Lesson summary: crowding out

In a previous lesson, we learned that fiscal policy can be used to close a recessionary gap. This sounds like great news! A country could just engage in deficit spending and spend its way out of a recession, right?

Not so fast! When countries run budget deficits, they typically pay for them by borrowing money. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out.

Most economists agree that deficit spending is not in itself a problem. In fact, deficit spending might even be necessary during severe recessions. But most economists also recognize the possibility that there may be long-term consequences of deficits and debts. The reduced spending on investment means that a country’s capital stock will not grow as fast. As a result, crowding out can reduce a country’s future potential output.

For example, if a country collects $\mathrm{\$}100$‍ million in taxes and spends $\mathrm{\$}100$‍ million, the budget balance is zero. Sometimes you will also see this referred to being “in balance” rather than “the budget balance is zero.” In either case, this is the formula:

But, if a government spends more than it takes in, it has a deficit. So if tax revenue is $\mathrm{\$}100$‍ million, but government spending is $\mathrm{\$}120$‍ million:

The budget is short $\mathrm{\$}20$‍ million, so the government will need to borrow that money. If the government runs the same deficit every year for three years, it will accrue a debt of $\mathrm{\$}60$‍ million:

There are two points of view on how deficits impact the market for loanable funds:

We can show each of these assumptions graphically:

If you want to spend $\mathrm{\$}50$‍ on pizzas, but you only have $\mathrm{\$}10$‍, you can’t afford it unless you take out a loan. Governments have an advantage you do not, though, in that they can print money. However, this is a tactic that governments rarely take because it leads to inflation or even hyperinflation. Instead, just like you, governments borrow money.

What if you want to borrow $\mathrm{\$}40$‍ and the government wants to borrow $\mathrm{\$}50$‍, but there is only $\mathrm{\$}60$‍ available to borrow? Now you and the government are competing to buy something that is scarce, which will drive prices up. As the real interest rate goes up, you decide you don’t really need a pizza that much. As a result of the government competing with you, and with any other private borrower, the interest rate goes up, and there is less private spending.

Your pizza dilemma illustrates the crowding out effect: when governments borrow it crowds out private sector borrowing. Less of that borrowing means less investment spending and interest-sensitive consumption in the short run.

Ultimately, the extent of crowding out depends on whether the economy can accommodate additional borrowing. If an economy is in a recession, there is less private investment spending to compete with, and crowding out is less of a concern. On the other hand, if an economy is near full employment output, there is likely to be more private investment; as a result, there is more potential for crowding out.

Long-run crowding out might slow the rate of capital accumulation. Recall that part of investment spending is businesses buying new equipment, and businesses usually borrow money to do that spending on new equipment. Therefore higher interest rates mean less borrowing, and less borrowing means less equipment (in other words capital) is purchased.

If there is less borrowing, less capital accumulation will occur. More capital contributes to an economy’s ability to produce goods and services in the long run. Therefore, a potential long-run impact of deficits and debts is a slower rate of economic growth because the deficit has crowded out private investment in capital.

Sometimes new learners confuse the terms deficit and debt. Deficits are a shortage of funds in any given year. Debts are shortages that have accumulated over many years. A mnemonic that might help keep them straight is that de$b$‍t $b$‍uilds up but de$f$‍icits are $f$‍or right now.

Elistan is currently operating below full employment.

PART 1. Draw a correctly labeled graph of the aggregate supply-aggregate demand model and label i) current output as Y_1, ii) the current price level as PL_1, and iii) the potential output as Y_f

PART 2: Assume policymakers decide to use fiscal policy to close the output gap. The marginal propensity to consume is $0.75$‍ and the output gap is $\mathrm{\$}120$‍ million. Calculate the minimum change in government spending required to close this output gap.

PART 3: If the government decides to lower taxes to close this gap, with the change in taxes be greater than, less than, or equal to the change in government spending? Explain.

PART 4: Suppose the government incurs a budget deficit as a result of the change in fiscal policy. Show the impact of the deficit on interest rate in the market for loanable funds.

PART 5: As a result of the change in the interest rate you showed in part 4, what will happen to Elistan’s production possibilities curve in the long run? Explain.