Crowding Out: Meaning, Types and Views | Monetary Economics

In this article we will discuss about:- 1. Meaning of Crowding Out 2. Types of Crowding Out 3. Views of Monetarists and Keynesians on the Crowding Out Effect.

Meaning of Crowding Out:

The term “crowding out” refers to the reduction in private expenditures on consumption and investment caused by an increase in government expenditure which increases aggregate demand and hence interest rates. The amount by which private expenditures fall with a given increase in government expenditure is called the crowding out effect.

When government expenditure displaces or crowds out an equal amount of private expenditure, the crowding out effect is said to be complete or total. On the contrary, the government expenditure may reduce private expenditure by less than the increase in government expenditure, then the crowding out effect is partial or incomplete. If private expenditures do not fall at all with increase in government expenditure, the crowding out effect is zero.

Types of Crowding Out:

Crowding out is of three types – physical, fiscal and financial.

We discuss them as under:

1. Physical Crowding Out:

Physical crowding out occurs when the government demand for factors and inputs increases in the event of their inelastic supply. This raises their prices and makes private investment schemes unviable and unprofitable thereby reducing private expenditure.

Thus physical crowding out results from a shortage of real productive resources. For example, the government increases direct public sector expenditure by starting new industries. It pays higher wages to attract technical experts from private sector industries and increases the demand for other resources, thereby reducing private investment.

If the economy is at full employment level, any rise in government expenditure will inevitably crowd out an equal amount of private expenditure. Such a situation is depicted in Fig. 1 in terms of the IS-LM model. The original full employment equilibrium is at Y_F .The increase in public sector investment shifts the IS curve to the right to IS₁.

This increases the demand for labour and other resources which are in inelastic supply. As a result, their prices rise which require larger transactions balances. The rise in prices will continue till the LM curve shifts to the left as LM₁ and intersects the IS curve at E₂Thus the interest rate is raised to R₂ which crowds out private investment.

Physical crowding out is a temporary and short run phenomenon. In the long run, there is the possibility of increasing real resources. The government can also stimulate private investment by selective industrial subsidies and adopting appropriate fiscal and monetary measures.

2. Fiscal Crowding Out:

Fiscal crowding out occurs when a rise in government expenditure from a budget deficit raises aggregate demand. Given a constant money supply, the interest rate rises. The stimulative effect of government deficit (or expenditure) will crowd out in greater or lesser degree a certain amount of private investment. The fiscal crowding out is usually explained in terms of the Keynesian analysis.

The mechanism is that the rise in government expenditure raises the aggregate demand. This sets in motion the multiplier process which raises nominal income. The rise in nominal income requires more money for transaction purposes. Further as investment increases, the demand for labour also rises which increases wages and prices.

The degree to which prices rise depends on the extent of the unemployment prevailing in the economy. The nearer is the economy to the level of full employment level, the higher will be the price level. When the economy is in full employment, the price level rises in proportion to the increase in government expenditure.

The rise in the price level leads to the rise in nominal income which, in turn, diverts money balances for transactions purposes and decreases the quantity of money available for speculative purposes. As the money supply is fixed, the residual money supply contracts and interest rates rise.

The rise in interest rates causes a fiscal crowding out of private investment with the increase in government expenditure. In a full employment situation, the fiscal crowding out is complete because government expenditure equals private expenditure which it displaces. If there is liquidity trap, there is no crowding out.

The fiscal crowding out is explained diagrammatically in Figure 2 where the rise in government expenditure is shown by the shifting of the IS curve to the right to IS₁ when this curve intersects the rising LM curve at E₂ Since the money supply is constant, the equilibrium level of the economy rises from E₁ to E₂ .The multiplier process raises the income level from OY₁to OY₂ and the interest rate from R₁ to R₂ Higher interest rate crowds out a certain amount of private investment.

3. Financial Crowding Out:

Financial crowding out occurs when the government increases its expenditure and finances it by selling new bonds in the money market. When the government sells bonds, the prices of securities fall and interest rates rise.

As a result, the private sector postpones or curtails some schemes because obtaining funds has become dearer. Thus the government expenditure crowds out private investment spending. Total financial crowding out occurs when the bond-financed government expenditure equals the same amount of displaced private investment.

Financial crowding out may occur in the following ways:

(1) Purchase of Gilt-edged Securities by Banks:

Private investment may be crowded out when banks buy gilt-edged securities and reduce the sanction of new loans to the private sector. Banks are attracted by such securities because the government offers higher returns in order to sell them.

(2) Competition with Private Sector Bonds:

When government bonds are sold in the market to finance government expenditure, they compete with bonds being sold to finance private investment. This leads to a rise in interest rates. Higher interest rates are assumed to have no effect in reducing the planned increase in government spending. It is only the financing of private investment which is crowded out.

(3) Wealth Effect:

When the government sells bonds, their buyers feel wealthier than before because they expect to have more resources available for consumption in future. But the incomes of these purchasers of bonds is reduced which lead to the curtailment of their present consumption expenditures which adversely affect private investment.

(4) Cut in Taxes:

There is another way for interest rates to rise and crowd out private investment. The government may cut taxes in order to create a budget deficit or to increase the size of the existing budget. The tax cut raises the consumption schedule which raises total output and income. People will like to hold more money in order to maintain the normal ratio of money to income. They will try to increase their money stocks by selling securities which will raise interest rates. Higher interest rates will crowd out private investment.

(5) Confidence Effects:

Private expenditure may also be crowded out by what are now called “confidence effects”. The confidence effects may be macro or micro. It was Keynes who suggested in his General Theory at the macro level that the government programme may through its effect on “confidence”, increase liquidity preference or diminish the marginal efficiency of capital, which again may retard other investment on the part of firms.

This is the macro level confidence effect. Suppose a firm expects to benefit from the closure of a rival firm which is running into losses. But the government gives subsidy to the loss-making firm. So the first firm cancels its plan of making extra investment to cater to expected expansion of the market. This is the micro level confidence effect which crowds out private investment.

Conclusion:

Arestis in his study of the crowding out effect on the UK economy came to the conclusion that government expenditure crowds out private expenditure only if it is tax-financed. But in the bond- financed case, there is no crowding out of private investment.

Views of Monetarists and Keynesians on the Crowding Out Effect:

The term crowding out refers to the reduction in private expenditure (or investment) caused by an increase in government expenditure through deficit budget via a tax cut or increased money supply or bond issue. An increase in government expenditure raises aggregate demand, national income and interest rates thereby reducing private investment. This is called the crowding effect of fiscal policy.

The Keynesian and monetarists differ on the effects of budget deficit on the crowding out effect. The main difference between the two arises from the fact that the Keynesians emphasise on “first-round” (short- run) effects which show “once-for-all-shift” of the IS curve, whereas the monetarists emphasise the “ultimate (long-run) effects”.

The Keynesian crowding out theory states that when the government resorts to deficit financing by issuing new bonds, its spending increases. National income rises. If the money supply is held constant people will need more money for business which will raise the rate of interest. A higher rate of interest will crowd out (reduce) private investment spending. These are the first-round effects which are explained in Fig. 3 where E₁ is the initial equilibrium position.

The rise in government expenditure financed by issuing bonds shifts the IS₁ curve rightward to IS₂ on a “once-for-all” basis and it cuts the LM curve at point E₂ .Since the money supply is constant, E₂ is the new equilibrium level of the economy. The multiplier process raises the income level from Y₁to Y₂ and the interest rate from R₁to R₂ Higher interest rate crowds out a certain amount of private investment.

The Keynesians hold that a deficit financed by printing notes (money creation) is more expansionary than bond-financed. But they do not believe that the reduction in private expenditure caused
by a higher interest will completely offset the increased government expenditure. In other words, the crowding out of private investment will not be full.

The reason for this is that a high interest rate has dual effects. First, it reduces private spending. Second, a high interest rate leads people to economise on cash balances. They, therefore, divert idle cash holdings for transactions purposes. That is why crowding out of private investment is only partial. On the other hand, Friedman emphasises the ultimate effects of a budget deficit (whether bond- financed or money financed) by taking account of the wealth effect.

When the government increases its expenditure by selling bonds in the market, their buyers feel themselves wealthier than before. The reason is that they expect to have more resources available for consumption and other purposes in future. As a result, they tend to increase the demand for money which shifts the LM curve leftward. This analysis assumes that bonds issued by the government are considered as wealth. Further, both the demand for money and expenditure on consumption are positively related to wealth.

Suppose the government increases its expenditure with bond- financed budget deficit. As a result, the public expenditure on buying bonds also increases. The rise in public expenditure shifts the IS₁ curve rightward to IS₂ in Fig. 4 on a “once-for-all basis”. This “first- round” effect raises the level of national income from Y, to Y₂, given the LM schedule.

The increase in national income, in turn, raises the demand for money and the purchase of government bonds by the public further raises the demand for money due to the wealth effect. As the LM₁ curve shifts leftward to LM₂ and the IS₂ curve shifts rightward to IS₃ so that the ultimate equilibrium is established at the initial level of income Y₁.

According to Friedman, the rise in interest rate to R₃ reduces private investment so that bond-financed government expenditure crowds out private investment. But the total expenditure remains unchanged and fiscal policy has no expansionary effect on national income.

If the budget deficit is money-financed, it will have an expansionary effect. This is because increase in money supply is greater than the wealth effect on the demand for money. In this case, the LM_: curve shifts rightward to LM₂, as shown in Fig. 5.

The increase in government expenditure shifts the IS₁ curve rightward to IS₂. The first-round effect raises the level of income from Y₁ to Y₂. According to Friedman, in a money-financed deficit, the money stock continues to grow and the LM curve continues to shift to the right causing falling interest rates.

In this case, the LM schedule exerts a dominant influence on subsequent changes in income than the IS schedule. The ultimate (long- run) equilibrium is shown with the shifting of the IS₂ curve rightward to IS₄ and also of the LM₂ curve rightward to LM₄ so that Y₄ equilibrium income level is established. The rate of interest has fallen from Y₂E₂ to Y₄E₄. Thus money- financed deficit is expansionary and it does not crowd out private investment.

Blinder and Solow have criticised Friedman’s crowding out model of debt-financed deficit for ignoring interest payments on outstanding debt. They point out that the government has not only to finance the budget deficit but also interest payments on outstanding debt.

They have shown that if private expenditure and demand for money are subject to wealth effects, then the IS and LM curves will be shifting from period to period and the short-run equilibrium will differ from the long-run equilibrium depending upon whether the budget is bond-financed or money-financed.

The short-run and long-run equilibrium situations in the case of bond-financed budget deficit are shown in Figure 6 (A). The rise in government expenditure as a result of bond- financed deficit shifts the 7S₁ curve rightward to IS₂. This shift is due to both the increase in government expenditure and rise in private expenditure following the wealth effect of bonds.

The LM₁ curve shifts leftward to LM₂ as a result of wealth effect which increases the demand for money. This raises the short-run equilibrium level of income from Y₁ to Y₂.

If the budget deficit is money financed creation, the increase in government expenditure is once-for-all increase in the short- run so that the IS₁ curve shifts rightward to IS₂ by the same extent, in Panel (B) of the figure. But the increase in the supply of money being greater than the wealth-induced increase in the demand for money, the LM₁ curve shifts rightward to LM’₂ in Panel (B).

This raises the short-run equilibrium level of income from Y’₁ to Y’2 . A comparison of the bond-financed and money-financed situations shows that money-financed income level Y’₂ is greater than the bond-financed level Y₂. This is because the increase in money supply lowers the interest rate form Y’₁ E₁ to Y’₂ E₂, in Panel (B). Hence money-financed deficit is more expansionary and it does not crowd out private investment. On the other hand, the bond-financed deficit raises the interest rate from Y₁ E₁ to Y₂ E₂ when the national income rises to Y₂ in Panel (A). It is also expansionary but it crowds out a part of private investment.

In the long-run, bond-financing is more expansionary than money-financing. This is because when “deficits are bond- financed, income must rise sufficiently to produce tax receipts (at given tax rates) that not only match the increased government expenditure on goods and services, but also cover the interest payments on the increased government debt. If deficits are, on the other hand, money financed, long-run equilibrium is established when income has merely risen sufficiently to produce tax revenues that each match the increased expenditure on goods and services.” Figure 6 (A) shows the bond-financed situation.

When in the long-run the IS₂ curve shifts to IS₆ and the LM₂ curve to LM₆, the new equilibrium level of income is set at Y₆. The money-financed situation is shown in Panel (B) where in the long- run the IS’₂ curve shifts to IS₄ and LM’₂ curve to LM’₄ and the new equilibrium is established at Y’₄ income level. As is clear from the two figures, Y₆ income level is greater than Y’₄ level.

The above analysis shows that the long-run effect of increased bond-financed government deficit is more expansionary but it crowds out private investment because the rate of interest rises sufficiently high. But the money-financed deficit though less expansionary than the former, it does not crowd out private investment through wealth effects.