budget deficits. The issue at hand still remains largely controversial.